UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

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 September 30, 2011

or

o TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from         to         

Commission file number: 001-33437

KKR FINANCIAL HOLDINGS LLC

(Exact name of registrant as specified in its charter)

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

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

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

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

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

Large accelerated filer x	Accelerated filer o
Non-accelerated filer o (Do not check if a smaller reporting company)	Smaller reporting company o

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

The number of shares of the registrant’s common shares outstanding as of October 28, 2011 was 178,145,482.

TABLE OF CONTENTS

		Page
Part I.
FINANCIAL INFORMATION
Item 1.	Financial Statements	3
Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	35
Item 3.	Quantitative and Qualitative Disclosures about Market Risk	64
Item 4.	Controls and Procedures	64
Part II.
OTHER INFORMATION
Item 1.	Legal Proceedings	64
Item 1A.	Risk Factors	64
Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds	65
Item 3.	Defaults Upon Senior Securities	65
Item 4.	(Removed and Reserved)	65
Item 5.	Other Information	66
Item 6.	Exhibits	66

2

PART I.    FINANCIAL INFORMATION

Item 1. Financial Statements

KKR Financial Holdings LLC and Subsidiaries

Condensed Consolidated Balance Sheets

(Unaudited)

(Amounts in thousands, except share information)

	September 30, 2011			December 31, 2010
Assets
Cash and cash equivalents	$	137,309		$	313,829
Restricted cash and cash equivalents	321,734			571,425
Securities available-for-sale, $690,336 and $728,558 pledged as collateral as of September 30, 2011 and December 31, 2010, respectively	786,195			838,894
Corporate loans, net of allowance for loan losses of $191,407 and $209,030 as of September 30, 2011 and December 31, 2010, respectively	6,115,948			5,857,816
Corporate loans held for sale	500,490			463,628
Residential mortgage-backed securities, at estimated fair value	88,209			93,929
Equity investments, at estimated fair value, $13,410 and $12,036 pledged as collateral as of September 30, 2011 and December 31, 2010, respectively	170,175			99,955
Derivative assets	26,066			19,519
Interest and principal receivable	59,917			57,414
Other assets	209,861			102,003
Total assets	$	8,415,904		$	8,418,412
Liabilities
Collateralized loan obligation secured debt	$	5,596,020		$	5,630,272
Collateralized loan obligation junior secured notes to affiliates	365,848			366,124
Credit facilities	38,300			18,400
Convertible senior notes	299,877			344,142
Junior subordinated notes	283,517			283,517
Accounts payable, accrued expenses and other liabilities	52,596			14,193
Accrued interest payable	15,987			22,846
Accrued interest payable to affiliates	7,579			6,316
Related party payable	3,687			12,988
Derivative liabilities	123,957			76,566
Total liabilities	6,787,368			6,775,364
Shareholders’ Equity
Preferred shares, no par value, 50,000,000 shares authorized and none issued and outstanding at September 30, 2011 and December 31, 2010	—			—
Common shares, no par value, 500,000,000 shares authorized, and 178,145,482 and 177,848,565 shares issued and outstanding at September 30, 2011 and December 31, 2010, respectively	—			—
Paid-in-capital	2,758,891			2,756,200
Accumulated other comprehensive (loss) income	(37,413		)	133,596
Accumulated deficit	(1,092,942		)	(1,246,748		)
Total shareholders’ equity	1,628,536			1,643,048
Total liabilities and shareholders’ equity	$	8,415,904		$	8,418,412

See notes to condensed consolidated financial statements.

3

KKR Financial Holdings LLC and Subsidiaries

Condensed Consolidated Statements of Operations

(Unaudited)

(Amounts in thousands, except per share information)

	For the three months ended September 30, 2011			For the three months ended September 30, 2010		For the nine months ended September 30, 2011			For the nine months ended September 30, 2010
Net investment income:
Loan interest income	$	104,197		$	96,814	$	316,498		$	282,812
Securities interest income	20,143			25,406		64,772			79,067
Other investment income	10,100			29		24,343			2,086
Total investment income	134,440			122,249		405,613			363,965
Interest expense	32,604			30,051		97,703			100,402
Interest expense to affiliates	12,688			5,791		38,926			17,072
Provision for loan losses	2,533			8,087		14,194			8,087
Net investment income	86,615			78,320		254,790			238,404
Other (loss) income:
Net realized and unrealized (loss) gain on investments	(24,531		)	19,441		73,194			83,047
Net realized and unrealized (loss) gain on derivatives and foreign exchange	(7,603		)	3,831		(295		)	(3,437		)
Net realized and unrealized gain (loss) on residential mortgage-backed securities, residential mortgage loans, and residential mortgage-backed securities issued, carried at estimated fair value	2,274			1,492		2,145			(7,764		)
Net (loss) gain on restructuring and extinguishment of debt	(1,736		)	—		(1,736		)	39,999
Other income	2,290			1,863		6,400			9,085
Total other (loss) income	(29,306		)	26,627		79,708			120,930
Non-investment expenses:
Related party management compensation	8,198			17,551		53,714			52,518
General, administrative and directors expenses	8,554			3,561		27,092			10,127
Professional services	1,134			1,041		4,257			3,335
Total non-investment expenses	17,886			22,153		85,063			65,980
Income before income tax expense	39,423			82,794		249,435			293,354
Income tax (benefit) expense	(397		)	452		8,344			489
Net income	$	39,820		$	82,342	$	241,091		$	292,865
Net income per common share:
Basic	$	0.22		$	0.52	$	1.35		$	1.85
Diluted	$	0.22		$	0.52	$	1.32		$	1.85
Weighted-average number of common shares outstanding:
Basic	177,723			157,057		177,493			157,018
Diluted	180,220			157,461		181,304			157,294

See notes to condensed consolidated financial statements.

4

KKR Financial Holdings LLC and Subsidiaries

Condensed Consolidated Statements of Changes in Shareholders’ Equity

(Unaudited)

(Amounts in thousands)

	Common Shares		Paid-In Capital			Accumulated Other Comprehensive Income (Loss)			Accumulated Deficit			Comprehensive Income			Total Shareholders’ Equity
Balance at January 1, 2011	177,849		$	2,756,200		$	133,596		$	(1,246,748	)				$	1,643,048
Net income	—		—			—			241,091			$	241,091		241,091
Net change in unrealized loss on cash flow hedges	—		—			(42,463		)	—			(42,463		)	(42,463		)
Net change in unrealized gain on securities available-for-sale	—		—			(128,546		)	—			(128,546		)	(128,546		)
Comprehensive income	—		—			—			—			$	70,082
Cash distributions on common shares	—		—			—			(87,285		)				(87,285		)
Issuance of common shares	171		1,297			—			—						1,297
Grant of restricted common shares	291		—			—			—						—
Cancellation of restricted common shares	(25	)	—			—			—						—
Repurchase and cancellation of common shares	(141	)	(1,297		)	—			—						(1,297		)
Share-based compensation expense related to restricted common shares	—		2,691			—			—						2,691
Balance at September 30, 2011	178,145		$	2,758,891		$	(37,413	)	$	(1,092,942	)				$	1,628,536

See notes to condensed consolidated financial statements.

5

KKR Financial Holdings LLC and Subsidiaries

Condensed Consolidated Statements of Cash Flows

(Unaudited)

(Amounts in thousands)

	For the ninemonths endedSeptember 30, 2011			For the ninemonths endedSeptember 30, 2010
Cash flows from operating activities:
Net income	$	241,091		$	292,865
Adjustments to reconcile net income to net cash provided by operating activities:
Net realized and unrealized loss on derivatives and foreign exchange	295			4,695
Net loss (gain) on restructuring and extinguishment of debt	1,736			(39,999		)
Write-off of debt issuance costs	1,977			8,160
Lower of cost or estimated fair value adjustment on corporate loans held for sale	56,165			21,362
Provision for loan losses	14,194			8,087
Impairment on securities available-for-sale and private equity investments at cost	2,619			9,979
Share-based compensation	2,691			5,338
Net unrealized (gain) loss on residential mortgage-backed securities, residential mortgage loans, and residential mortgage-backed securities issued, carried at estimated fair value	(2,145		)	7,764
Net realized and unrealized gain on investments	(131,978		)	(115,144		)
Deferred interest expense	—			4,427
Depreciation and net amortization	(67,588		)	(65,653		)
Changes in assets and liabilities:
Interest receivable	484			8,080
Other assets	9,766			(1,182		)
Related party payable	(9,301		)	9,064
Accounts payable, accrued expenses and other liabilities	11,791			505
Accrued interest payable	(6,859		)	(7,759		)
Accrued interest payable to affiliates	1,263			935
Net cash provided by operating activities	126,201			151,524
Cash flows from investing activities:
Principal payments from corporate loans	1,295,055			970,913
Principal payments from securities available-for-sale	87,676			86,295
Principal payments from residential mortgage-backed securities, at estimated fair value	5,348			11,436
Proceeds from sale of corporate loans	426,181			941,150
Proceeds from sale of securities available-for-sale	146,683			271,560
Proceeds from equity investments	14,457			123,047
Proceeds from securities sold, not yet purchased	41,095			—
Purchases of corporate loans	(2,022,446		)	(1,853,100		)
Purchases of securities available-for-sale	(203,314		)	(352,526		)
Purchases of equity and other investments	(153,355		)	(20,091		)
Cover securities sold, not yet purchased	(39,320		)	(78,727		)
Net proceeds, purchases, and settlements of derivatives	1,201			12,740
Net change in reverse repurchase agreements	—			80,250
Net change in restricted cash and cash equivalents	250,005			(22,514		)
Net cash (used in) provided by investing activities	(150,734		)	170,433
Cash flows from financing activities:
Issuance of collateralized loan obligation secured debt	439,409			—
Retirement of collateralized loan obligation secured debt	(474,723		)	(104,510		)
Retirement of collateralized loan obligation junior secured notes to affiliates	(276		)	(62,581		)
Repayment of credit facilities	—			(227,805		)
Proceeds from credit facilities	19,900			50,319
Proceeds from convertible senior notes	—			167,325
Repayment of convertible senior notes	(46,833		)	(93,922		)
Distributions on common shares	(87,285		)	(45,931		)
Issuance of common shares	1,297			—
Repurchase and cancellation of common shares	(1,297		)	—
Other capitalized costs	(2,179		)	(4,947		)
Net cash used in financing activities	(151,987		)	(322,052		)
Net decrease in cash and cash equivalents	(176,520		)	(95		)
Cash and cash equivalents at beginning of period	313,829			97,086
Cash and cash equivalents at end of period	$	137,309		$	96,991
Supplemental cash flow information:
Cash paid for interest	$	117,656		$	99,308
Net cash paid for income taxes	$	1,235		$	580
Non-cash investing and financing activities:
Deconsolidation of residential mortgage loans	$	—		$	2,034,772
Deconsolidation of residential mortgage-backed securities issued	$	—		$	(2,034,772	)
Subordinate tranche of the residential mortgage loan securitization trusts included in residential mortgage-backed securities	$	—		$	74,366
Equity component of the convertible senior notes	$	—		$	9,973
Loans transferred from held for investment to held for sale	$	817,924		$	936,110
Loans transferred from held for sale to held for investment	$	376,971		$	272,206

See notes to condensed consolidated financial statements.

6

KKR Financial Holdings LLC and Subsidiaries

Notes to Condensed Consolidated Financial Statements

Note 1. Organization

KKR Financial Holdings LLC together with its subsidiaries (the “Company”) is a specialty finance company with expertise in a range of asset classes. The Company’s core business strategy is to leverage the proprietary resources of its manager with the objective of generating both current income and capital appreciation by deploying capital to its strategies, which include bank loans and high yield securities, mezzanine, special situations, natural resources, commercial real estate and private equity. The Company’s holdings across these strategies primarily consist of below investment grade syndicated corporate loans, also known as leveraged loans, high yield debt securities and private equity. The corporate loans that the Company holds are purchased via assignment or participation in the primary or secondary market. In addition to the financial instruments the Company holds across its strategies, the Company deploys capital to both working and royalty interests in oil and gas properties through its natural resources strategy.

The majority of the Company’s holdings consist of corporate loans and high yield debt securities held in collateralized loan obligation (“CLO”) transactions that are structured as on-balance sheet securitizations and are used as long term financing for the Company’s investments in corporate debt. The senior secured debt issued by the CLO transactions is generally owned by unaffiliated third party investors and the Company owns the majority of the mezzanine and subordinated notes in the CLO transactions. The Company executes its core business strategy through its majority-owned subsidiaries, including CLOs.

KKR Financial Advisors LLC (the “Manager”), a wholly-owned subsidiary of KKR Asset Management LLC, manages the Company pursuant to a management agreement (the “Management Agreement”). KKR Asset Management LLC is a wholly-owned subsidiary of Kohlberg Kravis Roberts & Co. L.P. (“KKR”).

Note 2. Summary of Significant Accounting Policies

Basis of Presentation

The accompanying condensed consolidated financial statements have been prepared in conformity with accounting principles generally accepted in the United States of America (“GAAP”). The condensed consolidated financial statements include the accounts of the Company and entities established to complete secured financing transactions that are considered to be variable interest entities and for which the Company is the primary beneficiary.

These condensed consolidated financial statements should be read in conjunction with the consolidated financial statements and notes thereto included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2010. The Company’s results for any interim period are not necessarily indicative of results for a full year or any other interim period. In the opinion of management, all normal recurring adjustments have been included for a fair statement of this interim financial information.

Use of Estimates

The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the amounts reported in the Company’s condensed consolidated financial statements and accompanying notes. Actual results could differ from management’s estimates.

Consolidation

Effective January 1, 2010, the Company adopted new accounting guidance which amended the accounting for the transfers of financial assets, eliminated the concept of a qualified special purpose entity and significantly changed the criteria by which an enterprise determines whether or not it must consolidate a variable interest entity (“VIE”). Under the new accounting guidance, consolidation of a VIE requires both the power to direct the activities that most significantly impact the VIE’s economic performance and the obligation to absorb losses of the VIE or the right to receive benefits of the VIE that could potentially be significant to the VIE.

As a result of the adoption of the new accounting guidance regarding the amended consolidation model based on power and economics, the Company determined that six residential mortgage loan securitization trusts, which were previously consolidated by the Company as it was deemed to be the primary beneficiary, were required to be deconsolidated. The Company determined that it did not have the power to direct the activities that most significantly impact the economic performance of the securitization trusts or the performance of the securitization trusts’ underlying assets as the Company was never the servicer of the trusts nor did it participate in

7

any servicing activities. Accordingly, the Company determined that it was no longer the primary beneficiary of the six securitization trusts under the new accounting guidance and deconsolidated them as of January 1, 2010. This resulted in the reduction of both assets and liabilities of approximately $2.0 billion. In addition, loan interest income, interest expense, loan servicing expense, and net unrealized and realized gain (loss) associated with the residential mortgage loan securitization trusts are no longer reported on the Company’s condensed consolidated financial statements. The deconsolidation of the six residential mortgage loan securitization trusts had no net impact on the Company’s shareholders’ equity, results of operations and cash flows. Refer to Note 6 to these condensed consolidated financial statements for the impact of the deconsolidation.

KKR Financial CLO 2005-1, Ltd. (“CLO 2005-1”), KKR Financial CLO 2005-2, Ltd. (“CLO 2005-2”), KKR Financial CLO 2006-1, Ltd. (“CLO 2006-1”), KKR Financial CLO 2007-1, Ltd. (“CLO 2007-1”), KKR Financial CLO 2007-A, Ltd. (“CLO 2007-A”), KKR Financial CLO 2009-1, Ltd. (“CLO 2009-1”) and KKR Financial CLO 2011-1, Ltd. (“CLO 2011-1”) are entities established to complete secured financing transactions. These entities are VIEs which the Company consolidates as the Company has determined it has the power to direct the activities that most significantly impact these entities’ economic performance and the Company has both the obligation to absorb losses of these entities and the right to receive benefits from these entities that could potentially be significant to these entities. In CLO transactions, subordinated notes have the first risk of loss and conversely, the residual value upside of the transactions. These CLOs are considered non-recourse leverage to the Company.

The Company finances the majority of its corporate debt investments through its CLOs. Since all of the debt of CLO 2009-1 was retired in July 2009, CLO 2009-1 is excluded from the discussion below. As of September 30, 2011, the Company’s six CLOs, which excluded CLO 2009-1, held $7.6 billion par amount, or $6.8 billion estimated fair value, of corporate debt investments. As of December 31, 2010, the Company’s five CLOs, which excluded CLO 2009-1, held $7.1 billion par amount, or $6.8 billion estimated fair value, of corporate debt investments. The assets in each CLO can be used only to settle the debt of the related CLO. As of September 30, 2011, the aggregate CLO debt totaled $5.6 billion of secured debt outstanding held by unaffiliated third parties and $365.8 million of junior notes outstanding held by an affiliate of the Manager. As of December 31, 2010, the aggregate CLO debt totaled $5.6 billion of secured debt outstanding held by unaffiliated third parties and $366.1 million of junior notes outstanding held by an affiliate of the Manager.

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

All inter-company balances and transactions have been eliminated in consolidation.

Fair Value of Financial Instruments

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

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

The types of assets generally included in this category are equity securities listed in active markets.

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

The types of assets and liabilities generally included in this category are 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 derivatives.

Level 3: Inputs are unobservable inputs for the asset or liability, and include situations where there is little, if any, market activity for the asset or liability. In certain cases, the inputs used to measure 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 fair value measurement in its entirety falls has been determined based on the lowest level input that is significant to the fair value measurement in its entirety. The Company’s assessment of the significance of a particular input to the fair value measurement in its entirety requires judgment and consideration of factors specific to the asset.

8

The types of assets and liabilities generally included in this category are certain corporate debt securities, certain corporate loans held for sale, certain equity investments, at estimated fair value, residential mortgage-backed securities (“RMBS”), at estimated fair value and certain financial instruments classified as derivatives.

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

The availability of observable inputs can vary depending on the financial asset or liability and is affected by a wide variety of factors, including, for example, the type of product, whether the product is new, whether the product is traded on an active exchange or in the secondary market, and the current market condition. To the extent that valuation is based on models or inputs that are less observable or unobservable in the market, the determination of fair value requires more judgment. Accordingly, the degree of judgment exercised by the Company in determining fair value is greatest for instruments categorized in Level 3. In certain cases, the inputs used to measure fair value may fall into different levels of the fair value hierarchy. In such cases, for disclosure purposes, the level in the fair value hierarchy within which the fair value measurement in its entirety falls is determined based on the lowest level input that is significant to the fair value measurement in its entirety. The variability of the observable inputs affected by the factors described above may cause transfers between Levels 1, 2, and/or 3, which the Company recognizes at the end of the reporting period.

Many financial assets and liabilities have bid and ask prices that can be observed in the marketplace. Bid prices reflect the highest price that the Company and others are willing to pay for an asset. Ask prices represent the lowest price that the Company and others are willing to accept for an asset. For financial assets and liabilities whose inputs are based on bid-ask prices, the Company does not require that fair value always be a predetermined point in the bid-ask range. The Company’s policy is to allow for mid-market pricing and adjusting to the point within the bid-ask range that meets the Company’s best estimate of fair value.

Depending on the relative liquidity in the markets for certain assets, the Company may transfer assets to Level 3 if it determines that observable quoted prices, obtained directly or indirectly, are not available. The valuation techniques used for the assets and liabilities that are valued using Level 3 of the fair value hierarchy are described below.

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

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

Over-the-counter (“OTC”) Derivative Contracts:  OTC derivative contracts include forward, swap and option contracts related to interest rates, foreign currencies, credit standing of reference entities, and equity prices. The fair value of OTC derivative products can be modeled using a series of techniques, including closed-form analytic formulae, such as the Black-Scholes option-pricing model, and simulation models or a combination thereof. Many pricing models do not entail material subjectivity because the methodologies employed do not necessitate significant judgment, and the pricing inputs are observed from actively quoted markets, as is the case for generic interest rate swap and option contracts.

Residential Mortgage-Backed Securities, at Estimated Fair Value:  Residential mortgage-backed securities, residential mortgage loans, and residential mortgage-backed securities issued are initially valued at transaction price and are subsequently valued using industry recognized models (including Intex and Bloomberg) and data for similar instruments (e.g., nationally recognized pricing services or broker quotes). The most significant inputs to the valuation of these instruments are default and loss expectations and market credit spreads.

9

Cash and Cash Equivalents

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

Restricted Cash and Cash Equivalents

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

On the condensed consolidated statement of cash flows, net additions or reductions to restricted cash and cash equivalents are classified as an investing activity as restricted cash and cash equivalents reflect the receipts from collections or sales of investments, as well as payments made to acquire investments held by third parties.

Residential Mortgage-Backed Securities

The Company carries its residential mortgage-backed securities at estimated fair value with unrealized gains and losses reported in income. The Company elected the fair value option for its residential mortgage investments for the purpose of enhancing the transparency of its financial condition as fair value is consistent with how the Company manages the risks of its residential mortgage investments.

Securities Available-for-Sale

The Company classifies its investments in securities as available-for-sale as the Company may sell them prior to maturity and does not hold them principally for the purpose of selling them in the near term. These investments are carried at estimated fair value, with unrealized gains and losses reported in accumulated other comprehensive income. Estimated fair values are based on quoted market prices, when available, on estimates provided by independent pricing sources or dealers who make markets in such securities, or internal valuation models when external sources of fair value are not available. Upon the sale of a security, the realized net gain or loss is computed on a weighted average cost basis. Purchases and sales of securities are recorded on the trade date.

The Company monitors its available-for-sale securities portfolio for impairments. A loss is recognized when it is determined that a decline in the estimated fair value of a security below its amortized cost is other-than-temporary. The Company considers many factors in determining whether the impairment of a security is deemed to be other-than-temporary, including, but not limited to, the length of time the security has had a decline in estimated fair value below its amortized cost and the severity of the decline, the amount of the unrealized loss, recent events specific to the issuer or industry, external credit ratings and recent changes in such ratings. In addition, for debt securities, the Company considers its intent to sell the debt security, the Company’s estimation of whether or not it expects to recover the debt security’s entire amortized cost if it intends to hold the debt security, and whether it is more likely than not that the Company will be required to sell the debt security before its anticipated recovery. For equity securities, the Company also considers its intent and ability to hold the equity security for a period of time sufficient for a recovery in value.

The amount of the loss that is recognized when it is determined that a decline in the estimated fair value of a security below its amortized cost is other-than-temporary is dependent on certain factors. If the security is an equity security or if the security is a debt security that the Company intends to sell or estimates that it is more likely than not that the Company will be required to sell before recovery of its amortized cost, then the impairment amount recognized in earnings is the entire difference between the estimated fair value of the security and its amortized cost. For debt securities that the Company does not intend to sell or estimates that it is not more likely than not to be required to sell before recovery, the impairment is separated into the estimated amount relating to credit loss and the estimated amount relating to all other factors. Only the estimated credit loss amount is recognized in earnings, with the remainder of the loss amount recognized in other comprehensive income.

Unamortized premiums and unaccreted discounts on securities available-for-sale are recognized in interest income over the contractual life, adjusted for actual prepayments, of the securities using the effective interest method.

Securities available-for-sale acquired with deteriorated credit quality are recorded at initial cost and interest income is recognized as the difference between the Company’s estimate of all cash flows that it will receive from the loan in excess of its initial investment on a level-yield basis over the life of the loan (accretable yield) using the effective interest method.

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Equity Investments, at Estimated Fair Value

The Company has elected the fair value option of accounting for certain marketable equity securities and private equity investments. The Company elects the fair value option of accounting for private equity investments received through restructuring debt transactions or issued by an entity in which the Company may have significant influence. The Company elected the fair value option for certain equity investments for the purpose of enhancing the transparency of its financial condition as fair value is consistent with how the Company manages the risks of these equity investments. Equity investments, at estimated fair value, are managed based on overall value and potential returns. Investments carried at fair value are presented separately on the condensed consolidated balance sheets with unrealized gains and losses reported in net realized and unrealized gains and losses on investments on the condensed consolidated statements of operations.

Securities Sold, Not Yet Purchased

Securities sold, not yet purchased consist of equity and debt securities that the Company has sold short. In order to facilitate a short sale, the Company borrows the securities from another party and delivers the securities to the buyer. The Company will be required to “cover” its short sale in the future through the purchase of the security in the market at the prevailing market price and deliver it to the counterparty from which it borrowed. The Company is exposed to a loss to the extent that the security price increases during the time from when the Company borrowed the security to when the Company purchases it in the market to cover the short sale. Securities sold, not yet purchased are presented within accounts payable, accrued expenses and other liabilities on the condensed consolidated balance sheet with gains and losses reported in net realized and unrealized gains and losses on investments on the condensed consolidated statement of operations.

Corporate Loans

Corporate loans are generally held for investment and the Company initially records loans at their purchase prices. The Company subsequently accounts for loans based on their outstanding principal plus or minus unaccreted purchase discounts and unamortized purchase premiums. Corporate loans that the Company transfers to held for sale are transferred at the lower of cost or estimated fair value.

Interest income on loans includes interest at stated coupon rates adjusted for accretion of purchase discounts and the amortization of purchase premiums. Unamortized premiums and unaccreted discounts are recognized in interest income over the contractual life, adjusted for actual prepayments, of the loans using the effective interest method.

A loan is typically placed on non-accrual status at such time as: (i) management believes that scheduled debt service payments may not be paid when contractually due; (ii) the loan becomes 90 days delinquent; (iii) management determines the borrower is incapable of, or has ceased efforts toward, curing the cause of the impairment; or (iv) the net realizable value of the underlying collateral securing the loan decreases below the Company’s carrying value of such loan. As such, loans placed on non-accrual status may or may not be contractually past due at the time of such determination. While on non-accrual status, previously recognized accrued interest is reversed if it is determined that such amounts are not collectible and interest income is recognized using the cost-recovery method, cash-basis method or some combination of the two methods. A loan is placed back on accrual status when the ultimate collectability of the principal and interest is not in doubt.

The Company may modify corporate loans in transactions where the borrower is experiencing financial difficulty and a concession is granted to the borrower as part of the modification. These concessions may include a reduction in interest rate, payment extensions, forgiveness of principal, an exchange of assets or a combination thereof. Such modifications typically qualify as troubled debt restructurings.

In addition, the Company may also modify corporate loans which usually involve changes in existing interest rates combined with changes of existing maturities to prevailing market rates/maturities for similar instruments at the time of modification. Such modifications typically do not meet the definition of a troubled debt restructuring since the respective borrowers are neither experiencing financial difficulty nor are seeking a concession as part of the modification.

The corporate loans the Company invests in are generally deemed in default upon the non-payment of a single interest payment or as a result of the violation of a covenant in the respective loan agreement. The Company charges-off a portion or all of its amortized cost basis in a corporate loan when it determines that it is uncollectible due to either: i) the estimation based on a recovery value analysis of a defaulted loan that less than the amortized cost amount will be recovered through the agreed upon restructuring of the loan or as a result of a bankruptcy process of the issuer of the loan; or ii) the determination by the Company to transfer a loan to held for sale with the loan having an estimated market value below the amortized cost basis of the loan.

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Loans acquired with deteriorated credit quality are recorded at initial cost and interest income is recognized as the difference between the Company’s estimate of all cash flows that it will receive from the loan in excess of its initial investment on a level-yield basis over the life of the loan (accretable yield) using the effective interest method.

Corporate Loans Held for Sale

From time to time the Company makes the determination to transfer certain of its corporate loans from held for investment to held for sale. The decision to transfer a loan to held for sale is generally as a result of the Company determining that the respective loan’s credit quality in relation to the loan’s expected risk-adjusted return no longer meets the Company’s investment objective and/or the Company deciding to reduce or eliminate its exposure to a particular loan for risk management purposes. Corporate loans held for sale are stated at lower of cost or estimated fair value and are assessed on an individual basis. Prior to transferring a loan to held for sale, any difference between the carrying amount of the loan and its outstanding principal balance is recognized as an adjustment to the yield by the interest method. The loan is transferred from held for investment to held for sale at the lower of its cost or estimated fair value and is carried at the lower of its cost or estimated fair value thereafter. Subsequent to transfer and while the loan is held for sale, recognition as an adjustment to yield by the interest method is discontinued for any difference between the carrying amount of the loan and its outstanding principal balance.  Interest income on corporate loans classified as held for sale is recognized through accrual of the stated coupon rate for the loans, unless the loans are placed on non-accrual status, at which point previously recognized accrued interest is reversed if it is determined that such amounts are not collectible and interest income is recognized using either the cost-recovery method or on a cash-basis.

Allowance for Loan Losses

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

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

The unallocated component of the Company’s allowance for loan losses represents its estimate of probable losses inherent in the loan portfolio as of the balance sheet date where the specific loan that the loan loss relates to is indeterminable. The Company estimates the unallocated component of the allowance for loan losses through a comprehensive review of its loan portfolio and identifies certain loans that demonstrate possible indicators of impairment, including internally assigned credit quality indicators. This assessment excludes all loans that are determined to be impaired and as a result, an allocated reserve has been recorded as described in the preceding paragraph. Such indicators include, but are not limited to, the current and/or forecasted financial performance and liquidity profile of the issuer, specific industry or economic conditions that may impact the issuer, and the observable trading price of the loan if available. All loans are first categorized based on their assigned risk grade and further stratified based on the seniority of the loan in the issuer’s capital structure. The seniority classifications assigned to loans are senior secured, second lien and subordinate. Senior secured consists of loans that are the most senior debt in an issuer’s capital structure and therefore have a lower estimated loss severity than other debt that is subordinate to the senior secured loan. Senior secured loans often have a first lien on some or all of the issuer’s assets. Second lien consists of loans that are secured by a second lien interest on some or all of the issuer’s assets; however, the loan is subordinate to the first lien debt in the issuer’s capital structure. Subordinate consists of loans that are generally unsecured and subordinate to other debt in the issuer’s capital structure.

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

The Company applies a range of default and loss severity estimates in order to estimate a range of loss outcomes upon which to base its estimate of probable losses that results in the determination of the unallocated component of the Company’s allowance for loan losses.

Borrowings

The Company finances the majority of its investments through the use of secured borrowings in the form of securitization transactions structured as non-recourse secured financings and other secured and unsecured borrowings. In addition, the Company finances certain of its oil and gas asset acquisitions through borrowings. The Company recognizes interest expense on all borrowings on an accrual basis.

Trust Preferred Securities

Trusts formed by the Company for the sole purpose of issuing trust preferred securities are not consolidated by the Company as the Company has determined that it is not the primary beneficiary of such trusts. The Company’s investment in the common securities of such trusts is included in other assets on the Company’s condensed consolidated financial statements.

Derivative Financial Instruments

The Company recognizes all derivatives on the condensed consolidated balance sheet at estimated fair value. On the date the Company enters into a derivative contract, the Company designates and documents each derivative contract as one of the following at the time the contract is executed: (i) a hedge of a recognized asset or liability (“fair value” hedge); (ii) a hedge of a forecasted transaction or of the variability of cash flows to be received or paid related to a recognized asset or liability (“cash flow” hedge); (iii) a hedge of a net investment in a foreign operation; or (iv) a derivative instrument not designated as a hedging instrument (“free-standing derivative”). For a fair value hedge, the Company records changes in the estimated fair value of the derivative instrument and, to the extent that it is effective, changes in the fair value of the hedged asset or liability in the current period earnings in the same financial statement category as the hedged item. For a cash flow hedge, the Company records changes in the estimated fair value of the derivative to the extent that it is effective in other comprehensive (loss) income and subsequently reclassifies these changes in estimated fair value to net income in the same period(s) that the hedged transaction affects earnings. The effective portion of the cash flow hedges is recorded in the same financial statement category as the hedged item. For free-standing derivatives, the Company reports changes in the fair values in other (loss) income.

The Company formally documents at inception its hedge relationships, including identification of the hedging instruments and the hedged items, its risk management objectives, strategy for undertaking the hedge transaction and the Company’s evaluation of effectiveness of its hedged transactions. Periodically, the Company also formally assesses whether the derivative it designated in each hedging relationship is expected to be and has been highly effective in offsetting changes in estimated fair values or cash flows of the hedged item using either the dollar offset or the regression analysis method. If the Company determines that a derivative is not highly effective as a hedge, it discontinues hedge accounting.

Foreign Currency

The Company makes investments in non-United States dollar denominated securities and loans. As a result, the Company is subject to the risk of fluctuation in the exchange rate between the United States dollar and the foreign currency in which it makes an investment. In order to reduce the currency risk, the Company may hedge the applicable foreign currency. All investments denominated in a foreign currency are converted to the United States dollar using prevailing exchange rates on the balance sheet date. Income, expenses, gains and losses on investments denominated in a foreign currency are converted to the United States dollar using the prevailing exchange rates on the dates when they are recorded. Foreign exchange gains and losses are recorded in the condensed consolidated statements of operations.

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Manager Compensation

The Management Agreement provides for the payment of a base management fee to the Manager, as well as an incentive fee if the Company’s financial performance exceeds certain benchmarks. Additionally, the Management Agreement provides for the Manager to be reimbursed for certain expenses incurred on the Company’s behalf. See Note 12 to these condensed consolidated financial statements for additional discussion on the payment of the base management fee and incentive fee. The base management fee and the incentive fee are accrued and expensed during the period for which they are earned by the Manager.

Share-Based Compensation

The Company accounts for share-based compensation issued to its directors and to its Manager using the fair value based methodology in accordance with relevant accounting guidance. Compensation cost related to restricted common shares issued to the Company’s directors is measured at its estimated fair value at the grant date, and is amortized and expensed over the vesting period on a straight-line basis. Compensation cost related to restricted common shares and common share options issued to the Manager is initially measured at estimated fair value at the grant date, and is remeasured on subsequent dates to the extent the awards are unvested. The Company has elected to use the graded vesting attribution method to amortize compensation expense for the restricted common shares and common share options granted to the Manager.

Income Taxes

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

The Company holds an equity interest in KKR Financial Holdings II, LLC (“KFH II”), which elected to be taxed as a real estate investment trust (a “REIT”) under the Internal Revenue Code of 1986, as amended (the “Code”). KFH II holds certain real estate mortgage-backed securities. A REIT generally is not subject to United States federal income tax to the extent that it currently distributes its income and satisfies certain asset, income and ownership tests, and recordkeeping requirements, but it may be subject to some amount of federal, state, local and foreign taxes based on its taxable income.

The Company has wholly-owned domestic and foreign subsidiaries that are taxable as corporations for United States federal income tax purposes and thus are not consolidated with the Company for United States federal income tax purposes. For financial reporting purposes, current and deferred taxes are provided for on the portion of earnings recognized by the Company with respect to its interest in the domestic taxable corporate subsidiaries, because each is taxed as a regular corporation under the Code. Deferred income tax assets and liabilities are computed based on temporary differences between the GAAP condensed consolidated financial statements and the United States federal income tax basis of assets and liabilities as of each condensed consolidated balance sheet date. The foreign corporate subsidiaries were formed to make certain foreign and domestic investments from time to time. The foreign corporate subsidiaries are organized as exempted companies incorporated with limited liability under the laws of the Cayman Islands, and are anticipated to be exempt from United States federal and state income tax at the corporate entity level because they restrict their activities in the United States to trading in stock and securities for their own account. However, the Company will be required to include their current taxable income in the Company’s calculation of its taxable income allocable to shareholders. CLO 2005-1, CLO 2005-2, CLO 2006-1, CLO 2007-1, CLO 2007-A, CLO 2009-1 and CLO 2011-1 are foreign subsidiaries of the Company that elected to be treated as disregarded entities or partnerships for United States federal income tax purposes. These subsidiaries were established to facilitate securitization transactions, structured as secured financing transactions.

The Company must recognize the tax impact from an uncertain tax position only if it is more likely than not that the tax position will be sustained on examination by the taxing authorities, based on the technical merits of the position. The tax impact recognized in the financial statements from such a position is measured based on the largest benefit that has a greater than 50% likelihood of being realized upon ultimate resolution. Penalties and interest related to uncertain tax positions are recorded as tax expense. Significant judgment is required in the identification of uncertain tax positions and in the estimation of penalties and interest on uncertain tax positions. If it is determined that recognition for an uncertain tax provision is necessary, the Company would record a liability for an unrecognized tax expense from an uncertain tax position taken or expected to be taken.

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Earnings Per Share

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

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

Note 3. Earnings per Share

The following table presents a reconciliation of basic and diluted net income per common share for the three and nine months ended September 30, 2011 and 2010 (amounts in thousands, except per share information), as well as the distributions declared per common share during the three and nine months ended September 30, 2011 and 2010:

	Three months endedSeptember 30				Nine months endedSeptember 30
	2011		2010		2011		2010
Net income	$	39,820	$	82,342	$	241,091	$	292,865
Less: Dividends and undistributed earnings allocated to participating securities	99		687		921		2,482
Net income applicable to common shareholders	$	39,721	$	81,655	$	240,170	$	290,383
Basic:
Basic weighted average shares outstanding	177,723		157,057		177,493		157,018
Net income per share	$	0.22	$	0.52	$	1.35	$	1.85
Diluted:
Basic weighted average shares outstanding	177,723		157,057		177,493		157,018
Dilutive effect of convertible senior notes	2,497		404		3,811		276
Diluted weighted average shares outstanding(1)	180,220		157,461		181,304		157,294
Net income per share	$	0.22	$	0.52	$	1.32	$	1.85
Distributions declared per common share	$	0.18	$	0.12	$	0.49	$	0.29

(1)Potential anti-dilutive common shares excluded from diluted earnings per share related to common share options were 1,932,279 for both the three and nine months ended September 30, 2011 and 2010.

Note 4. Securities Available-for-Sale

The following table summarizes the Company’s securities classified as available-for-sale as of September 30, 2011 and December 31, 2010, which are carried at estimated fair value (amounts in thousands):

	September 30, 2011									December 31, 2010
	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	$	712,118	$	84,823	$	(21,950	)	$	774,991	$	646,638	$	192,496	$	(3,614	)	$	835,520
Common and preferred stock	13,484		—		(2,280		)	11,204		3,117		257		—			3,374
Total	$	725,602	$	84,823	$	(24,230	)	$	786,195	$	649,755	$	192,753	$	(3,614	)	$	838,894

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The following table shows the gross unrealized losses and fair value of the Company’s available-for-sale securities, aggregated by length of time that the individual securities have been in a continuous unrealized loss position as of September 30, 2011 and December 31, 2010 (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
September 30, 2011
Corporate debt securities	$	322,052	$	(21,238	)	$	21,638	$	(712	)	$	343,690	$	(21,950	)
Common and preferred stock	11,204		(2,280		)	—		—			11,204		(2,280		)
Total	$	333,256	$	(23,518	)	$	21,638	$	(712	)	$	354,894	$	(24,230	)
December 31, 2010
Corporate debt securities	$	41,656	$	(1,331	)	$	36,631	$	(2,283	)	$	78,287	$	(3,614	)

The unrealized losses in the table above are considered to be temporary impairments due to market factors and are not reflective of credit deterioration. The Company considers many factors when evaluating whether an impairment is other-than-temporary. For corporate debt securities included in the table above, the Company does not intend to sell them and does not believe that it is more likely than not that the Company will be required to sell any of its corporate debt securities prior to recovery. In addition, based on the analyses performed by the Company on each of its corporate debt securities, the Company believes that it is able to recover the entire amortized cost amount of the corporate debt securities included in the table above.

During both the three and nine months ended September 30, 2011, the Company recognized losses totaling $1.5 million for corporate debt securities that it determined to be other-than-temporary impaired based on the criteria above. During the three and nine months ended September 30, 2010, the Company recognized losses totaling $0.5 million and $1.7 million, respectively, for corporate debt securities that it determined to be other-than-temporarily impaired. The Company intended to sell these securities and as a result, the entire amount was recorded through earnings in net realized and unrealized gain on investments in the condensed consolidated statements of operations.

For equity securities included in the table above, because the Company has the intent and ability to hold these equity securities until recovery, the related unrealized losses are not considered to be other-than-temporary impairments. During the three and nine months ended September 30, 2011 and 2010, the Company did not recognize any loss for common and preferred stock that it determined to be other-than-temporary impaired based on the criteria above.

As of September 30, 2011, the Company had no corporate debt securities in default. As of December 31, 2010, the Company had corporate debt securities in default with an estimated fair value of $1.1 million from one issuer.

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

	For the three months ended September 30, 2011		For the three months ended September 30, 2010		For the nine months ended September 30, 2011			For the nine months ended September 30, 2010
Gross realized gains	$	33,881	$	17,598	$	70,822		$	60,398
Gross realized losses	—		—		(477		)	—
Net realized gains	$	33,881	$	17,598	$	70,345		$	60,398

The Company’s securities available-for-sale portfolio has certain credit risk concentrated in a limited number of issuers. As of September 30, 2011, approximately 47% of the estimated fair value of the Company’s securities available-for-sale portfolio was concentrated in ten issuers, with the two largest concentrations of securities available-for-sale in securities issued by First Data Corporation and SandRidge Energy, Inc., which combined represented $127.0 million, or approximately 16% of the estimated fair value of the Company’s securities available-for-sale. As of December 31, 2010, approximately 60% of the estimated fair value of the Company’s securities available-for-sale portfolio was concentrated in ten issuers, with the two largest concentrations of securities available-for-sale in securities issued by NXP BV and First Data Corporation, which combined represented $208.6 million, or approximately 25% of the estimated fair of value of the Company’s securities available-for-sale.

Note 7 to these condensed consolidated financial statements describes the Company’s borrowings under which the Company has pledged securities available-for-sale for borrowings. The following table summarizes the estimated fair value of securities available-for-sale pledged as collateral as of September 30, 2011 and December 31, 2010 (amounts in thousands):

	As ofSeptember 30, 2011		As of December 31, 2010
Pledged as collateral for collateralized loan obligation secured debt and junior secured notes to affiliates	$	690,336	$	728,558
Total	$	690,336	$	728,558

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Note 5. Corporate Loans and Allowance for Loan Losses

The following table summarizes the Company’s corporate loans as of September 30, 2011 and December 31, 2010 (amounts in thousands):

	September 30, 2011									December 31, 2010
	Corporate Loans			Corporate Loans Held for Sale			Total Corporate Loans			Corporate Loans			Corporate Loans Held for Sale			Total Corporate Loans
Principal(1)	$	6,502,493		$	660,399		$	7,162,892		$	6,398,997		$	481,152		$	6,880,149
Net unamortized discount	(195,138		)	(112,756		)	(307,894		)	(332,151		)	(12,776		)	(344,927		)
Total amortized cost	6,307,355			547,643			6,854,998			6,066,846			468,376			6,535,222
Lower of cost or fair value adjustment	—			(47,153		)	(47,153		)	—			(4,748		)	(4,748		)
Allowance for loan losses	(191,407		)	—			(191,407		)	(209,030		)	—			(209,030		)
Net carrying value	$	6,115,948		$	500,490		$	6,616,438		$	5,857,816		$	463,628		$	6,321,444

(1)Principal amount is net of charge-offs and other adjustments totaling $80.4 million and $58.2 million as of September 30, 2011 and December 31, 2010, respectively.

As of September 30, 2011 and December 31, 2010, the Company had an allowance for loan losses of $191.4 million and $209.0 million, respectively. As described in Note 2 to these condensed consolidated financial statements, the allowance for loan losses represents the Company’s estimate of probable credit losses inherent in its loan portfolio as of the balance sheet date. The Company’s allowance for loan losses consists of two components, an allocated component and an unallocated component. The allocated component of the allowance for loan losses consists of individual loans that are impaired. The unallocated component of the allowance for loan losses represents the Company’s estimate of losses inherent, but not identified, in its portfolio as of the balance sheet date.

The following table summarizes the changes in the allowance for loan losses for the Company’s corporate loan portfolio during the three and nine months ended September 30, 2011 and 2010 (amounts in thousands):

	For the three months ended September 30, 2011		For the three months ended September 30, 2010			For the nine months ended September 30, 2011			For the nine months ended September 30, 2010
Allowance for loan losses:
Beginning balance	$	188,874	$	210,218		$	209,030		$	237,308
Provision for loan losses	2,533		8,087			14,194			8,087
Charge-offs	—		(9,275		)	(31,817		)	(36,365		)
Ending balance	$	191,407	$	209,030		$	191,407		$	209,030

The following table summarizes the ending balances of the allowance and corporate loans portfolio by basis of impairment method as of September 30, 2011 and December 31, 2010 (amounts in thousands):

	September 30, 2011		December 31, 2010
Allowance for loan losses:
Ending balance: individually evaluated for impairment	$	191,407	$	207,633
Ending balance: collectively evaluated for impairment	—		—
Ending balance: loans acquired with deteriorated credit quality	—		1,397
	$	191,407	$	209,030
Corporate loans (recorded investment)(1):
Ending balance: individually evaluated for impairment	$	6,330,657	$	6,065,596
Ending balance: collectively evaluated for impairment	—		—
Ending balance: loans acquired with deteriorated credit quality	—		25,007
	$	6,330,657	$	6,090,603

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

17

As of September 30, 2011, the allocated component of the allowance for loan losses totaled $28.5 million and relates to investments in certain loans issued by five issuers with an aggregate par amount of $84.4 million and an aggregate recorded investment of $69.4 million. As of December 31, 2010, the allocated component of the allowance for loan losses totaled $50.1 million and relates to investments in certain loans issued by five issuers with an aggregate par amount of $225.6 million and an aggregate recorded investment of $149.8 million.

The following table summarizes the Company’s recorded investment in impaired loans and the related allowance for credit losses for the three and nine months ended September 30, 2011 (amounts in thousands):

For the three months ended September 30, 2011	Recorded Investment		Unpaid Principal Balance		Related Allowance		Average Recorded Investment		Interest Income Recognized
With no related allowance recorded	$	—	$	—	$	—	$	—	$	—
With an allowance recorded	69,420		84,443		28,474		62,982		633
Total	$	69,420	$	84,443	$	28,474	$	62,982	$	633

For the nine months ended September 30, 2011	Recorded Investment		Unpaid Principal Balance		Related Allowance		Average Recorded Investment		Interest Income Recognized
With no related allowance recorded	$	—	$	—	$	—	$	4,055	$	—
With an allowance recorded	69,420		84,443		28,474		78,993		1,672
Total	$	69,420	$	84,443	$	28,474	$	83,048	$	1,672

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

For the year ended December 31, 2010	Recorded Investment		Unpaid Principal Balance		Related Allowance		Average Recorded Investment		Interest Income Recognized
With no related allowance recorded	$	16,219	$	83,215	$	—	$	12,873	$	2,853
With an allowance recorded	133,566		142,377		50,112		133,014		8,256
Total	$	149,785	$	225,592	$	50,112	$	145,887	$	11,109

As of September 30, 2011 and December 31, 2010, the allocated component of the allowance for loan losses included all impaired loans. While all of the Company’s impaired loans are on non-accrual status, the Company’s non-accrual loans also include those held for sale that are measured at the lower of cost or fair value and are not reflected in the table above.

As of September 30, 2011, the Company had loans on non-accrual status with total recorded investment of $171.3 million, which included $69.4 million of impaired loans that were held for investment and $101.9 million of non-accrual loans held for sale. The amount of interest income recognized using the cash-basis method during the time within the period that the loans were non-accrual was $4.0 million and $9.7 million for the three and nine months ended September 30, 2011, respectively, which included $0.6 million for impaired loans that were held for investment and $3.4 million for non-accrual loans held for sale for the three months ended September 30, 2011 and $1.7 million for impaired loans that were held for investment and $8.0 million for non-accrual loans held for sale for the nine months ended September 30, 2011. As of December 31, 2010, the Company had loans on non-accrual status with total recorded investment of $165.1 million, which included $149.8 million of impaired loans that were held for investment and $15.3 million of non-accrual loans held for sale. The amount of interest income recognized using the cash-basis method during the time within the period that the loans were impaired was $4.1 million and $11.1 million for the three and nine months ended September 30, 2010, respectively.

The Company did not have any corporate loans past due at September 30, 2011 or December 31, 2010.

18

The unallocated component of the allowance for loan losses totaled $162.9 million and $158.9 million as of September 30, 2011 and December 31, 2010, respectively. As described in Note 2 to these condensed consolidated financial statements, the Company estimates the unallocated components of the allowance for loan losses through a comprehensive review of its loan portfolio and identifies certain loans that demonstrate possible indicators of impairments, including credit quality indicators. The following table summarizes how the Company determines internally assigned grades related to credit quality based on a combination of concern as to probability of default and the seniority of the loan in the issuer’s capital structure as of September 30, 2011 and December 31, 2010 (amounts in thousands):

Internally Assigned Grade	Capital Hierarchy	Recorded Investment September 30, 2011 (1)		Recorded Investment December 31, 2010 (1)
High	Senior Secured Loan	$	922,482	$	945,435
	Second Lien Loan	311,757		389,981
	Subordinated	14,460		—
		$	1,248,699	$	1,335,416
Moderate	Senior Secured Loan	$	665,306	$	494,433
	Second Lien Loan	—		38,448
	Subordinated	6,900		4,431
		$	672,206	$	537,312
Low	Senior Secured Loan	$	4,147,964	$	3,829,458
	Second Lien Loan	83,400		137,182
	Subordinated	108,968		101,450
		$	4,340,332	$	4,068,090
	Total Unallocated	$	6,261,237	$	5,940,818
	Total Allocated	69,420		149,785
	Total Loans Held for Investment	$	6,330,657	$	6,090,603

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

During the three and nine months ended September 30, 2011, the Company transferred $129.3 million and $817.9 million amortized cost amount, respectively, of loans from held for investment to held for sale. During the three and nine months ended September 30, 2010, the Company transferred $187.0 million and $936.1 million amortized cost amount, respectively, of loans from held for investment to held for sale. The transfers of certain loans to held for sale were due to the Company’s determination that credit quality of a loan in relation to its expected risk-adjusted return no longer met the Company’s investment objective and the determination by the Company to reduce or eliminate the exposure for certain loans as part of its portfolio risk management practices. Also, during the three and nine months ended September 30, 2011, the Company transferred $88.1 million and $377.0 million amortized cost amount, respectively, from loans held for sale back to loans held for investment as the circumstances that led to the initial transfer to held for sale were no longer present. Also, during the three and nine months ended September 30, 2010, the Company transferred  $192.2 million and $272.2 million amortized cost amount, respectively, from loans held for sale back to loans held for investment as the circumstances that led to the initial transfer to held for sale were no longer present.

During the three and nine months ended September 30, 2011, the Company recorded charge-offs totaling zero and $31.8 million, respectively, comprised primarily of loans transferred to loans held for sale. During the three and nine months ended September 30, 2010, the Company recorded charge-offs totaling $9.3 million and $36.4 million, respectively, comprised primarily of loans transferred to loans held for sale.

As of September 30, 2011, the Company had $500.5 million of loans held for sale, an increase of $36.9 million from December 31, 2010, due to additional loans the Company determined it had the intention of selling. The Company recorded a $43.8 million and $56.2 million net charge to earnings during the three and nine months ended September 30, 2011, respectively, for the lower of cost or estimated fair value adjustment for certain loans held for sale which had a carrying value of $500.5 million as of September 30, 2011. The Company reduced the lower of cost or estimated fair value allowance by $8.8 million and recorded a $21.4 million net charge to earnings during the three and nine months ended September 30, 2010, respectively, for the lower of cost or estimated fair value adjustment for certain loans held for sale.

As of September 30, 2011, the Company had no corporate loans in default. As of December 31, 2010, the Company held corporate loans that were in default with a total amortized cost of $18.6 million from one issuer. The majority of corporate loans in default during 2010 were included in the loans for which the allocated component of the Company’s allowance for losses was related to, or for which the Company determined were loans held for sale as of December 31, 2010.

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The Company did not modify any loans that qualified as troubled debt restructurings during the three and nine months ended September 30, 2011 and 2010. The Company did modify zero and $1.2 billion amortized cost of corporate loans during the three and nine months ended September 30, 2011, respectively. The Company modified $200.8 million and $464.3 million amortized cost of corporate loans during the three and nine months ended September 30, 2010, respectively. These modifications involved changes in existing rates and maturities to prevailing market rates/maturities for similar instruments and did not qualify as troubled debt restructurings as the respective borrowers were neither experiencing financial difficulty nor were seeking (nor granted) a concession as part of the modification. In addition, these modifications of non-troubled debt holdings were accomplished with modified loans that were not substantially different from the loans prior to modification.

The Company’s corporate loan portfolio has certain credit risk concentrated in a limited number of issuers. As of September 30, 2011, approximately 47% of the total amortized cost basis of the Company’s corporate loan portfolio was concentrated in twenty issuers, with the three largest concentrations of corporate loans in loans issued by U.S. Foodservice, Texas Competitive Electric Holdings Company LLC and Modular Space Corporation, which combined represented $1.0 billion, or approximately 14% of the aggregated amortized cost basis of the Company’s corporate loans. As of December 31, 2010, approximately 51% of the total amortized cost basis of the Company’s corporate loan portfolio was concentrated in twenty issuers, with the three largest concentrations of corporate loans in loans issued by Texas Competitive Electric Holdings Company LLC, Modular Space Corporation, and U.S. Foodservice, which combined represented $1.1 billion, or approximately 16% of the aggregated amortized cost basis of the Company’s corporate loans.

Note 7 to these condensed consolidated financial statements describes the Company’s borrowings under which the Company has pledged loans for borrowings. The following table summarizes the amortized cost of corporate loans held for sale and corporate loans pledged as collateral as of September 30, 2011 and December 31, 2010 (amounts in thousands):

	As of September 30, 2011		As ofDecember 31, 2010
Pledged as collateral for collateralized loan obligation secured debt and junior secured notes to affiliates	$	6,569,246	$	6,152,924
Total	$	6,569,246	$	6,152,924

Note 6. Deconsolidation of Residential Mortgage Loans Securitization Trusts

On January 1, 2010, the Company deconsolidated six residential mortgage securitization trusts as a result of the Company’s adoption of new accounting guidance regarding the consolidation model for variable interest entities. The Company has no exposure to loss in excess of the estimated fair value of the $74.4 million RMBS which were issued by these six residential mortgage securitization trusts.

The following information represents the assets and liabilities removed from the Company’s consolidated balance sheet as of January 1, 2010 as a result of the deconsolidation of the six residential mortgage loan securitization trusts (amounts in thousands):

	As of January 1, 2010
Assets
Residential mortgage loans, at estimated fair value(1)	$	2,023,333
Real estate owned (recorded within other assets on the 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 $74.4 million which represents the estimated fair value of the Company’s RMBS which were issued by the six residential mortgage loan securitization trusts that were deconsolidated under GAAP as of January 1, 2010.

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As a result of the deconsolidation of the six residential mortgage loan securitization trusts, all references to residential mortgage loans interest income, RMBS Issued interest expense, net realized and unrealized gain (loss) on residential mortgage loans and RMBS Issued, and loan servicing expense relate to prior period balances and activities.

Residential mortgage loans

The Company carried its residential mortgage loans at estimated fair value with unrealized gains and losses reported in income. The Company had elected the fair value option for its residential mortgage loans for the purpose of enhancing the transparency of its financial condition as fair value was consistent with how the Company managed the risks of its residential mortgage investments.

Residential mortgage-backed securities issued

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

Note 7. Borrowings

Certain information with respect to the Company’s borrowings as of September 30, 2011 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)
CLO 2005-1 senior secured notes	$	728,103	0.58	%	2,035	$	784,552
CLO 2005-2 senior secured notes	766,706		0.63		2,249	869,978
CLO 2006-1 senior secured notes	683,265		0.68		2,521	875,346
CLO 2007-1 senior secured notes	2,075,040		0.84		3,515	2,377,971
CLO 2007-1 junior secured notes(2)	61,491		—		3,515	70,468
CLO 2007-A senior secured notes	831,185		1.20		2,207	909,562
CLO 2007-A junior secured notes(3)	10,821		—		2,207	11,841
CLO 2011-1 senior debt	439,409		1.60		2,511	542,361
Total collateralized loan obligation secured debt	5,596,020					6,442,079
CLO 2007-1 junior secured notes to affiliates(4)	300,396		—		3,515	342,382
CLO 2007-A junior secured notes to affiliates(5)	65,452		—		2,207	71,624
Total collateralized loan obligation junior secured notes to affiliates	365,848					414,006
Senior secured credit facility	—		3.62		946	—
Asset-based borrowing facility(6)	38,300		2.59		1,497	88,769
Total credit facilities	38,300					88,769
7.0% Convertible senior notes	135,437		7.00		289	—
7.5% Convertible senior notes	164,440		7.50		1,934	—
Junior subordinated notes	283,517		5.40		9,170	—
Total borrowings	$	6,583,562				$	6,944,854

(1)Collateral for borrowings consists of corporate loans, securities available-for-sale and equity investments, at estimated fair value.

(2)CLO 2007-1 junior secured notes consist of $55.7 million of mezzanine notes with a weighted average borrowing rate of 3.6% and $5.8 million of subordinated notes that do not have a contractual coupon rate, but instead receive a pro rata amount of the net distributions from CLO 2007-1.

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(3)CLO 2007-A junior secured notes consist of $6.2 million of mezzanine notes with a weighted average borrowing rate of 6.9% and $4.6 million of subordinated notes that do not have a contractual coupon rate, but instead receive a pro rata amount of the net distributions from CLO 2007-A.

(4)CLO 2007-1 junior secured notes to affiliates consist of $170.1 million of mezzanine notes with a weighted average borrowing rate of 5.1% and $130.3 million of subordinated notes that do not have a contractual coupon rate, but instead receive a pro rata amount of the net distributions from CLO 2007-1.

(5)CLO 2007-A junior secured notes to affiliates consist of $55.0 million of mezzanine notes with a weighted average borrowing rate of 6.4% and $10.5 million of subordinated notes that do not have a contractual coupon rate, but instead receive a pro rata amount of the net distributions from CLO 2007-A.

(6)Collateral for borrowings consists of oil and gas assets purchased for an aggregate purchase price of approximately $89.1 million, whereby no impairment was deemed to exist. These oil and gas assets are included in other assets in the condensed consolidated balance sheets at carrying amount.

Certain information with respect to the Company’s borrowings as of December 31, 2010 is summarized in the following table (dollar amounts in thousands):

	Outstanding Borrowings		Weighted Average Borrowing Rate		Weighted Average Remaining Maturity (in days)	Fair Value of Collateral(1)
CLO 2005-1 senior secured notes	$	833,220	0.61	%	2,308	$	898,017
CLO 2005-2 senior secured notes	801,323		0.60		2,522	887,573
CLO 2006-1 senior secured notes	683,265		0.66		2,794	845,342
CLO 2007-1 senior secured notes	2,075,040		0.84		3,788	2,452,442
CLO 2007-1 junior secured notes(2)	61,504		—		3,788	72,689
CLO 2007-A senior secured notes	1,165,099		1.18		2,480	1,218,688
CLO 2007-A junior secured notes(3)	10,821		—		2,480	11,318
Total collateralized loan obligation secured debt	5,630,272					6,386,069
CLO 2007-1 junior secured notes to affiliates(4)	300,672		—		3,788	353,430
CLO 2007-A junior secured notes to affiliates(5)	65,452		—		2,480	68,462
Total collateralized loan obligation junior secured notes to affiliates	366,124					421,892
Senior secured credit facility	—		3.51		1,219	—
Asset-based borrowing facility(6)	18,400		2.76		1,770	32,760
Total credit facilities	18,400					32,760
7.0% Convertible senior notes	180,577		7.00		562	—
7.5% Convertible senior notes	163,565		7.50		2,207	—
Junior subordinated notes	283,517		5.42		9,443	—
Total borrowings	$	6,642,455				$	6,840,721

(1)Collateral for borrowings consists of corporate loans, securities available-for-sale, and equity investments, at estimated fair value.

(2)CLO 2007-1 junior secured notes consist of $55.7 million of mezzanine notes with a weighted average borrowing rate of 3.6% and $5.8 million of subordinated notes that do not have a contractual coupon rate, but instead receive a pro rata amount of the net distributions from CLO 2007-1.

(3)CLO 2007-A junior secured notes consist of $6.2 million of mezzanine notes with a weighted average borrowing rate of 7.0% and $4.6 million of subordinated notes that do not have a contractual coupon rate, but instead receive a pro rata amount of the net distributions from CLO 2007-A.

(4)CLO 2007-1 junior secured notes to affiliates consist of $170.4 million of mezzanine notes with a weighted average borrowing rate of 5.1% and $130.3 million of subordinated notes that do not have a contractual coupon rate, but instead receive a pro rata amount of the net distributions from CLO 2007-1.

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(5)CLO 2007-A junior secured notes to affiliates consist of $55.0 million of mezzanine notes with a weighted average borrowing rate of 6.4% and $10.5 million of subordinated notes that do not have a contractual coupon rate, but instead receive a pro rata amount of the net distributions from CLO 2007-A.

(6)Collateral for borrowings consists of oil and gas assets purchased during the fourth quarter of 2010 for an aggregate purchase price of approximately $32.8 million, whereby no impairment was deemed to exist. These oil and gas assets are included in other assets in the condensed consolidated balance sheets.

CLO Debt

On March 31, 2011, the Company closed CLO 2011-1, a $400.0 million secured financing transaction secured by the assets held in CLO 2011-1. At closing, the Company entered into a senior loan agreement (the “CLO 2011-1 Agreement”) through which CLO 2011-1 was able to borrow up to $300.0 million through a non-recourse loan secured by the assets held in CLO 2011-1. On July 6, 2011, the Company amended the CLO 2011-1 Agreement to upsize the transaction to $600.0 million, whereby CLO 2011-1 is able to borrow up to an additional $150.0 million, or total of $450.0 million. Under the amended CLO 2011-1 Agreement, the CLO 2011-1 senior loan matures on August 15, 2018 and borrowings under the CLO 2011-1 Agreement bear interest at a rate of the three-month London interbank offered rate (“LIBOR”) plus 1.35%.  As of September 30, 2011, the Company had $439.4 million of borrowings outstanding under the CLO 2011-1 Agreement.

The indentures governing the Company’s CLO transactions stipulate the reinvestment period during which the collateral manager, which is an affiliate of the Company’s Manager, can generally sell or buy assets at its discretion and can reinvest principal proceeds into new assets. CLO 2007-A ended its reinvestment period during the fourth quarter of 2010 and both CLO 2005-1 and CLO 2005-2 ended their reinvestment periods in the second quarter of 2011. As a result, principal proceeds from the assets held in each of these three transactions are generally used to amortize the outstanding balance of senior notes outstanding. During the three and nine months ended September 30, 2011, $253.1 million and $474.7 million, respectively, of original CLO 2007-A, CLO 2005-1 and CLO 2005-2 senior notes were repaid. CLO 2006-1 and CLO 2007-1 will end their respective reinvestment periods during August 2012 and May 2014, respectively. CLO 2011-1 does not have a reinvestment period and all principal proceeds from holdings in CLO 2011-1 will be used to amortize the transaction.

During 2010, in an open market auction, the Company purchased $10.3 million of mezzanine notes issued by CLO 2007-A for $5.5 million and $72.7 million of mezzanine and subordinate notes issued by CLO 2007-1 for $38.8 million, both of which were previously held by an affiliate of the Manager. These transactions resulted in the Company recording an aggregate gain on extinguishment of debt totaling $38.7 million during the nine months ended September 30, 2010.

Credit Facilities

Senior Secured Credit Facility

On May 3, 2010, the Company entered into a credit agreement for a four-year $210.0 million asset-based revolving credit facility (the “2014 Facility”), maturing on May 3, 2014, that is subject to, among other things, the terms of a borrowing base derived from the value of eligible specified financial assets. The borrowing base is subject to certain caps and concentration limits customary for financings of this type. The Company may obtain additional commitments under the 2014 Facility so long as the aggregate amount of commitments at any time does not exceed $600.0 million. On May 5, 2010, the Company obtained additional commitments of $40.0 million, bringing the total amount of commitments under the 2014 Facility to $250.0 million.

The Company has the right to prepay loans under the 2014 Facility in whole or in part at any time. Loans under the 2014 Facility bear interest at a rate equal to LIBOR plus 3.25% per annum. The 2014 Facility contains customary covenants applicable to the Company, including a restriction from making distributions to holders of common shares in excess of 65% of the Company’s estimated annual taxable income.

As of September 30, 2011, the Company had no borrowings outstanding under the 2014 Facility.

Asset-Based Borrowing Facility

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

23

On May 13, 2011, the Company entered into an amendment to the 2015 Natural Resources Facility, increasing the commitment from $49.7 million to $81.1 million.

As of September 30, 2011, the Company had $38.3 million of borrowings outstanding under the 2015 Natural Resources Facility. In addition, under the 2015 Natural Resources Facility, the Company had a letter of credit outstanding totaling $1.0 million.

As of September 30, 2011, the Company believes it was in compliance with the covenant requirements for both credit facilities.

Convertible Debt

On January 15, 2010, the Company issued $172.5 million of 7.5% convertible senior notes due January 15, 2017 (“7.5% Notes”). The 7.5% Notes bear interest at a rate of 7.5% per annum on the principal amount, accruing from January 15, 2010. Interest is payable semiannually in arrears on January 15 and July 15 of each year, beginning on July 15, 2010. The 7.5% Notes will mature on January 15, 2017 unless previously redeemed, repurchased or converted in accordance with their terms prior to such date. Holders of the 7.5% Notes may convert their notes at the applicable conversion rate at any time prior to the close of business on the business day immediately preceding the stated maturity date subject to the Company’s right to terminate the conversion rights of the notes. The Company may satisfy its obligation with respect to the 7.5% Notes tendered for conversion by delivering to the holder either cash, common shares, no par value, issued by the Company or a combination thereof. The initial conversion rate for each $1,000 principal amount of 7.5% Notes was 122.2046 common shares, which is equivalent to an initial conversion price of approximately $8.18 per share. The conversion rate is adjusted under certain circumstances, including the occurrence of certain fundamental change transactions and the payment of a quarterly cash distribution in excess of $0.05 per share, but will not be adjusted for accrued and unpaid interest on the 7.5% Notes. As of September 30, 2011, the conversation rate for each $1,000 principal amount of 7.5% Notes was 130.0516 common shares.

In accordance with accounting for convertible debt instruments that may be settled in cash upon conversion, the Company separately accounted for the liability and equity components to reflect the nonconvertible debt borrowing rate. The Company determined that the equity component of the 7.5% Notes totaled $10.0 million and is included in paid-in-capital on the Company’s condensed consolidated balance sheet as of September 30, 2011 and December 31, 2010. The remaining liability component of $164.4 million and $163.6 million as of September 30, 2011 and December 31, 2010, respectively, which is included within convertible senior notes on the Company’s condensed consolidated balance sheet as of September 30, 2011 and December 31, 2010, is comprised of the principal $172.5 million less the unamortized debt discount of $8.1 million and $8.9 million, respectively. The total debt discount amortization recognized for the three and nine months ended September 30, 2011 was $0.3 million and $0.9 million, respectively. The total debt discount amortization recognized for the three and nine months ended September 30, 2010 was $0.3 million and $0.8 million, respectively. The debt discount will continue to be amortized at the effective interest rate of 8.6%. For the three and nine months ended September 30, 2011, the total interest expense recognized on the 7.5% Notes was $3.2 million and $9.7 million, respectively. For the three and nine months ended September 30, 2010, the total interest expense recognized on the 7.5% Notes was $3.2 million and $9.2 million, respectively.

On August 23, 2011, the Company repurchased $45.1 million par amount of its 7.0% convertible senior notes due July 15, 2012 (the “7.0% Notes”). This transaction resulted in the Company recording a loss of $1.7 million and a write-off of $0.1 million of unamortized debt issuance costs during the third quarter of 2011. As of September 30, 2011, the Company had committed to purchase an additional $1.2 million par amount of its 7.0% Notes. The 7.0% Notes are convertible into the Company’s common shares at a conversion price of $31.00. This conversion rate for each $1,000 principal amount of 7.0% Notes is 32.2581 of the Company’s common shares.

During the first quarter of 2010, the Company repurchased an aggregate $95.2 million par amount of the 7.0% Notes. These transactions resulted in the Company recording a gain of $1.3 million, which was partially offset by a write-off of $0.6 million of unamortized debt issuance costs during 2010.

Note 8. Derivative Financial Instruments

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

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The table below summarizes the aggregate notional amount and estimated net fair value of the derivative instruments as of September 30, 2011 and December 31, 2010 (amounts in thousands):

	As of September 30, 2011						As of December 31, 2010
	Notional			Estimated Fair Value			Notional			Estimated Fair Value
Cash Flow Hedges:
Interest rate swaps	$	508,333		$	(100,849	)	$	483,333		$	(58,365	)
Free-Standing Derivatives:
Commodity swaps	—			3,322			—			(226		)
Credit default swaps—protection sold	33,500			(3,653		)	13,500			492
Total rate of return swaps	—			159			—			104
Foreign exchange forward contracts	(231,582		)	(16,004		)	(154,405		)	(17,296		)
Foreign exchange options	130,207			15,909			130,207			14,791
Common stock warrants	—			3,225			—			3,453
Total	$	440,458		$	(97,891	)	$	472,635		$	(57,047	)

Cash Flow Hedges

The Company uses interest rate derivatives consisting of swaps to hedge a portion of the interest rate risk associated with its borrowings under CLO senior secured notes as well as certain of its floating rate junior subordinated notes. The Company designates these financial instruments as cash flow hedges.

In September 2011, the Company entered into a $25.0 million notional pay-fixed, receive-variable interest rate swap. In June 2010, the Company entered into a $100.0 million notional pay-fixed, receive-variable interest rate swap. These swaps have been designated as cash flow hedges, the objective of which is to eliminate the variability of cash flows in the interest payments of the Company’s floating rate junior subordinated notes debt due to fluctuations in the indexed rate. Changes in value of the interest rate swap are recorded through other comprehensive (loss) income, with gains or losses representing hedge ineffectiveness, if any, recognized in earnings during the reporting period. The hedged transaction period is through July 2037 for the $25.0 million interest rate swap and October 2036 for the $100.0 million interest rate swap; both dates are the stated maturities of the applicable floating rate junior subordinated debt.

The following table shows the net losses recognized in other comprehensive (loss) income related to derivatives in cash flow hedging relationships for the three and nine months ended September 30, 2011 and 2010 (amounts in thousands):

	For the three months ended September 30, 2011			For the three months endedSeptember 30, 2010			For the nine months ended September 30, 2011			For thenine months endedSeptember 30, 2010
Losses recognized in other comprehensive (loss) income on cash flow hedges	$	(40,636	)	$	(17,609	)	$	(42,463	)	$	(44,432	)

Free-Standing Derivatives

Free-standing derivatives are derivatives that the Company has entered into in conjunction with its investment and risk management activities, but for which the Company has not designated the derivative contract as a hedging instrument for accounting purposes. Such derivative contracts may include credit default swaps (“CDS”), foreign exchange contracts and options, interest rate swaps and commodity derivatives. Free-standing derivatives also include investment financing arrangements (total rate of return swaps) whereby the Company receives the sum of all interest, fees and any positive change in fair value amounts from a reference asset with a specified notional amount and pays interest on such notional amount plus any negative change in fair value amounts from such reference asset.

Gains and losses on free-standing derivatives are reported on the condensed consolidated statements of operations in net realized and unrealized (loss) gain on derivatives and foreign exchange. Unrealized gains (losses) represent the change in fair value of the derivative instruments and are noncash items.

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For all hedges where hedge accounting is being applied, effectiveness testing and other procedures to ensure the ongoing validity of the hedges are performed at least quarterly. During the three and nine months ended September 30, 2011 and 2010, the Company recognized an immaterial amount of ineffectiveness in income on the condensed consolidated statements of operations from its cash flow hedges.

Credit Default Swaps

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

As of September 30, 2011 and December 31, 2010, the Company had sold protection with a notional amount of $33.5 million and $13.5 million, respectively. The Company sells protection to replicate fixed income securities and to complement the spot market when cash securities of the referenced entity of a particular maturity are not available or when the derivative alternative is less expensive compared to other purchasing alternatives.

Commodity Derivatives

In an effort to minimize the effects of the volatility of oil, natural gas and natural gas liquids prices, the Company will from time to time, enter into derivative instruments such as swap contracts to hedge its forecasted commodities sales. The Company does not designate these contracts as cash flow hedges and as such, the changes in fair value of these instruments are recorded in current period earnings.

The Company entered into commodity derivative contracts, consisting of oil, natural gas and certain natural gas liquid products receive-fixed, pay-floating swaps for certain years through 2015. For the three and nine months ended September 30, 2011, the Company had an immaterial amount of commodity derivatives settlements, which are settled monthly.

Note 9. Accumulated Other Comprehensive (Loss) Income

The components of accumulated other comprehensive (loss) income were as follows (amounts in thousands):

	As of September 30, 2011			As of December 31, 2010
Net unrealized gains on available-for-sale securities	$	60,593		$	189,139
Net unrealized losses on cash flow hedges	(98,006		)	(55,543		)
Accumulated other comprehensive (loss) income	$	(37,413	)	$	133,596

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

	Three monthsendedSeptember 30, 2011			Three monthsendedSeptember 30, 2010			Nine monthsendedSeptember 30, 2011			Nine monthsendedSeptember 30, 2010
Unrealized (losses) gains on securities available-for-sale:
Unrealized (losses) gains arising during period	$	(69,657	)	$	51,787		$	(58,568	)	$	41,676
Reclassification adjustments for gains realized in net income(1)	(33,881		)	(18,120		)	(69,978		)	(64,498		)
Unrealized (losses) gains on securities available-for-sale	(103,538		)	33,667			(128,546		)	(22,822		)
Unrealized losses on cash flow hedges	(40,636		)	(17,609		)	(42,463		)	(44,432		)
Other comprehensive (loss) income	$	(144,174	)	$	16,058		$	(171,009	)	$	(67,254	)

(1)Excludes an impairment charge of $1.5 million for investments which were determined to be other-than-temporary for the both the three and nine months ended September 30, 2011. Excludes an impairment charge of $0.5 million and $1.7 million for investments which were determined to be other-than-temporary for the three and nine months ended September 30, 2010, respectively.

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Note 10. Commitments & Contingencies

Commitments

As part of its strategy of investing in corporate loans, the Company commits to purchase interests in primary market loan syndications, which obligate the Company to acquire a predetermined interest in such loans at a specified price on a to-be-determined settlement date. Consistent with standard industry practices, once the Company has been informed of the amount of its syndication allocation in a particular loan by the syndication agent, the Company bears the risks and benefits of changes in the fair value of the syndicated loan from that date forward. In addition, the Company also commits to purchase corporate loans in the secondary market that similar to the above, the Company bears the risks and benefits of changes in the fair value from the trade date forward. As of September 30, 2011 and December 31, 2010, the Company had committed to purchase corporate loans with aggregate commitments totaling $101.6 million and $90.9 million, respectively. In addition, the Company participates in certain contingent financing arrangements, whereby the Company is committed to provide funding of up to a specific amount at the discretion of the borrower. As of September 30, 2011 and December 31, 2010, the Company had unfunded financing commitments for corporate loans totaling $8.2 million and $31.6 million, respectively. In addition, as of September 30, 2011 and December 31, 2010, the Company had unfunded financing commitments for private equity investments totaling $7.7 million and $13.1 million, respectively. The Company did not have any material losses as of September 30, 2011, nor does it expect material losses related to those corporate loans and private equity investments 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 notes issued to the Company by CLO 2005-2 (the “2005-2 Notes”) and approximately $222.4 million of mezzanine and junior notes issued to the Company by CLO 2006-1 (the “2006-1 Notes”), as well as certain other notes issued to the Company by another CLO. The surrendered notes were cancelled by the trustee under the applicable indenture, and the obligations due under such surrendered notes were deemed extinguished.

During 2010, certain holders of the senior notes of CLO 2006-1 (the “2006-1 Noteholders”) notified the related trustee of purported defaults under the indenture related to the surrender of the 2006-1 Notes. The Company does not believe based on discussions with counsel that an event of default has occurred and is engaged in discussions with the 2006-1 Noteholders to resolve this matter. Accordingly, the Company does not believe that this matter will have a material effect on its financial condition.

Note 11. Common Shares, Restricted Shares and Share Options

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

The exercise price for any share option granted under the 2007 Share Incentive Plan may not be less than 100% of the fair market value of the common shares at the time the common share option is granted. Each option to acquire a common share must terminate no more than ten years from the date it is granted. As of September 30, 2011, the 2007 Share Incentive Plan authorizes a total of 8,589,625 shares that may be used to satisfy awards under the 2007 Share Incentive Plan. On January 21, 2011, the Compensation Committee of the board of directors granted the Manager 240,845 restricted common shares subject to graded vesting over four years with the final vesting date of March 1, 2015. On August 9, 2011, the board of directors were granted 50,566 restricted common shares subject to graded vesting over three years with the final vesting date of August 9, 2014.

The following table summarizes restricted common share transactions:

	Manager		Directors		Total
Unvested shares as of January 1, 2011	1,097,000		212,604		1,309,604
Issued	240,845		50,566		291,411
Vested	(1,097,000	)	(92,903	)	(1,189,903	)
Cancelled	—		(24,591	)	(24,591	)
Unvested shares as of September 30, 2011	240,845		145,676		386,521

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The Company is required to value any unvested restricted common shares granted to the Manager at the current market price. The Company valued the unvested restricted common shares granted to the Manager at $7.43 and $8.78 per share at September 30, 2011 and 2010, respectively. There were $2.2 million of total unrecognized compensation costs related to unvested restricted common shares granted as of September 30, 2011 and 2010. These costs are expected to be recognized over the next four years.

As of September 30, 2011 and 2010, 1,932,279 common share options were exercisable. As of September 30, 2011, the common share options were fully vested and expire in August 2014. The following table summarizes common share option transactions:

	Number of Options	Weighted Average Exercise Price
Outstanding as of January 1, 2011	1,932,279	$	20.00
Granted	—	—
Exercised	—	—
Forfeited	—	—
Outstanding as of September 30, 2011	1,932,279	$	20.00

For the three and nine months ended September 30, 2011 and 2010, the components of share-based compensation expense are as follows (amounts in thousands):

	For the three months ended September 30, 2011		For the three months ended September 30, 2010		For the nine months ended September 30, 2011		For the nine months ended September 30, 2010
Restricted shares granted to Manager	$	136	$	1,943	$	2,077	$	4,437
Restricted shares granted to certain directors	212		189		614		901
Total share-based compensation expense	$	348	$	2,132	$	2,691	$	5,338

Note 12. Management Agreement and Related Party Transactions

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

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

Base Management Fees and Manager Share-Based Compensation

For the three and nine months ended September 30, 2011, the Company incurred $6.7 million and $19.5 million, respectively, in base management fees. As of September 30, 2011, the Company had $2.2 million base management fee payable to the Manager. In addition, the Company recognized share-based compensation expense related to restricted common shares granted to the Manager of $0.1 million and $2.1 million for the three and nine months ended September 30, 2011, respectively (see Note 11). For the three and nine months ended September 30, 2010, the Company incurred $4.9 million and $13.7 million, respectively, in base management fees. In addition, the Company recognized share-based compensation expense related to restricted common shares granted to the Manager of $1.9 million and $4.4 million, respectively, for the three and nine months ended September 30, 2010 (see Note 11).

Base management fees incurred and share-based compensation expense relating to restricted common shares granted to the Manager are included in related party management compensation on the condensed consolidated statements of operations. Expenses incurred by the Manager and reimbursed by the Company are reflected in the respective condensed consolidated statements of operations, non-investment expense category based on the nature of the expense.

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The Manager is waiving base management fees related to the $230.4 million common share offering and $270.0 million common share rights offering that occurred during the third quarter of 2007 until such time as the Company’s common share closing price on the New York Stock Exchange is $20.00 or more for five consecutive trading days. Accordingly, the Manager permanently waived approximately $2.2 million of base management fees during each of the three months ended September 30, 2011 and 2010 and $6.6 million during each of the nine months ended September 30, 2011 and 2010.

Incentive Fees

During the three and nine months ended September 30, 2011, the Manager earned zero and $28.2 million, respectively, of incentive fees. During the three and nine months ended September 30, 2010, the Manager earned $9.4 million and $30.3 million, respectively, of incentive fees. Of this amount, the Manager permanently waived payment of $9.7 million of incentive fees that were related to the $38.7 million gain recorded by the Company as a result of the repurchase of $83.0 million of mezzanine and subordinate notes issued by CLO 2007-1 and CLO 2007-A during the quarter ended March 31, 2010. Incentive fees are included in related party management compensation on the Company’s condensed consolidated statement of operations.

CLO Management Fees

An affiliate of the Manager entered into separate management agreements with the respective investment vehicles for CLO 2005-1, CLO 2005-2, CLO 2006-1, CLO 2007-1, CLO 2007-A, CLO 2009-1 and CLO 2011-1 and is entitled to receive fees for the services performed as collateral manager for all of these CLOs, except for CLO 2011-1. The collateral manager has the option to waive the fees it earns for providing management services for the CLO.

During the three and nine months ended September 30, 2011, the collateral manager waived management fees for all CLOs, except for CLO 2005-1, totaling $8.4 million and $25.6 million, respectively. During the three and nine months ended September 30, 2010, the collateral manager waived management fees for all CLOs, except for CLO 2005-1, totaling $8.7 million and $21.9 million, respectively. For the three and nine months ended September 30, 2011, the Company recorded an expense for CLO management fees totaling $1.3 million and $4.0 million, respectively. For the three and nine months ended September 30, 2010, the Company recorded an expense for CLO management fees of $1.3 million and $4.1 million, respectively.

Reimbursable General and Administrative Expenses

Beginning January 2009, the Manager permanently waived reimbursable general and administrative expenses allocable to the Company in an amount equal to the incremental CLO management fees received by the Manager. For the three and nine months ended September 30, 2010, the Manager permanently waived reimbursement of allocable general and administrative expenses totaling zero and $2.4 million, respectively. Due to the reinstatement of waived CLO management fees beginning with two CLOs in the second half of 2009, effective June 2010, all incremental CLO management fees received by the Manager had been fully applied to offset these reimbursable expenses. Accordingly, for the three and nine months ended September 30, 2011, there were no reimbursable general and administrative expenses waived by the Manager; rather, the Company incurred reimbursable general and administrative expenses to its Manager of $1.6 million and $4.9 million, respectively, as compared to $1.3 million and $2.2 million for the three and nine months ended September 30, 2010, respectively.

Affiliated Investments

The Company has invested in corporate loans, debt securities and other investments of entities that are affiliates of KKR. As of September 30, 2011, the aggregate par amount of these affiliated investments totaled $2.5 billion, or approximately 30% of the total investment portfolio, and consisted of 28 issuers. The total $2.5 billion in affiliated investments was comprised of $2.2 billion of corporate loans, $199.9 million of corporate debt securities available-for-sale and $58.6 million of equity investments, at estimated fair value. As of December 31, 2010, the aggregate par amount of these affiliated investments totaled $2.4 billion, or approximately 30% of the total investment portfolio, and consisted of 27 issuers. The total $2.4 billion in affiliated investments was comprised of $2.1 billion of corporate loans, $314.2 million of corporate debt securities available-for-sale and $25.6 million of equity investments, at estimated fair value.

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Note 13. Fair Value of Financial Instruments

Fair Value of Financial Instruments

The fair value of certain instruments including securities available-for-sale, corporate loans and derivatives is based on quoted market prices or estimates provided by independent pricing sources. The fair value of cash and cash equivalents, interest receivable, and interest payable approximates cost due to the short-term nature of these instruments.

The table below discloses the carrying value and the estimated fair value of the Company’s financial instruments as of September 30, 2011 and December 31, 2010 (amounts in thousands):

	As of September 30, 2011				As of December 31, 2010
	Carrying Amount		Estimated Fair Value		Carrying Amount		Estimated Fair Value
Financial Assets:
Cash, restricted cash, and cash equivalents	$	459,043	$	459,043	$	885,254	$	885,254
Securities available-for-sale	786,195		786,195		838,894		838,894
Corporate loans, net of allowance for loan losses of $191,407 and $209,030 as of September 30, 2011 and December 31, 2010 respectively	6,115,948		5,904,793		5,857,816		6,060,530
Corporate loans held for sale	500,490		537,112		463,628		473,681
Residential mortgage-backed securities	88,209		88,209		93,929		93,929
Equity investments, at estimated fair value	170,175		170,175		99,955		99,955
Interest and principal receivable	59,917		59,917		57,414		57,414
Derivative assets	26,066		26,066		19,519		19,519
Private equity investments, at cost(1)	3,672		1,675		4,800		5,051
Financial Liabilities:
Collateralized loan obligation secured debt	$	5,596,020	$	5,248,045	$	5,630,272	$	5,176,052
Collateralized loan obligation junior secured notes to affiliates	365,848		288,913		366,124		254,522
Credit facilities	38,300		38,300		18,400		18,400
Convertible senior notes	299,877		356,203		344,142		425,564
Junior subordinated notes	283,517		263,671		283,517		264,025
Accounts payable, accrued expenses and other liabilities	51,404		51,404		14,193		14,193
Accrued interest payable	15,987		15,987		22,846		22,846
Accrued interest payable to affiliates	7,579		7,579		6,316		6,316
Related party payable	3,687		3,687		12,988		12,988
Securities sold, not yet purchased	1,192		1,192		—		—
Derivative liabilities	123,957		123,957		76,566		76,566

(1)During the three and nine months ended September 30, 2011, the Company recognized a loss totaling zero and $1.1 million, respectively for private equity investments, at cost, that it determined to be other-than-temporarily impaired based on the estimated fair value using unobservable inputs. Private equity investments, at cost are included in other assets on the condensed consolidated balance sheets.

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Fair Value Measurements

The following table presents information about the Company’s assets and liabilities measured at fair value on a recurring basis as of September 30, 2011, and indicates the fair value hierarchy of the valuation techniques utilized by the Company to determine such fair value (amounts in thousands):

	Quoted Prices in Active Markets for Identical Assets (Level 1)			Significant Other Observable Inputs (Level 2)			Significant Unobservable Inputs (Level 3)		Balance as of September 30, 2011
Assets:
Securities available-for-sale	$	5,417		$	712,831		$	67,947	$	786,195
Residential mortgage-backed securities	—			—			88,209		88,209
Equity investments, at estimated fair value	1,231			34,971			133,973		170,175
Total rate of return swaps	—			—			159		159
Foreign exchange options, net	—			—			15,909		15,909
Common stock warrants	1,046			—			2,179		3,225
Commodities swaps, net	—			3,322			—		3,322
Other assets	—			—			1,706		1,706
Total	$	7,694		$	751,124		$	310,082	$	1,068,900
Liabilities:
Securities sold, not yet purchased	$	(1,192	)	$	—		$	—	$	(1,192	)
Cash flow interest rate swaps, net	—			(100,849		)	—		(100,849		)
Foreign exchange forward contracts, net	—			(16,004		)	—		(16,004		)
Credit default swaps—protection sold	—			(3,653		)	—		(3,653		)
Total	$	(1,192	)	$	(120,506	)	$	—	$	(121,698	)

The following table presents information about the Company’s assets measured at fair value on a non-recurring basis as of September 30, 2011, and indicates the fair value hierarchy of the valuation techniques utilized by the Company to determine such fair value (amounts in thousands). There were no liabilities measured at fair value on a non-recurring basis:

	Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)		Balance as of September 30, 2011
Loans held for sale(1)	$	—	$	397,115	$	—	$	397,115
Total	$	—	$	397,115	$	—	$	397,115

(1)As of September 30, 2011, total loans held for sale had a carrying value of $500.5 million of which $397.1 million was carried at estimated fair value and the remaining $103.4 million carried at amortized cost. The $397.1 million carried at estimated fair value was classified as Level 2 given that the assets were valued using quoted prices and other observable inputs in an active market.

The following table presents information about the Company’s assets and liabilities measured at fair value on a recurring basis as of December 31, 2010, and indicates the fair value hierarchy of the valuation techniques utilized by the Company to determine such fair value (amounts in thousands):

	Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Other Observable Inputs (Level 2)			Significant Unobservable Inputs (Level 3)		Balance as of December 31, 2010
Assets:
Securities available-for-sale	$	3,374	$	752,423		$	83,097	$	838,894
Residential mortgage-backed securities	—		—			93,929		93,929
Equity investments, at estimated fair value	—		15,023			84,932		99,955
Credit default swaps—protection sold	—		492			—		492
Total rate of return swaps	—		—			104		104
Foreign exchange options, net	—		—			14,791		14,791
Common stock warrants	—		—			3,453		3,453
Total	$	3,374	$	767,938		$	280,306	$	1,051,618
Liabilities:
Cash flow interest rate swaps	$	—	$	(58,365	)	$	—	$	(58,365	)
Foreign exchange forward contracts, net	—		(17,296		)	—		(17,296		)
Commodities swaps, net	—		(226		)	—		(226		)
	$	—	$	(75,887	)	$	—	$	(75,887	)

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The following table presents information about the Company’s assets measured at fair value on a non-recurring basis as of December 31, 2010, and indicates the fair value hierarchy of the valuation techniques utilized by the Company to determine such fair value (amounts in thousands). There were no liabilities measured at fair value on a non-recurring basis:

	Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)		Balance as of December 31, 2010
Loans held for sale(1)	$	—	$	254,682	$	14,443	$	269,125
Private equity investments(2)	—		—		1,800		1,800
Total	$	—	$	254,682	$	16,243	$	270,925

(1)As of December 31, 2010, total loans held for sale had a carrying value of $463.6 million of which $269.1 million was carried at estimated fair value and the remaining $194.5 million carried at amortized cost. Of the $269.1 million carried at estimated fair value, $254.7 million was classified as Level 2 given that the assets were valued using quoted prices and other observable inputs in an active market. The remaining $14.4 million was classified as Level 3 given that the Company applied unobservable inputs based on the best available information to determine the estimated fair value.

(2)Represents private equity investments accounted for under the cost method that were classified as Level 3 when the assets were impaired and measured at estimated fair value using unobservable inputs.

The following table presents additional information about assets, including derivatives that are measured at fair value on a recurring basis for which the Company has utilized Level 3 inputs to determine fair value, for the three months ended September 30, 2011 (amounts in thousands):

	Securities Available- For-Sale			Residential Mortgage- Backed Securities			Equity Investments, at Estimated Fair Value			Total Rate of Return Swaps			Common Stock Warrants			Foreign Exchange Options, Net			Other Assets
Beginning balance as of July 1, 2011	$	93,075		$	88,538		$	156,684		$	163		$	4,399		$	18,952		$	1,119
Total gains or losses (realized and unrealized):
Included in earnings(1)	(611		)	1,428			(14,417		)	(4		)	(37		)	(3,043		)	1,027
Included in other comprehensive (loss) income	(8,982		)	—			—			—			—			—			—
Transfers out of Level 3(2)	(17,332		)	—			(28,546		)	—			—			—			—
Purchases	2,761			—			20,252			—			—			—			400
Sales	—			—			—			—			—			—			—
Settlements	(964		)	(1,757		)	—			—			(2,183		)	—			(840		)
Ending balance as of September 30, 2011	$	67,947		$	88,209		$	133,973		$	159		$	2,179		$	15,909		$	1,706
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)	$	—		$	10,620		$	(2,622	)	$	—		$	(536	)	$	(3,043	)	$	1,027

(1)Amounts are included in net realized and unrealized (loss) gain on investments, net realized and unrealized (loss) gain on derivatives and foreign exchange or net realized and unrealized gain (loss) on residential mortgage-backed securities, residential mortgage loans, and residential mortgage-backed securities issued, carried at estimated fair value in the condensed consolidated statements of operations.

(2)Certain securities available-for-sale and equity investments, at estimated fair value, were transferred out of Level 3 primarily the result of additional observable inputs from third party broker quotes. There were no significant transfers in to Level 3 from Level 1 or 2.

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The following table presents additional information about assets, including derivatives that are measured at fair value on a recurring basis for which the Company has utilized Level 3 inputs to determine fair value, for the nine months ended September 30, 2011 (amounts in thousands):

	Securities Available- For-Sale			Residential Mortgage- Backed Securities			Equity Investments, at Estimated Fair Value			Total Rate of Return Swaps		Common Stock Warrants			Foreign Exchange Options, Net		Other Assets
Beginning balance as of January 1, 2011	$	83,097		$	93,929		$	84,932		$	104	$	3,453		$	14,791	$	—
Total gains or losses (realized and unrealized):
Included in earnings(1)	(356		)	(373		)	28,471			55		909			1,118		1,031
Included in other comprehensive (loss) income	(6,043		)	—			—			—		—			—		—
Transfers out of Level 3(2)	(4,346		)	—			(28,546		)	—		—			—		—
Purchases	8,903			—			40,344			—		—			—		400
Sales	(1,665		)	—			(286		)	—		—			—		—
Settlements	(11,643		)	(5,347		)	9,058			—		(2,183		)	—		275
Ending balance as of September 30, 2011	$	67,947		$	88,209		$	133,973		$	159	$	2,179		$	15,909	$	1,706
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)	$	—		$	17,729		$	33,952		$	—	$	(536	)	$	1,118	$	1,031

(1)Amounts are included in net realized and unrealized (loss) gain on investments, net realized and unrealized (loss) gain on derivatives and foreign exchange or net realized and unrealized gain (loss) on residential mortgage-backed securities, residential mortgage loans, and residential mortgage-backed securities issued, carried at estimated fair value in the condensed consolidated statements of operations.

(2)Certain securities available-for-sale and equity investments, at estimated fair value, were transferred out of Level 3 primarily the result of additional observable inputs from third party broker quotes. There were no significant transfers in to Level 3 from Level 1 or 2.

The following table presents additional information about assets, including derivatives that are measured at fair value on a recurring basis for which the Company has utilized Level 3 inputs to determine fair value, for the three months ended September 30, 2010 (amounts in thousands):

	Securities Available- For-Sale		Residential Mortgage- Backed Securities			Equity Investments, at Estimated Fair Value			Total Rate of Return Swaps		Common Stock Warrants		Foreign Exchange Options		Free-Standing Derivatives Interest Rate Swaps
Beginning balance as of July 1, 2010	$	72,773	$	107,081		$	26,482		$	37	$	126	$	—	$	4,764
Total gains or losses (realized and unrealized):
Included in earnings(1)	649		2,208			(5,835		)	98		84		15,309		(3,482		)
Included in other comprehensive income	5,279		—			—			—		—		—		—
Transfers in to level 3(2)	22,287		—			41,740			—		—		—		—
Purchases, sales, other settlements and issuances, net	11,846		(3,037		)	6,545			—		2,716		—		(10		)
Ending balance as of September 30, 2010	$	112,834	$	106,252		$	68,932		$	135	$	2,926	$	15,309	$	1,272
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)	$	—	$	7,698		$	(5,835	)	$	—	$	84	$	15,309	$	(3,482	)

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(1)Amounts are included in net realized and unrealized gain (loss) on investments, net realized and unrealized gain (loss) on derivatives and foreign exchange or net realized and unrealized gain (loss) on residential mortgage-backed securities, residential mortgage loans, and residential mortgage-backed securities issued, carried at estimated fair value in the condensed consolidated statements of operations.

(2)Certain securities available-for-sale and equity investments, at estimated fair value, were transferred in to level 3 reflecting reduced transparency of prices for these financial instruments as a result of less trading activity.

The following table presents additional information about assets, including derivatives that are measured at fair value on a recurring basis for which the Company has utilized Level 3 inputs to determine fair value, for the nine months ended September 30, 2010 (amounts in thousands):

	Securities Available- For-Sale			Residential Mortgage- Backed Securities			Equity Investments, at Estimated Fair Value			Total Rate of Return Swaps			Common Stock Warrants		Foreign Exchange Options		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(2)	4,927			(5,076		)	(8,732		)	1,801			135		15,309		1,348
Included in other comprehensive (loss) income	6,957			—			—			—			—		—		—
Transfers in to level 3(3)	22,788			—			41,740			—			—		—		—
Purchases, sales, other settlements and issuances, net	(3,126		)	(10,610		)	17,635			(13,475		)	320		—		205
Ending balance as of September 30, 2010	$	112,834		$	106,252		$	68,932		$	135		$	2,926	$	15,309	$	1,272
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)	$	—		$	5,383		$	(8,732	)	$	—		$	135	$	15,309	$	151

(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 gain (loss) on investments, net realized and unrealized gain (loss) on derivatives and foreign exchange or net realized and unrealized gain (loss) on residential mortgage-backed securities, residential mortgage loans, and residential mortgage-backed securities issued, carried at estimated fair value in the condensed consolidated statements of operations.

(3)Certain securities available-for-sale and equity investments, at estimated fair value, were transferred in to level 3 reflection reduced transparency of prices for these financial instruments as a result of less trading activity.

Note 14. Subsequent Events

On November 3, 2011, the Company’s board of directors declared a cash distribution for the quarter ended September 30, 2011 on the Company’s common shares of $0.18 per share. The distribution is payable on December 1, 2011 to common shareholders of record as of the close of business on November 17, 2011.

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

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

The following discussion and analysis of our financial condition and results of operations should be read in conjunction with our condensed consolidated financial statements and related notes included elsewhere in this Quarterly Report on Form 10-Q. Certain information contained in this Quarterly Report on Form 10-Q constitutes “forward-looking” statements within the meaning of Section 27A of the Securities Act of 1933, as amended and Section 21E of the Securities Exchange Act of 1934, as amended, that are based on our current expectations, estimates and projections, including, but not limited to, statements regarding the level of future collateralized loan obligation investments, our liquidity and the potential to issue future capital or refinance or replace existing indebtedness. Statements that are not historical facts, including statements about our beliefs and expectations, are forward-looking statements. The words “believe,” “anticipate,” “intend,” “aim,” “expect,” “strive,” “plan,” “estimate,” and “project,” and similar words identify forward-looking statements. Such statements are not guarantees of future performance, events or results and involve potential risks and uncertainties. Accordingly, actual results and the timing of certain events could differ materially from those addressed in forward-looking statements due to a number of factors including, but not limited to, changes in interest rates and market values, financing and capital availability, changes in prepayment rates, general economic and political conditions and events, changes in market conditions, particularly in the global fixed income, credit and equity markets, the impact of current, pending and future legislation, regulation and legal actions, and other factors not presently identified. Other factors that may impact our actual results are discussed under “Risk Factors” in Item 1A of the Company’s Annual Report on Form 10-K filed with the Securities Exchange Commission, or the SEC, on February 28, 2011, as further supplemented by the disclosure under “Risk Factors” in Item 1A of this Quarterly Report on Form 10-Q. We do not undertake, and specifically disclaim, any obligation to publicly release the result of any revisions that may be made to any forward-looking statements to reflect the occurrence of anticipated or unanticipated events or circumstances after the date of such statements, except for as required by federal securities laws.

Executive Overview

We are a specialty finance company with expertise in a range of asset classes. Our core business strategy is to leverage the proprietary resources of our manager with the objective of generating both current income and capital appreciation by deploying capital to our strategies, which include bank loans and high yield securities, mezzanine, special situations, natural resources, commercial real estate and private equity. Our holdings across these strategies primarily consist of below investment grade syndicated corporate loans, high yield debt securities and private equity. The corporate loans that we hold are purchased via assignment or participation in the primary or secondary market. In addition to the financial instruments we hold across our strategies, we also deploy capital to both working and royalty interests in oil and gas properties through our natural resources strategy.

The majority of our holdings consist of corporate loans and high yield debt securities held in collateralized loan obligation (“CLO”) transactions that are structured as on-balance sheet securitizations and are used as long term financing for our investments in corporate debt. The senior secured debt issued by the CLO transactions is primarily owned by unaffiliated third party investors and we own the majority of the subordinated notes in the CLO transactions. Our CLO transactions consist of six CLO transactions, KKR Financial CLO 2005-1, Ltd. (“CLO 2005-1”), KKR Financial CLO 2005-2, Ltd. (“CLO 2005-2”), KKR Financial CLO 2006-1, Ltd. (“CLO 2006-1”), KKR Financial CLO 2007-1, Ltd. (“CLO 2007-1”), KKR Financial CLO 2007-A, Ltd. (“CLO 2007-A”), and KKR Financial CLO 2011-1, Ltd. (“CLO 2011-1”) (collectively the “Cash Flow CLOs”). In addition, our CLO transactions include KKR Financial CLO 2009-1 Ltd. (“CLO 2009-1”). However, as all of the debt of CLO 2009-1 was retired in July 2009, CLO 2009-1 is excluded from our six Cash Flow CLOs above. We execute our core business strategy through our majority-owned subsidiaries, including CLOs.

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

We are managed by KKR Financial Advisors LLC (our “Manager”), a wholly-owned subsidiary of KKR Asset Management LLC, pursuant to a management agreement (the “Management Agreement”). KKR Asset Management LLC is a wholly-owned subsidiary of Kohlberg Kravis Roberts & Co. L.P. (“KKR”).

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Business Environment

The third quarter of 2011 was plagued with continued volatility and uncertainty as concerns about the eurozone debt crisis and global economic conditions persisted. Combined with various proposed regulatory reform measures and global downgrades, we witnessed a flight to treasuries from risk-averse investors as overall asset valuations declined. Overall, the S&P/LSTA Loan index returned (3.9)% for the third quarter of 2011 and (1.3)% for the first nine months of 2011, while the Merrill Lynch High Yield Master II index returned (6.3)% for the third quarter of 2011 and (1.7)% for the first nine months of 2011. Despite the lower asset prices across markets given the uncertain macroeconomic environment, there were fewer defaults for the three and nine months ended September 30, 2011 as compared to the three and nine months ended September 30, 2010 as evidenced by the S&P LSTA Lagging 12-Month Default Rate, which decreased to 0.9% in September 2011 from 1.5% in June 2011 and 2.9% in December 2010.

During the third quarter of 2011, interest rates in the U.S. increased, albeit only slightly, with the three-month London interbank offered rate (“LIBOR”) at 0.37% as of September 30, 2011, compared to 0.25% as of June 30, 2011 and 0.29% as of September 30, 2010. In order to compensate investors for owning higher-risk assets by providing an income premium, the number of assets with LIBOR floors increased. As of September 30, 2011, 31.4% of our floating corporate debt portfolio had LIBOR floors compared to 26.2% as of June 30, 2011 and 21.0% as of September 30, 2010.

Summary of Results

Our net income for the three and nine months ended September 30, 2011 totaled $39.8 million (or $0.22 per diluted common share), and $241.1 million (or $1.32 per diluted common share), respectively, as compared to net income of $82.3 million (or $0.52 per diluted common share), and $292.9 million (or $1.85 per diluted common share), for the three and nine months ended September 30, 2010, respectively. The decrease in net income of $42.5 million from the three months ended September 30, 2010 to the same period in 2011 was primarily due to the $24.5 million net realized and unrealized loss on investments during the three months ended September 30, 2011, which included a $43.8 million lower of cost or estimated fair value adjustment to corporate loans held for sale. In comparison, the three months ended September 30, 2010 had $19.4 million of net realized and unrealized gain on investments. The decrease in net income of $51.8 million from the nine months ended September 30, 2010 compared to the same period in 2011 was attributable to a decline of $41.2 million in total other income and an increase of $19.1 million in non-investment expenses, partially offset by $16.4 million of additional net investment income. For the nine months ended September 30, 2010, total other income included a one-time net gain on restructuring and extinguishment of debt of $40.0 million primarily related to the purchase of notes issued by CLO 2007-A and CLO 2007-1. The components of these amounts for the three and nine months ended September 30, 2011 and 2010 are detailed further below under “Results of Operations.”

Book value per share decreased $0.77 from $9.91 as of June 30, 2011 and $0.10 from $9.24 as of December 31, 2010 to $9.14 as of September 30, 2011. The decrease in book value per share from June 30, 2011 was primarily driven by a decrease in our accumulated other comprehensive income, a component of shareholders’ equity, of $0.81 per share primarily as a result of declines in value of our securities-available-for sale and interest rate swaps designated as cash flow hedges, as well as our quarterly distribution to shareholders of $0.18 per common share, partially offset by our earnings for the quarter of $0.22 per common share. The decrease in book value per share from December 31, 2010 was also driven by a decrease in our accumulated other comprehensive income of $0.96 per share and our aggregate distributions to shareholders of $0.49 per common share, partially offset by earnings for the year of $1.35 per common share.

Cash Distributions to Shareholders

On November 3, 2011, our board of directors declared a cash distribution for the quarter ended September 30, 2011 on our common shares of $0.18 per share. The distribution is payable on December 1, 2011 to common shareholders of record as of the close of business on November 17, 2011.

The amount and timing of distributions to our common shareholders, including quarterly distributions or any special distributions, is determined by our board of directors and is based upon a review of various factors including current market conditions, existing restrictions under borrowing agreements, the amount of ordinary taxable income or loss earned by us and gains or losses recognized by us on the disposition of assets and our liquidity needs. For this purpose, we will generally determine gains or losses based upon the price we paid for those assets. However, because of the tax rules applicable to partnerships, the gains or losses recognized by a shareholder on the sale of assets held by us may be higher or lower depending upon the purchase price the shareholder paid for our shares. See “Partnership Tax Matters—Non-Cash ‘Phantom’ Taxable Income” for further discussion about taxable income allocable to holders of our common shares.

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Consolidation

CLO 2005-1, CLO 2005-2, CLO 2006-1, CLO 2007-1, CLO 2007-A, CLO 2009-1 and CLO 2011-1 are all variable interest entities (“VIEs”) that we consolidate as we have determined we have the power to direct the activities that most significantly impact these entities’ economic performance and we have both the obligation to absorb losses of these entities and the right to receive benefits from these entities that could potentially be significant to these entities.

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

Investment Portfolio

Overview

Our core business strategy is to leverage the proprietary resources of our Manager with the objective of generating both current income and capital appreciation by deploying capital to different strategies that reflect the opportunity set that our Manager specializes in. These strategies and a summary of each are as follows:

·Bank loans and high yield: We deploy capital to this strategy primarily through our CLO subsidiaries. This strategy primarily consists of senior secured corporate loans and debt securities, but also includes second lien, unsecured and subordinated corporate loans and debt securities.

·Mezzanine: Mezzanine opportunities generally represent the private debt instruments located in the middle of a company’s capital structure, senior to common or preferred equity but subordinate to senior secured debt. Generally, mezzanine securities take the form of privately negotiated subordinated debt, and, to a lesser extent, senior notes or preferred stock, with some form of equity participation either through common or preferred stock, options or warrants.

·Special situations: Special situations opportunities may take the form of debt and/or equity and generally consist of deploying capital to deeply discounted secondary market opportunities, debtor-in-possession and exit facilities, rescue financing transactions and other distressed opportunities.

·Natural resources: Our natural resources strategy consists of deploying capital to oil and gas opportunities by acquiring working interests in conventional and unconventional producing properties, acquiring royalty interests in both producing properties and unconventional resource developments (i.e. emerging shale plays) and deploying capital to private equity opportunities focused on the oil and gas sector.

·Private equity: Our private equity strategy consists of deploying capital to private equity opportunities primarily on a side-by-side basis with KKR’s private equity funds.

The majority of our investments are held through CLO transactions that are managed by an affiliate of our Manager and for which we own the majority, and in some cases all, of the residual economic interests in the transaction through the subordinated notes in the transaction. As of September 30, 2011, our Cash Flow CLOs, which were structured as financing vehicles engaged in holding primarily corporate debt investments, held $7.6 billion par amount or $6.8 billion estimated fair value of corporate debt investments. Our corporate debt investments held through our Cash Flow CLOs consists of the following as of September 30, 2011:

·Corporate loans: Corporate loans consist of bank loans that are held through our CLOs with an aggregate par value of $6.8 billion and estimated fair value of $6.2 billion. Corporate loans held through our CLO transactions have a weighted average coupon of 4.4%, of which 99.9% of the corporate loans are floating rate with a weighted average coupon spread to LIBOR of 3.7%. The remaining 0.1% are fixed rate with a weighted average coupon of 11.5%.

·Corporate debt securities: Corporate debt securities consists of high yield bonds held through our CLOs with an aggregate par amount of $755.0 million and estimated fair value of $690.3 million. Corporate debt securities held through our CLO transactions have a weighted average coupon of 8.3%, of which 77.2% of the corporate debt securities are fixed rate with a weighted average coupon of 9.6%. The remaining 22.8% are floating rate with a weighted average coupon spread to LIBOR of 3.8%.

Weighted average coupon and coupon spreads are calculated based on par values. Fixed and floating percentages are also calculated based on par values.

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In addition to the corporate debt portfolio, we hold two pay-fixed, receive-variable interest rate swaps through certain of our CLOs. These interest rate derivatives consist of swaps to hedge a portion of the interest rate risk associated with our borrowings under the CLO senior secured notes. As of September 30, 2011, the contractual notional balance of these amortizing interest rate swaps was $383.3 million.

These Cash Flow CLOs had aggregate secured debt outstanding totaling $5.6 billion held by unaffiliated third parties and aggregate junior secured notes outstanding totaling $365.8 million held by an affiliate of our Manager. In CLO transactions, subordinated notes effectively represent the equity in such transactions as they have the first risk of loss and conversely, the residual value upside of the transactions. As we hold the majority or all of the subordinated notes in each of the Cash Flow CLOs, we consolidate all of the Cash Flow CLOs and reflect all income and losses related to the assets in these Cash Flow CLOs on our condensed consolidated statement of operations even though a minority interest in two of our CLO transactions is not held by us.

The indentures governing the CLO transactions stipulate the reinvestment period during which the collateral manager, an affiliate of our Manager, can generally sell or buy assets at its discretion and can reinvest principal proceeds into new assets. CLO 2007-A ended its reinvestment period during the fourth quarter of 2010 and both CLO 2005-1 and CLO 2005-2 ended their reinvestment periods in the second quarter of 2011. As a result, principal proceeds from the assets held in each of these three transactions are generally used to amortize the outstanding balance of senior notes outstanding. During the three and nine months ended September 30, 2011, $253.1 million and $474.7 million, respectively, of original CLO 2007-A, CLO 2005-1 and CLO 2005-2 senior notes were repaid. CLO 2006-1 and CLO 2007-1 will end their respective reinvestment periods during August 2012 and May 2014, respectively. CLO 2011-1 does not have a reinvestment period and all principal proceeds from holdings in CLO 2011-1 will be used to amortize the transaction. Accordingly, absent any new CLO transactions that we may enter into, our total investments held through CLOs will continue to decline as investments are paid down or paid off once the reinvestment period ends. In addition, pursuant to the terms of the indentures governing our CLO transactions, we have the ability to call in a CLO transaction by redeeming the notes and reinvesting the proceeds into a new CLO.

On an unconsolidated basis, which reflects our interests in our CLO subsidiaries as notes versus actual corporate loans and high yield securities on a consolidated basis, our investment portfolio primarily consists of the following holdings as of September 30, 2011:

·CLO note holdings: We hold $1.2 billion par of mezzanine and subordinated notes in our six Cash Flow CLO transactions. As our Cash Flow CLOs are consolidated under accounting principles generally accepted in the United States of America (“GAAP”), these holdings are not reflected on our condensed consolidated balance sheet as the assets and liabilities of our CLO subsidiaries are consolidated and our ownership interests in the Cash Flow CLOs are eliminated for consolidation.

·Corporate loans: Our corporate loans consist of bank loans that are held outside of our CLO transactions. These corporate loans are comprised of loans eligible to be included in future CLO transactions with an aggregate par value of $51.1 million and estimated fair value of $45.9 million. Corporate loans held for future CLO transactions have a weighted average coupon of 4.1%, with all of the corporate loans being floating rate with a weighted average coupon spread to LIBOR of 3.4%. In addition, these corporate loans include loans that are not being held for future CLO transactions with an aggregate par value of $277.1 million and estimated fair value of $150.4 million. These loans have a weighted average coupon of 6.6%, with all of the corporate loans being floating rate with a weighted average coupon spread to LIBOR of 5.3%. In addition, we hold equity from two issuers with an estimated fair value of $20.7 million, which were restructured from debt instruments to equity.

·Corporate debt securities: Our corporate debt securities consists of high yield bonds. These corporate debt securities are comprised of debt securities that are not being held for future CLO transactions with an aggregate par value of $21.0 million and estimated fair value of $18.8 million. These debt securities are fixed rate with a weighted average coupon of 10.7%.

·Mezzanine: Our mezzanine holdings consist of (i) $46.4 million par amount of debt with an estimated fair value of $46.3 million and (ii) $12.5 million amortized cost of equity with an estimated fair value of $11.4 million. The $46.4 million par amount of mezzanine debt has a weighted average coupon of 13.6%.

·Special situations: Our special situations holdings consist of (i) $141.1 million par amount of debt with an $108.2 million amortized cost and estimated fair value of $112.8 million, (ii) $35.9 million amortized cost of equity, including warrants, with an estimated fair value of $32.0 million, and (iii) $5.2 million amortized cost of other investments with an estimated fair value of $5.6 million. The $141.1 million par amount of debt has a weighted average coupon of 8.3%.

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·Natural resources: Our natural resources holdings consist of (i) private equity focused on the oil and gas sector with an aggregate cost basis of $29.6 million and an estimated fair value of $63.4 million, (ii) oil and gas working interests in proved developed and proved undeveloped properties in Texas with a carrying amount of $88.8 million, partially financed with $38.3 million borrowed under a non-recourse, asset-based credit facility, and (iii) overriding royalty interests with a carrying amount of $52.7 million.

·Private equity: Our private equity holdings, excluding those related to the oil and gas sector, have an aggregate cost basis of $53.2 million with an estimated fair value of $45.4 million.

·Residential mortgage backed securities (“RMBS”): Our RMBS have an aggregate par amount of $196.4 million with an estimated fair value of $88.2 million.

Critical Accounting Policies

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

Fair Value of Financial Instruments

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

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

The types of assets generally included in this category are equity securities listed in active markets.

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

The types of assets and liabilities generally included in this category are 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 derivatives.

Level 3:  Inputs are unobservable inputs for the asset or liability, and include situations where there is little, if any, market activity for the asset or liability. In certain cases, the inputs used to measure 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 fair value measurement in its entirety falls has been determined based on the lowest level input that is significant to the fair value measurement in its entirety. Our assessment of the significance of a particular input to the fair value measurement in its entirety requires judgment and the consideration of factors specific to the asset.

The types of assets and liabilities generally included in this category are certain corporate debt securities, certain corporate loans held for sale, certain equity investments, at estimated fair value, RMBS, at estimated fair value and certain financial instruments classified as derivatives.

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

The availability of observable inputs can vary depending on the financial asset or liability and is affected by a wide variety of factors, including, for example, the type of product, whether the product is new, whether the product is traded on an active exchange or in the secondary market, and the current market condition. To the extent that valuation is based on models or inputs that are less observable or unobservable in the market, the determination of fair value requires more judgment. Accordingly, the degree of judgment exercised by us in determining fair value is greatest for instruments categorized in Level 3. In certain cases, the inputs used to measure fair value may fall into different levels of the fair value hierarchy. In such cases, for disclosure purposes, the level in the fair value hierarchy within which the fair value measurement in its entirety falls is determined based on the lowest level input that is significant to the fair value measurement in its entirety. The variability of the observable inputs affected by the factors described above may cause transfers between Levels 1, 2, and/or 3, which we recognize at the end of the reporting period.

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

Depending on the relative liquidity in the markets for certain assets, we may transfer assets to Level 3 if we determine that observable quoted prices, obtained directly or indirectly, are not available. The valuation techniques used for the assets and liabilities that are valued using Level 3 of the fair value hierarchy are described below.

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

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

Over-the-counter (“OTC”) Derivative Contracts:  OTC derivative contracts include forward, swap and option contracts related to interest rates, foreign currencies, credit standing of reference entities, and equity prices. The fair value of OTC derivative products can be modeled using a series of techniques, including closed-form analytic formulae, such as the Black-Scholes option-pricing model, and simulation models or a combination thereof. Many pricing models do not entail material subjectivity because the methodologies employed do not necessitate significant judgment, and the pricing inputs are observed from actively quoted markets, as is the case for generic interest rate swap and option contracts.

Residential Mortgage-Backed Securities, at Estimated Fair Value:  Residential mortgage-backed securities, residential mortgage loans, and residential mortgage-backed securities issued are initially valued at transaction price and are subsequently valued using industry recognized models (including Intex and Bloomberg) and data for similar instruments (e.g., nationally recognized pricing services or broker quotes). The most significant inputs to the valuation of these instruments are default and loss expectations and market credit spreads.

Share-Based Compensation

We account for share-based compensation issued to members of our board of directors and our Manager using the fair value based methodology in accordance with GAAP. We do not have any employees, although we believe that members of our board of directors are deemed to be employees for purposes of interpreting and applying accounting principles relating to share-based compensation. We record as compensation costs the restricted common shares that we issue to members of our board of directors at estimated fair value as of the grant date and we amortize the cost into expense over the three-year vesting period using the straight-line

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method. We record compensation costs for restricted common shares and common share options that we issued to our Manager at estimated fair value as of the grant date and we remeasure the amount on subsequent reporting dates to the extent the awards have not vested. Unvested restricted common shares are valued using observable secondary market prices. Unvested common share options are valued using the Black-Scholes model and assumptions based on observable market data for comparable companies. We amortize compensation expense related to the restricted common shares and common share options that we granted to our Manager using the graded vesting attribution method.

Because we remeasure the amount of compensation costs associated with the unvested restricted common shares and unvested common share options that we issued to our Manager as of each reporting period, our share-based compensation expense reported in our condensed consolidated financial statements will change based on the estimated fair value of our common shares and this may result in earnings volatility. For the three months ended September 30, 2011, share-based compensation totaled $0.3 million. As of September 30, 2011, a $1 increase in the price of our common shares would have increased our future share-based compensation expense by approximately $0.2 million and this future share-based compensation expense would be recognized over the remaining vesting periods of our outstanding restricted common shares. As of September 30, 2011, the common share options were fully vested and expire in August 2014. As of September 30, 2011, future unamortized share-based compensation totaled $2.2 million, of which the following will be recognized: $0.4 million in 2011, $1.1 million in 2012 and $0.7 million in 2013 through 2015.

Accounting for Derivative Instruments and Hedging Activities

We recognize all derivatives on our condensed consolidated balance sheets at estimated fair value. On the date we enter into a derivative contract, we designate and document each derivative contract as one of the following at the time the contract is executed: (i) a hedge of a recognized asset or liability (“fair value” hedge); (ii) a hedge of a forecasted transaction or of the variability of cash flows to be received or paid related to a recognized asset or liability (“cash flow” hedge); (iii) a hedge of a net investment in a foreign operation; or (iv) a derivative instrument not designated as a hedging instrument (“free-standing derivative”). For a fair value hedge, we record changes in the estimated fair value of the derivative instrument and, to the extent that it is effective, changes in the fair value of the hedged asset or liability in the current period earnings in the same financial statement category as the hedged item. For a cash flow hedge, we record changes in the estimated fair value of the derivative to the extent that it is effective in other comprehensive income (loss) and subsequently reclassify these changes in estimated fair value to net income in the same period(s) that the hedged transaction affects earnings. The effective portion of the cash flow hedges is recorded in the same financial statement category as the hedged item. For free-standing derivatives, we report changes in the fair values in other income (loss).

We formally document at inception our hedge relationships, including identification of the hedging instruments and the hedged items, our risk management objectives, strategy for undertaking the hedge transaction and our evaluation of effectiveness of our hedged transactions. Periodically, we also formally assess whether the derivative designated in each hedging relationship is expected to be and has been highly effective in offsetting changes in estimated fair values or cash flows of the hedged item using either the dollar offset or the regression analysis method. If we determine that a derivative is not highly effective as a hedge, we discontinue hedge accounting.

We are not required to account for our derivative contracts using hedge accounting as described above. If we decide not to designate the derivative contracts as hedges or if we fail to fulfill the criteria necessary to qualify for hedge accounting, then the changes in the estimated fair values of our derivative contracts would affect periodic earnings immediately potentially resulting in the increased volatility of our earnings. The qualification requirements for hedge accounting are complex and as a result, we must evaluate, designate, and thoroughly document each hedge transaction at inception and perform ineffectiveness analysis and prepare related documentation at inception and on a recurring basis thereafter. As of September 30, 2011, the estimated fair value of our net derivative liabilities totaled $97.9 million.

Impairments

We monitor our available-for-sale securities portfolio for impairments. A loss is recognized when it is determined that a decline in the estimated fair value of a security below its amortized cost is other-than-temporary. We consider many factors in determining whether the impairment of a security is deemed to be other-than-temporary, including, but not limited to, the length of time the security has had a decline in estimated fair value below its amortized cost and the severity of the decline, the amount of the unrealized loss, recent events specific to the issuer or industry, external credit ratings and recent changes in such ratings. In addition, for debt securities we consider our intent to sell the debt security, our estimation of whether or not we expect to recover the debt security’s entire amortized cost if we intend to hold the debt security, and whether it is more likely than not that we will be required to sell the debt security before its anticipated recovery. For equity securities, we also consider our intent and ability to hold the equity security for a period of time sufficient for a recovery in value.

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The amount of the loss that is recognized when it is determined that a decline in the estimated fair value of a security below its amortized cost is other-than-temporary is dependent on certain factors. If the security is an equity security or if the security is a debt security that we intend to sell or estimate that it is more likely than not that we will be required to sell before recovery of its amortized cost, then the impairment amount recognized in earnings is the entire difference between the estimated fair value of the security and its amortized cost. For debt securities that we do not intend to sell or estimate that we are not more likely than not to be required to sell before recovery, the impairment is separated into the estimated amount relating to credit loss and the estimated amount relating to all other factors. Only the estimated credit loss amount is recognized in earnings, with the remainder of the loss amount recognized in other comprehensive (loss) income.

This process involves a considerable amount of judgment by our management. As of September 30, 2011, we had aggregate unrealized losses on our securities classified as available-for-sale of approximately $24.2 million, which if not recovered may result in the recognition of future losses. During both the three and nine months ended September 30, 2011, we recorded charges for impairments of securities that we determined to be other-than-temporary totaling $1.5 million.

Allowance for Loan Losses

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

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

The unallocated component of our allowance for loan losses represents our estimate of probable losses inherent in our loan portfolio as of the balance sheet date where the specific loan that the loan loss relates to is indeterminable. We estimate the unallocated component of our allowance for loan losses through a comprehensive quarterly review of our loan portfolio and identify certain loans that demonstrate possible indicators of impairment, including internally assigned credit quality indicators. This assessment excludes all loans that are determined to be impaired and as a result, an allocated reserve has been recorded as described in the preceding paragraph. Such indicators include, but are not limited to, the current and/or forecasted financial performance and liquidity profile of the issuer, specific industry or economic conditions that may impact the issuer, and the observable trading price of the loan if available. All loans are first categorized based on their assigned risk grade and further stratified based on the seniority of the loan in the issuer’s capital structure. The seniority classifications assigned to loans are senior secured, second lien and subordinate. Senior secured consists of loans that are the most senior debt in an issuer’s capital structure and therefore have a lower estimated loss severity than other debt that is subordinate to the senior secured loan. Senior secured loans often have a first lien on some or all of the issuer’s assets. Second lien consists of loans that are secured by a second lien interest on some or all of the issuer’s assets; however, the loan is subordinate to the first lien debt in the issuer’s capital structure. Subordinate consists of loans that are generally unsecured and subordinate to other debt in the issuer’s capital structure.

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

We apply a range of default and loss severity estimates in order to estimate a range of loss outcomes upon which to base our estimate of probable losses that results in the determination of the unallocated component of our allowance for loan losses. As of September 30, 2011, the range of outcomes used to estimate concern as to the probability of default was between 1% and 20% and the range of loss severity assumptions was between 5% and 85%. The estimates and assumptions we use to estimate our allowance for

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loan losses are based on our estimated range of outcomes that are determined from industry information providing both historical and forecasted empirical performance of the type of corporate loans that we invest in, as well as from our own estimates based on the nature of our corporate loan portfolio. These estimates and assumptions are susceptible to change due to our corporate loan portfolio’s performance as well as industry and general economic conditions. Changes in the assumptions and estimates used to estimate our allowance for loan losses could have a material impact on our financial condition and results of operations.

As of September 30, 2011, our allowance for loan losses totaled $191.4 million.

Results of Operations

Summary

The following discussion presents an analysis of our results of operations on a comparative basis for the three and nine months ended September 30, 2011 and 2010. Our results of operations may be materially affected by market fluctuations and current economic events, particularly in the fixed income and equity markets. A summary of key financial results are as follows (amounts in thousands, except per share information):

	For the threemonths endedSeptember 30, 2011			For the threemonths endedSeptember 30, 2010		For the ninemonths endedSeptember 30, 2011		For the ninemonths endedSeptember 30, 2010
Net investment income	$	86,615		$	78,320	$	254,790	$	238,404
Total other (loss) income	(29,306		)	26,627		79,708		120,930
Total non-investment expenses	17,886			22,153		85,063		65,980
Income before income tax expense	39,423			82,794		249,435		293,354
Income tax (benefit) expense	(397		)	452		8,344		489
Net income	$	39,820		$	82,342	$	241,091	$	292,865
Net income per share—diluted	$	0.22		$	0.52	$	1.32	$	1.85

Net Investment Income

The following table presents the components of our net investment income for the three and nine months ended September 30, 2011 and 2010:

Comparative Net Investment Income Components

(Amounts in thousands)

	For the threemonths ended September 30, 2011		For the threemonths ended September 30, 2010		For the ninemonths ended September 30, 2011		For the ninemonths ended September 30, 2010
Investment Income:
Corporate loans and securities interest income	$	98,501	$	96,523	$	288,136	$	273,139
Residential mortgage-backed securities interest income	3,352		5,518		11,311		19,169
Other investment income	9,994		27		19,568		140
Dividend income	106		2		4,775		1,946
Net discount accretion	22,487		20,179		81,823		69,571
Total investment income	134,440		122,249		405,613		363,965
Interest Expense:
Collateralized loan obligation secured debt	15,306		16,490		45,508		44,271
Credit facilities	837		628		2,289		12,299
Convertible senior notes	6,763		6,966		20,755		21,193
Junior subordinated notes	3,875		3,930		11,615		11,698
Interest rate swaps	5,707		2,022		17,049		10,730
Other interest expense	116		15		487		211
Total interest expense	32,604		30,051		97,703		100,402
Interest expense to affiliates	12,688		5,791		38,926		17,072
Provision for loan losses	2,533		8,087		14,194		8,087
Net investment income	$	86,615	$	78,320	$	254,790	$	238,404

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As presented in the table above, net investment income increased $8.3 million and $16.4 million for the three and nine months ended September 30, 2011, respectively, compared to the same periods in 2010. Total investment income, consisting primarily of interest income, other investment income and discount accretion from our investment portfolio, totaled $134.4 million and $405.6 million for the three and nine months ended September 30, 2011, respectively, and $122.2 million and $364.0 million for the three and nine months ended September 30, 2010, respectively.

For the three months ended September 30, 2011 compared to the three months ended September 30, 2010

The increase in total investment income of $12.2 million from the three months ended September 30, 2010 to 2011 was primarily attributable to other investment income increasing $10.0 million related to revenue earned on our working and royalty interests in oil and gas properties. As we began acquiring working and royalty interests during the fourth quarter of 2010, no such revenue was earned or recorded in prior year periods.

For the nine months ended September 30, 2011 compared to the nine months ended September 30, 2010

The increase in total investment income of $41.6 million from the nine months ended September 30, 2010 to 2011 was primarily attributable to (i) corporate loans and securities interest income increasing $15.0 million, (ii) other investment income increasing $19.4 million and (iii) net discount accretion increasing $12.3 million. First, the increase in corporate loans and securities income of $15.0 million, or 5%, for the nine months ended September 30, 2011 as compared to the nine months ended September 30, 2010 is primarily attributable to a larger corporate debt portfolio, combined with an increase in the weighted average coupon of our corporate debt portfolio from 4.6% for the nine months ended September 30, 2010 to 4.9% for the nine months ended September 30, 2011, calculated based on the average par balances for the respective periods. The increase in the weighted average coupon of our corporate debt portfolio is due to an increase in the percentage of our corporate debt portfolio with LIBOR floors from 21.0% as of September 30, 2010 to 31.4% as of September 30, 2011, as well as the acquisition of holdings during the nine months ended September 30, 2011 with comparatively higher rates. Second, the increase in other investment income of $19.4 million from the nine months ended September 30, 2010 compared to the same period in 2011 is primarily attributable to revenue earned on our working and royalty interests in oil and gas properties. As we began acquiring working and royalty interests in oil and gas properties during the fourth quarter of 2010, no such revenue was earned or recorded in prior year periods. As we continue to grow our natural resources holdings, we expect the related net revenue to steadily increase as production increases through the acquisition of additional oil and gas assets and drilling of existing undeveloped property. Lastly, net discount accretion increased $12.3 million primarily due to principal prepayments on our corporate debt portfolio which resulted in an additional $9.1 million of accelerated discount accretion during the nine months ended September 30, 2011, compared to the same period in 2010.

The increase in total investment income was slightly offset by an increase in interest expense to affiliates of $21.9 million from the nine months ended September 30, 2010 to 2011 due to all Cash Flow CLOs passing certain compliance tests in 2011 and thereby, resuming payments to mezzanine and subordinate note holders, including an affiliate of our Manager. In addition, a provision for loan losses totaling $14.2 million was recorded for the nine months ending September 30, 2011, compared to $8.1 million for the same period in 2010.

Other (Loss) Income

The following table presents the components of other income for the three and nine months ended September 30, 2011 and 2010:

Comparative Other (Loss) Income Components

(Amounts in thousands)

	For the three months ended September 30, 2011			For the three months ended September 30, 2010			For the ninemonths ended September 30, 2011			For the ninemonths ended September 30, 2010
Net realized and unrealized (loss) gain on derivatives and foreign exchange:
Interest rate swaps	$	—		$	(3,482	)	$	—		$	1,350
Commodity swaps	3,450			—			3,573			—
Credit default swaps	(2,568		)	448			(2,897		)	1,703
Total rate of return swaps	(4		)	98			55			1,801
Common stock warrants	(980		)	84			34			135
Foreign exchange(1)	(7,501		)	6,683			(966		)	(8,426		)
Options	—			—			(94		)	—
Total realized and unrealized (loss) gain on derivatives and foreign exchange	(7,603		)	3,831			(295		)	(3,437		)
Net realized loss on residential mortgage-backed securities, at estimated fair value	(9,408		)	(6,206		)	(24,563		)	(13,147		)
Net unrealized gain on residential mortgage-backed securities, at estimated fair value	11,682			7,698			26,708			5,383
Net realized and unrealized (loss) gain on investments(2)	(23,165		)	21,705			75,319			93,782
Net realized and unrealized gain (loss) on securities sold, not yet purchased	125			—			494			(756		)
Impairment of securities available-for-sale and private equity at cost	(1,491		)	(2,264		)	(2,619		)	(9,979		)
Net (loss) gain on restructuring and extinguishment of debt	(1,736		)	—			(1,736		)	39,999
Other income	2,290			1,863			6,400			9,085
Total other (loss) income	$	(29,306	)	$	26,627		$	79,708		$	120,930

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(1)Includes foreign exchange contracts and foreign exchange remeasurement gain or loss.

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

For the three months ended September 30, 2011 compared to the three months ended September 30, 2010

Other losses totaled $29.3 million for the three months ended September 30, 2011 as compared to total other income of $26.6 million for the three months ended September 30, 2010. Total other loss for the third quarter of 2011 was primarily driven by net realized and unrealized loss on investments of $23.2 million and net realized and unrealized loss on derivatives and foreign exchange of $7.6 million.

The $23.2 million net realized and unrealized loss on investments for the three months ended September 30, 2011 included a $43.8 million lower of cost or estimated fair value charge as a result of overall declines in asset prices leading to unrealized mark-to-market losses. While corporate loans held for investment are carried at amortized cost, corporate loans held for sale are stated at the lower of cost or estimated fair value and are assessed on an individual basis, with any unrealized gains or losses reported in the condensed consolidated statement of operations. These unrealized losses were partially offset with a $33.3 million realized gain related to the sale of one corporate debt security. The $7.6 million of net realized and unrealized loss on derivatives and foreign exchange was primarily related to foreign exchange remeasurement losses arising from the weakening of foreign currencies against the U.S. dollar. As of September 30, 2011, 4.3% of our corporate debt portfolio was denominated in foreign currencies, of which 71.4% was denominated in euros.

Comparatively, during the third quarter of 2010, we had no lower of cost or estimated fair value charge; rather, we recorded a reduction to the lower of cost or estimated fair value allowance by $8.8 million and recorded a $3.8 million realized and unrealized gain on derivatives and foreign exchange.

For the nine months ended September 30, 2011 compared to the nine months ended September 30, 2010

The decrease in total other income of $41.2 million from the nine months ended September 30, 2010 to 2011 was primarily attributable to two factors. First, net realized and unrealized gain on investments declined $18.5 million year over year primarily as a result of an additional $34.8 million lower of cost or estimated fair value adjustment to corporate loans held for sale recorded during the nine months ended September 30, 2011, partially offset by realized gains from the sale of corporate debt securities during 2011. Second, during 2010, in an open market auction, we purchased $83.0 million of notes issued by CLO 2007-A and CLO 2007-1, both of which were previously held by an affiliate of our Manager. These transactions resulted in us recording an aggregate one-time gain on extinguishment of debt totaling $38.7 million for the nine months ended September 30, 2010. Comparatively, during the nine months ended September 30, 2011, we recorded a $1.7 million loss related to the $45.1 million repurchase of our 7.0% convertible notes due July 2012.

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Non-Investment Expenses

The following table presents the components of non-investment expenses for the three and nine months ended September 30, 2011 and 2010:

Comparative Non-Investment Expense Components

(Amounts in thousands)

	For the three months ended September 30, 2011			For the three months ended September 30, 2010		For the ninemonths ended September 30, 2011		For the ninemonths ended September 30, 2010
Related party management compensation:
Base management fees	$	6,742		$	4,870	$	19,522	$	13,708
Incentive fees	—			9,424		28,159		30,306
Share-based compensation	136			1,943		2,077		4,437
CLO management fees	1,320			1,314		3,956		4,067
Related party management compensation	8,198			17,551		53,714		52,518
Professional services	1,134			1,041		4,257		3,335
Insurance	438			584		1,733		1,857
Directors’ expenses	(41		)	654		890		2,159
Other general and administrative	8,157			2,323		24,469		6,111
Total non-investment expenses	$	17,886		$	22,153	$	85,063	$	65,980

As presented in the table above, our non-investment expenses decreased $4.3 million and increased $19.1 million from the three and nine months ended September 30, 2010, respectively, to the same period in 2011. The significant components of non-investment expense are described below.

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

The base management fee payable was calculated in accordance with the Management Agreement and is based on an annual rate of 1.75% times our “equity” as defined in the Management Agreement. Base management fees increased by $1.9 million and $5.8 million from the three and nine months ended September 30, 2010, respectively, to the same periods in 2011 primarily due to an increase in “equity” resulting from net income earned throughout 2010 and into 2011, and the December 2010 equity offering of 19.4 million common shares, which generated proceeds of $175.7 million.

Our Manager is also entitled to a quarterly incentive fee provided that our quarterly “net income,” as defined in the Management Agreement, before the incentive fee exceeds a defined return hurdle. Incentive fees of zero and $28.2 million were earned by the Manager during the three and nine months ended September 30, 2011, respectively, as compared to $9.4 million and $30.3 million during the three and nine months ended September 30, 2010, respectively.

An affiliate of our Manager entered into separate management agreements with the respective investment vehicles CLO 2005-1, CLO 2005-2, CLO 2006-1, CLO 2007-1, CLO 2007-A, CLO 2009-1 and CLO 2011-1 and is entitled to receive fees for the services performed as collateral manager for all of these CLOs, except for CLO 2011-1. The collateral manager has the option to waive the fees it earns for providing management services for the CLOs and has done so in prior periods.

During the three and nine months ended September 30, 2011, the collateral manager waived management fees for all CLOs, except for CLO 2005-1, totaling $8.4 million and $25.6 million, respectively. During the three and nine months ended September 30, 2010, the collateral manager waived the management fees for all CLOs, except for CLO 2005-1, totaling $8.7 million and $21.9 million, respectively. For the three and nine months ended September 30, 2011, we recorded an expense for CLO management fees totaling $1.3 million and $4.0 million, respectively. For the three and nine months ended September 30, 2010, we recorded an expense for CLO management fees totaling $1.3 million and $4.1 million, respectively.

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Other general and administrative expenses increased $5.8 million and $18.4 million from the three and nine months ended September 30, 2010, respectively, to the same periods in 2011. These increases were primarily attributable to expenses related to the acquisition, management and operation of our working interests and overriding royalty interests natural resources investments, including recurring charges for depreciation, depletion and amortization. There were no related expenses for the three and nine months ended September 30, 2010 as we began acquiring working interests and overriding royalty interests through our natural resources strategy during the fourth quarter of 2010. In addition, for the three and nine months ended September 30, 2011, other general and administrative expenses included expenses incurred by our Manager on our behalf that were reimbursable to our Manager pursuant to the Management Agreement. Comparatively, for most of the first half of 2010, our Manager permanently waived reimbursement of allocable general and administrative expenses in an amount equal to the incremental CLO management fees received by our Manager. Beginning January 1, 2009, our Manager permanently waived reimbursable general and administrative expenses allocable to us in an amount equal to the incremental CLO management fees received by our Manager. For the three and nine months ended September 30, 2010, our Manager permanently waived reimbursement of allocable general and administrative expenses totaling zero and $2.4 million, respectively. Due to the reinstatement of waived CLO management fees beginning in 2009, effective June 2010, all incremental CLO management fees received by our Manager had been fully applied to offset these reimbursable expenses. Accordingly, for the three and nine months ended September 30, 2011, there were no reimbursable general and administrative expenses waived by our Manager; rather, we incurred reimbursable general and administrative expenses to our Manager of $1.6 million and $4.9 million, respectively, as compared to $1.3 million and $2.2 million for the three and nine months ended September 30, 2010, respectively.

Professional services expenses consist of legal, accounting and other professional services. Directors’ expenses represent share-based compensation, as well as expenses and reimbursements due to the board of directors for their services.

Income Tax Provision

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

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

We have wholly-owned domestic and foreign subsidiaries that are taxable as corporations for United States federal income tax purposes and thus are not consolidated by us for United States federal income tax purposes. For financial reporting purposes, current and deferred taxes are provided for on the portion of earnings recognized by us with respect to our interest in the domestic taxable corporate subsidiaries, because each is taxed as a regular corporation under the Code. Deferred income tax assets and liabilities are computed based on temporary differences between the GAAP condensed consolidated financial statements and the United States federal income tax basis of assets and liabilities as of each condensed consolidated balance sheet date. The foreign corporate subsidiaries were formed to make certain foreign and domestic investments from time to time. The foreign corporate subsidiaries are organized as exempted companies incorporated with limited liability under the laws of the Cayman Islands, and are anticipated to be exempt from United States federal and state income tax at the corporate entity level because they restrict their activities in the United States to trading in stock and securities for their own account. They generally will not be subject to corporate income tax in our financial statements on their earnings, and no provisions for income taxes for the three months ended September 30, 2011 were recorded; however, we will be required to include their current taxable income in our calculation of our taxable income allocable to shareholders. CLO 2005-1, CLO 2005-2, CLO 2006-1, CLO 2007-1, CLO 2007-A, CLO 2009-1 and CLO 2011-1 are our foreign subsidiaries that elected to be treated as disregarded entities or partnerships for United States federal income tax purposes. These subsidiaries were established to facilitate securitization transactions, structured as secured financing transactions.

KFH II, our REIT subsidiary, is not expected to incur a 2011 federal or state tax expense. However, we recorded $0.4 million of federal tax benefit for our domestic corporate subsidiaries for the three months ended September 30, 2011. We recorded $6.2 million of federal and $1.9 million of state tax expense for our domestic corporate subsidiaries for the nine months ended September 30, 2011. Additionally, we recorded $0.2 million of state and foreign tax expense for our non-corporate subsidiaries for the nine months ended September 30, 2011. Accordingly, for the three and nine months ended September 30, 2011, we recorded income tax benefit of $0.4 million and income tax expense of $8.3 million, respectively.

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Investment Portfolio

Our investment portfolio primarily consists of corporate debt holdings, consisting of corporate loans and corporate debt securities (the majority of which is included in securities available-for-sale in the table below). The details of our corporate debt portfolio are discussed below under “Corporate Debt Portfolio”.

The following table summarizes the carrying value of our investment portfolio by strategy as of September 30, 2011 (amounts in thousands):

	Bank Loans				Special		Private		Natural
	& High Yield Bonds		Mezzanine		Situations		Equity		Resources		Total
Corporate loans(1)	$	6,717,772	$	43,079	$	46,994	$	—	$	—	$	6,807,845
Securities available-for-sale	709,088		3,183		73,924		—		—		786,195
Equity investments, at estimated fair value(2)	26,739		10,936		24,932		44,204		63,364		170,175
Other assets	—		3,000		6,258		672		141,443		151,373
Total(3)	$	7,453,599	$	60,198	$	152,108	$	44,876	$	204,807	$	7,915,588

(1)Includes loans held for sale and are presented gross of allowance for loan losses totaling $191.4 million as of September 30, 2011.

(2)Includes certain marketable equity securities and private equity investments, including bank loans and high yield debt securities which were restructured from debt instruments to equity, for which we elected the fair value option of accounting.

(3)Excludes our investments in residential mortgage-backed securities with an estimated fair value of $88.2 million and securities sold, not yet purchased with an estimated fair value of $1.2 million.

Corporate Debt Portfolio

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

We do not require specific collateral or security to support our corporate loans and debt securities; however, these loans and debt securities are either secured through a first or second lien on the assets of the issuer or are unsecured. We do not have access to any collateral of the issuer of the corporate loans and debt securities, rather the seniority in the capital structure of the loans and debt securities determines the seniority of our investment with respect to prioritization of claims in the event that the issuer defaults on the outstanding debt obligation.

Corporate Loans

Our corporate loan portfolio had an aggregate par value of $7.2 billion and $6.9 billion as of September 30, 2011 and December 31, 2010, respectively. Our corporate loan portfolio consists of debt obligations of corporations, partnerships and other entities in the form of senior secured loans, second lien loans and subordinated loans.

The following table summarizes our corporate loans portfolio stratified by type as of September 30, 2011 and December 31, 2010. Loans that are not deemed to be held for sale are carried at amortized cost net of allowance for loan losses on our condensed consolidated balance sheets. Loans that are classified as held for sale are carried at the lower of net amortized cost or estimated fair value on our condensed consolidated balance sheets.

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Corporate Loans

(Amounts in thousands)

	September 30, 2011(1)									December 31, 2010(1)
	Par		Carrying Value			Amortized Cost		Estimated Fair Value		Par		Carrying Value			Amortized Cost		Estimated Fair Value
Senior secured	$	6,480,186	$	6,227,835		$	6,227,835	$	5,867,462	$	6,110,495	$	5,829,691		$	5,829,691	$	5,820,754
Second lien	494,592		451,846			451,846		382,754		631,896		576,160			576,160		533,450
Subordinated	268,513		175,317			175,317		191,689		195,964		129,371			129,371		180,007
Subtotal	7,243,291		6,854,998			6,854,998		6,441,905		6,938,355		6,535,222			6,535,222		6,534,211
Lower of cost or fair value adjustment	—		(47,153		)	—		—		—		(4,748		)	—		—
Allowance for loan losses	—		(191,407		)	—		—		—		(209,030		)	—		—
Total	$	7,243,291	$	6,616,438		$	6,854,998	$	6,441,905	$	6,938,355	$	6,321,444		$	6,535,222	$	6,534,211

(1)Includes loans held for sale.

As of September 30, 2011, $7.2 billion par amount, or 99.9%, of our corporate loan portfolio was floating rate and $9.1 million par amount, or 0.1%, was fixed rate. In addition, as of September 30, 2011, $299.0 million par amount, or 4.1%, of our corporate loan portfolio was denominated in foreign currencies, of which 74.0% was denominated in euros. As of December 31, 2010, $6.9 billion par amount, or 99.8%, of our corporate loan portfolio was floating rate and $15.9 million par amount, or 0.2%, was fixed rate. In addition, as of December 31, 2010, $273.5 million par amount, or 3.9%, of our corporate loan portfolio was denominated in foreign currencies, of which 91.7% was denominated in euros.

All of our floating rate corporate loans have index reset frequencies of less than twelve months with the majority resetting at least quarterly. The weighted average coupon on our floating rate corporate loans was 4.5% as of both September 30, 2011 and December 31, 2010, and the weighted average coupon spread to LIBOR of our floating rate corporate loan portfolio was 3.8% as of both September 30, 2011 and December 31, 2010. The weighted average years to maturity of our floating rate corporate loans was 4.3 years as of both September 30, 2011 and December 31, 2010.

As of September 30, 2011, our fixed rate corporate loans had a weighted average coupon of 11.7% and a weighted average years to maturity of 4.0 years, as compared to 11.4% and 5.3 years, respectively, as of December 31, 2010.

We hold certain corporate loans designated as being non-accrual, impaired and/or in default. Non-accrual loans consist of both corporate loans held for investment and corporate loans held for sale. Loans are placed on non-accrual when there is uncertainty regarding whether future income amounts on the loan will be earned and collected. While on non-accrual status, interest income is recognized using the cost-recovery method, cash-basis method or some combination of the two methods. A loan is placed back on accrual status when the ultimate collectability of the principal and interest is not in doubt. When placed on non-accrual status, previously recognized accrued interest is reversed and charged against current income.

As of September 30, 2011, we had loans on non-accrual status with a total recorded investment of $171.3 million, which included $69.4 million of impaired loans that were held for investment and $101.9 million of non-accrual loans held for sale. As of December 31, 2010, we had loans on non-accrual status with a total recorded investment of $165.1 million, which included $149.8 million of impaired loans that were held for investment and $15.3 million of non-accrual loans held for sale. The $6.2 million increase in non-accrual loans from $165.1 million as of December 31, 2010 to $171.3 million as of September 30, 2011 is primarily due to net new additions to loans on non-accrual status of $46.2 million, partially offset by $21.4 million of charge-offs during the nine months ended September 30, 2011 that were the result of transferring certain loans from held for investment to held for sale and $18.6 million of restructurings. During the three and nine months ended September 30, 2011, we recognized $4.0 million and $9.7 million, respectively, of interest income from cash receipts for loans on non-accrual status. During the three and nine months ended September 30, 2010, we recognized $4.1 million and $11.1 million, respectively, of interest income from cash receipts for loans on non-accrual status.

Impaired loans consist of loans held for investment where we have determined that it is more likely than not that we will not recover our outstanding investment in the loan under the contractual terms of the loan agreement. Impaired loans may or may not be in default at the time a loan is designated as being impaired and all impaired loans are placed on non-accrual status. Impaired loans declined from $149.8 million as of December 31, 2010 to $69.4 million as of September 30, 2011 primarily due to $109.8 million of impaired loans transferred to held for sale and $3.8 million of paydowns and restructurings, partially offset by net new additions to impaired loans of $33.2 million.

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Defaulted loans consist of corporate loans that have defaulted under the contractual terms of their loan agreements.  As of September 30, 2011, we had no corporate loans in default. As of December 31, 2010, we had corporate loans in default with a total amortized cost of $18.6 million from one issuer. The balance of defaulted loans is comprised of loans held for investment and loans held for sale. Loans that are held for sale are carried at the lower of amortized cost or estimated market value and, accordingly, no allowance for loan losses is maintained for such loans. Loans that are specifically identified as being impaired have a specific allocated reserve that represents the excess of the loan’s amortized cost amount over its estimated fair value. Since defaulted loans may primarily consist of loans classified as held for sale and impaired loans consist of only loans held for investment, fluctuations in the balances of defaulted loans will not necessarily correspond to fluctuations in impaired loans.

We did not modify any loans that qualified as troubled debt restructurings during the three and nine months ended September 30, 2011 and 2010. During the three and nine months ended September 30, 2011, we did modify zero and $1.2 billion amortized cost of corporate loans, respectively. During the three and nine months ended September 30, 2010, we modified $200.8 million and $464.3 million amortized cost of corporate loans, respectively. These modifications involved changes in existing rates and maturities to prevailing market rates/maturities for similar instruments and did not qualify as troubled debt restructurings as the respective borrowers were neither experiencing financial difficulty nor were seeking (nor granted) a concession as part of the modification. In addition, these modifications of non-troubled debt holdings were accomplished with modified loans that were not substantially different from the loans prior to modification.

The following table summarizes the changes in our allowance for loan losses for the three and nine months ended September 30, 2011 and 2010 (amounts in thousands):

	For the three months ended September 30, 2011		For the three months ended September 30, 2010			For the nine months ended September 30, 2011			For the nine months ended September 30, 2010
Balance at beginning of year	$	188,874	$	210,218		$	209,030		$	237,308
Provision for loan losses	2,533		8,087			14,194			8,087
Charge-offs	—		(9,275		)	(31,817		)	(36,365		)
Balance at end of year	$	191,407	$	209,030		$	191,407		$	209,030

As of September 30, 2011 and December 31, 2010, we had an allowance for loan loss of $191.4 million and $209.0 million, respectively. As described under “Critical Accounting Policies”, our allowance for loan losses represents our estimate of probable credit losses inherent in our corporate loan portfolio held for investment as of the balance sheet date. Estimating our allowance for loan losses involves a high degree of management judgment and is based upon a comprehensive review of our loan portfolio that is performed on a quarterly basis. Our allowance for loan losses consists of two components, an allocated component and an unallocated component. The allocated component of our allowance for loan losses pertains to specific loans that we have determined are impaired. We determine a loan is impaired when we estimate that it is probable that we will be unable to collect all amounts due according to the contractual terms of the loan agreement. On a quarterly basis we perform a comprehensive review of our entire loan portfolio and identify certain loans that we have determined are impaired. Once a loan is identified as being impaired we place the loan on non-accrual status, unless the loan is already on non-accrual status, and record a reserve that reflects our best estimate of the loss that we expect to recognize from the loan. The expected loss is estimated as being the difference between our current cost basis of the loan, including accrued interest receivable, and the loan’s estimated fair value.

The unallocated component of our allowance for loan losses represents our estimate of probable losses inherent in our loan portfolio as of the balance sheet date where the specific loan that the loan loss relates to is indeterminable. We estimate the unallocated component of our allowance for loan losses through a comprehensive quarterly review of our loan portfolio and identify certain loans that demonstrate possible indicators of impairment, including internally assigned credit quality indicators. This assessment excludes all loans that are determined to be impaired and as a result, an allocated reserve has been recorded as described in the preceding paragraph. Such indicators include, but are not limited to, the current and/or forecasted financial performance and liquidity profile of the issuer, specific industry or economic conditions that may impact the issuer, and the observable trading price of the loan if available. All loans are first categorized based on their assigned risk grade and further stratified based on the seniority of the loan in the issuer’s capital structure. The seniority classifications assigned to loans are senior secured, second lien and subordinate. Senior secured consists of loans that are the most senior debt in an issuer’s capital structure and therefore have a lower estimated loss severity than other debt that is subordinate to the senior secured loan. Senior secured loans often have a first lien on some or all of the issuer’s assets. Second lien consists of loans that are secured by a second lien interest on some or all of the issuer’s assets; however, the loan is subordinate to the first lien debt in the issuer’s capital structure. Subordinate consists of loans that are generally unsecured and subordinate to other debt in the issuer’s capital structure.

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

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

As of September 30, 2011, the allocated component of our allowance for loan losses totaled $28.5 million and relates to investments in certain loans issued by five issuers with an aggregate par amount of $84.4 million and an aggregate recorded investment of $69.4 million. As of December 31, 2010, the allocated component of our allowance for loan losses totaled $50.1 million and relates to investments in certain loans issued by five issuers with an aggregate par amount of $225.6 million and an aggregate recorded investment of $149.8 million.

The unallocated component of our allowance for loan losses totaled $162.9 million and $158.9 million as of September 30, 2011 and December 31, 2010, respectively.

During the three and nine months ended September 30, 2011, we transferred $129.3 million and $817.9 million amortized cost amount, respectively, of loans from held for investment to held for sale. During the three and nine months ended September 30, 2010, we transferred $187.0 million and $936.1 million amortized cost amount, respectively, of loans from held for investment to held for sale. The transfers of certain loans to held for sale were due to our determination that credit quality of a loan in relation to its expected risk-adjusted return no longer met our investment objective and our determination to reduce or eliminate the exposure for certain loans as part of our portfolio risk management practices. Also, during the three and nine months ended September 30, 2011, we transferred $88.1 million and $377.0 million amortized cost amount, respectively, from loans held for sale back to loans held for investment as the circumstances that led to the initial transfer to held for sale were no longer present. Also, during the three and nine months ended September 30, 2010, we transferred $192.2 million and $272.2 million amortized cost amount, respectively, from loans held for sale back to loans held for investment as the circumstances that led to the initial transfer to held for sale were no longer present.

During the three and nine months ended September 30, 2011, we recorded charge-offs totaling zero and $31.8 million, respectively, comprised primarily of loans transferred to loans held for sale. During the three and nine months ended September 30, 2010, we recorded charge-offs totaling $9.3 million and $36.4 million, respectively, comprised primarily of loans transferred to loans held for sale.

As of September 30, 2011, we had $500.5 million of loans held for sale, an increase of $36.9 million from December 31, 2010 due to the transfer of loans to held for sale that we had the intention of selling. We recorded a $43.8 million and $56.2 million net charge to earnings during the three and nine months ended September 30, 2011, respectively, for the lower of cost or estimated fair value adjustment for certain loans held for sale which had a carrying value of $500.5 million as of September 30, 2011. We reduced the lower of cost or estimated fair value allowance by $8.8 million and recorded a $21.4 million net charge to earnings during the three and nine months ended September 30, 2010, respectively, for the lower of cost or estimated fair value adjustment for certain loans held for sale.

Our corporate loan portfolio has certain credit risk concentrated in a limited number of issuers. As of September 30, 2011, approximately 47% of the total amortized cost basis of our corporate loan portfolio was concentrated in twenty issuers, with the three largest concentrations of corporate loans in loans issued by U.S. Foodservice, Texas Competitive Electric Holdings Company LLC and Modular Space Corporation, which combined represented $1.0 billion, or approximately 14% of the aggregated amortized cost basis of our corporate loans. As of December 31, 2010, approximately 51% of the total amortized cost basis of our corporate loan portfolio was concentrated in twenty issuers, with the three largest concentrations of corporate loans in loans issued by Texas Competitive Electric Holdings Company LLC, Modular Space Corporation, and U.S. Foodservice, which combined represented $1.1 billion, or approximately 16% of the aggregated amortized cost basis of our corporate loans.

Corporate Debt Securities

Our corporate debt securities portfolio had an aggregate par value of $854.3 million and $843.7 million as of September 30, 2011 and December 31, 2010, respectively. Our corporate debt securities portfolio consists of debt obligations of corporations, partnerships and other entities in the form of senior secured, senior unsecured and subordinated bonds.

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In accordance with GAAP, securities available-for-sale on our condensed consolidated balance sheets include (i) certain corporate debt securities and (ii) common and preferred stock, all of which are required to have unrealized gains and losses reported in accumulated other comprehensive income on the condensed consolidated balance sheets. Based on this criteria, our corporate debt securities classified as securities available-for-sale comprise a subset of the total corporate debt securities portfolio.

The following table summarizes our corporate debt securities portfolio stratified by type as of September 30, 2011 and December 31, 2010:

Corporate Debt Securities

(Amounts in thousands)

	September 30, 2011(1)								December 31, 2010(1)
	Par		Carrying Value		Amortized Cost		Estimated Fair Value		Par		Carrying Value		Amortized Cost		Estimated Fair Value
Senior secured	$	339,800	$	315,267	$	321,665	$	315,267	$	281,998	$	287,908	$	276,158	$	287,908
Senior unsecured	412,187		380,714		329,957		380,714		445,678		448,562		304,622		448,562
Subordinated	102,316		80,450		60,896		80,450		116,061		99,800		66,608		99,800
Total	$	854,303	$	776,431	$	712,518	$	776,431	$	843,737	$	836,270	$	647,388	$	836,270

(1)Excludes common and preferred stock. Includes both corporate debt securities classified as (i) securities available-for-sale (which have unrealized gains and losses reported in accumulated other comprehensive (loss) income on the condensed consolidated balance sheets) and (ii) other assets (which have unrealized gains and losses recorded on the condensed consolidated statements of operations).

As of September 30, 2011, $644.0 million par amount, or 75.4%, of our corporate debt securities portfolio was fixed rate and $210.3 million par amount, or 24.6%, was floating rate. In addition, as of September 30, 2011, $51.6 million par amount, or 6.0%, of our corporate debt securities portfolio, was denominated in foreign currencies, of which 56.8% was denominated in euros. As of December 31, 2010, $680.7 million par amount, or 80.7%, of our corporate debt securities portfolio was fixed rate and $163.0 million par amount, or 19.3%, was floating rate. In addition, as of December 31, 2010, $10.1 million par amount, or 1.2%, of our corporate debt securities portfolio, was denominated in foreign currencies, of which 12.4% was denominated in euros.

As of September 30, 2011, our fixed rate corporate debt securities had a weighted average coupon of 9.6% and a weighted average years to maturity of 6.3 years, as compared to 9.5% and 6.3 years, respectively, as of December 31, 2010. All of our floating rate corporate debt securities have index reset frequencies of less than twelve months. The weighted average coupon on our floating rate corporate debt securities was 5.2% as of September 30, 2011 and 6.1% as of December 31, 2010, and the weighted average coupon spread to LIBOR of our floating rate corporate debt securities was 4.7% as of September 30, 2011 and 5.4% as of December 31, 2010. The weighted average years to maturity of our floating rate corporate debt securities was 2.9 years and 3.2 years as of September 30, 2011 and December 31, 2010, respectively.

During the three and nine months ended September 30, 2011, we recorded impairment losses of $1.5 million for corporate debt securities that we determined to be other-than-temporarily impaired. For the three and nine months ended September 30, 2010, we recorded impairment losses totaling $0.5 million and $1.7 million, respectively, for corporate debt and equity securities that we determined to be other-than-temporarily impaired. These securities were determined to be other-than-temporarily impaired either due to our determination that recovery in value was no longer likely or because we decided to sell the respective security in response to specific credit concerns regarding the issuer.

As of September 30, 2011, we had no corporate debt securities in default. As of December 31, 2010, we had corporate debt securities in default with an estimated fair value of $1.1 million from one issuer.

Our corporate debt securities portfolio has certain credit risk concentrated in a limited number of issuers. As of September 30, 2011, approximately 47% of the estimated fair value of our corporate debt securities portfolio was concentrated in ten issuers, with the two largest concentrations of debt securities in securities issued by First Data Corporations and SandRidge Energy, Inc., which combined represented $127.0 million, or approximately 16% of the estimated fair value of our corporate debt securities. As of December 31, 2010, approximately 60% of the estimated fair value of our corporate debt securities was concentrated in ten issuers, with the two largest concentrations of corporate debt securities issued by NXP BV and First Data Corporation, which combined represented $208.6 million, or approximately 25% of the estimated fair of value of our corporate debt securities.

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Other Holdings

Our other holdings primarily consist of marketable and private equity investments and investments in real assets and royalty interests made through our natural resources strategy.

Equity Holdings

As of September 30, 2011, our equity investments consisted of (i) marketable equity securities (included in securities available-for-sale on our condensed consolidated balance sheet) with an aggregate cost amount of $13.5 million and an estimated fair value of $11.2 million, (ii) private equity investments carried at cost (included in other assets on our condensed consolidated balance sheet) with an aggregate cost amount of $3.7 million and an estimated fair value of $1.7 million, and (iii) equity investments, carried at estimated fair value, with an aggregate cost amount of $138.6 million and an estimated fair value of $170.2 million. In comparison, as of December 31, 2010, our (i) marketable equity securities had an aggregate cost amount of $3.1 million and an estimated fair value of $3.4 million, (ii) private equity investments carried at cost had an aggregate cost amount of $4.8 million and an estimated fair value of $5.1 million, and (iii) equity investments, carried at estimated fair value, had an aggregate cost of $98.7 million and an estimated fair value of $100.0 million. Equity investments carried at estimated fair value primarily consist of private equity investments. The increase in estimated fair value of our equity investments, carried at estimated fair value, was largely due to an unrealized gain recorded in the second quarter of 2011 related to a $10.0 million private equity investment in Hilcorp Resources Holdings L.P. acquired through our natural resources strategy. In May 2011, we entered into a definitive agreement to sell this private equity investment for approximately $27.0 million and we expect this transaction to settle during the fourth quarter of 2011.

Natural Resources Holdings

Our natural resources holdings include non-operated working interests in producing oil and natural gas fields primarily located in Texas. The working interests were acquired during the fourth quarter of 2010 and second quarter of 2011, and as of September 30, 2011, had a carrying value of $88.8 million. These interests are in both proved developed and proved undeveloped properties, with the majority of our exposure to natural gas, followed by natural gas liquids and then oil. The acquisition of these working interests was partially financed with $38.3 million of borrowings through a five-year $81.1 million non-recourse, asset-based credit facility maturing November 5, 2015.

In addition to natural resources working interests, during the first quarter of 2011, we acquired overriding royalty interests in acreage in south Texas. The overriding royalty interests include producing oil and natural gas properties, but most of the acreage is still under development. The overriding royalty interest properties are operated by an unaffiliated third party and as of September 30, 2011, had a carrying value of $52.7 million.

Portfolio Purchases

We made investment portfolio purchases of $645.5 million and $2.4 billion par amount during the three and nine months ended September 30, 2011, respectively, as compared to $504.9 million and $2.3 billion for the three and nine months ended September 30, 2010, respectively, primarily comprised of the following:

Investment Portfolio Purchases

(Dollar amounts in thousands)

	For the three monthsended September 30, 2011				For the three monthsended September 30, 2010				For the nine monthsended September 30, 2011				For the nine monthsended September 30, 2010
	Par Amount		%		Par Amount		%		Par Amount		%		Par Amount		%
Corporate loans	$	521,698	81.7	%	$	456,090	90.4	%	$	2,067,507	87.7	%	$	1,939,943	82.7	%
Corporate debt securities	96,302		15.1		41,586		8.2		249,904		10.6		383,886		16.4
Equity investments, at estimated fair value	20,252		3.2		7,269		1.4		40,395		1.7		20,090		0.9
Total	$	638,252	100.0	%	$	504,945	100.0	%	$	2,357,806	100.0	%	$	2,343,919	100.0	%

Shareholders’ Equity

Our shareholders’ equity at both September 30, 2011 and December 31, 2010 totaled $1.6 billion. Included in our shareholders’ equity as of September 30, 2011 and December 31, 2010 is accumulated other comprehensive loss totaling $37.4 million and accumulated other comprehensive income totaling $133.6 million, respectively.

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Our average shareholders’ equity and return on average shareholders’ equity for the three and nine months ended September 30, 2011 was $1.7 billion and 9.2% and $1.7 billion and 18.6%, respectively. Our average shareholders’ equity and return on average shareholders’ equity for the three and nine months ended September 30, 2010 were $1.3 billion and 24.7% and $1.3 billion and 30.4%, respectively. Return on average shareholders’ equity is defined as net income divided by weighted average shareholders’ equity.

Our book value per share as of September 30, 2011 and December 31, 2010 was $9.14 and $9.24, respectively, and was computed based on 178,145,482 and 177,848,565 shares issued and outstanding as of September 30, 2011 and December 31, 2010, respectively.

On July 28, 2011, our board of directors declared a cash distribution for the quarter ended June 30, 2011 of $0.18 per share to common shareholders of record on August 11, 2011. The distribution was paid on August 25, 2011.

On November 3, 2011, our board of directors declared a cash distribution for the quarter ended September 30, 2011 of $0.18 per share to common shareholders of record on November 17, 2011. The distribution is payable on December 1, 2011.

In March 2011, we sold 136,895 of our common shares in broker transactions at prevailing market prices pursuant to an effective registration statement under the Securities Act. The net proceeds of our sales were used to fund repurchases of common shares previously awarded to certain of our officers, including shares repurchased in connection with the satisfaction of tax withholding obligations.

Liquidity and Capital Resources

We actively manage our liquidity position with the objective of preserving our ability to fund our operations and fulfill our commitments on a timely and cost-effective basis. Although we believe our current sources of liquidity are adequate to preserve our ability to fund our operations and fulfill our commitments, we will continue to evaluate opportunities to issue incremental capital. This may include taking advantage of market opportunities to issue equity or refinance or replace indebtedness, including the issuance of new debt securities and retiring debt pursuant to privately negotiated transactions, open market purchases or otherwise.

Our 7.0% convertible senior notes (the “7.0% Notes”) with $135.4 million principal amount outstanding as of September 30, 2011, mature in July 2012. On August 23, 2011, we repurchased $45.1 million par amount of our 7.0% Notes. This transaction resulted in us recording a loss of $1.7 million and a write-off of $0.1 million of unamortized debt issuance costs during the third quarter of 2011. As of September 30, 2011, we had committed to purchase an additional $1.2 million par amount of our 7.0% Notes. As of September 30, 2011, the conversion rate for each $1,000 principal amount of the notes was 32.2581, which is equivalent to a conversion price of approximately $31.00 per common share. We currently believe that we will have sufficient liquidity to meet this July 2012 debt maturity, however, if attractive market opportunities arise, we may raise capital either through debt or equity or a combination thereof to replace the funding represented by the 7.0% Notes. As of September 30, 2011, we had unrestricted cash and cash equivalents totaling $137.3 million.

The majority of our investments are held in Cash Flow CLOs. Accordingly, the majority of our cash flows have historically been received from our investments in the mezzanine and subordinated notes of our CLOs. With respect to all of these CLOs, except for CLO 2011-1, the cash flows we would generally expect to receive from our CLO holdings are paid to the senior note holders of the CLOs during the period in which a CLO is not in compliance with an over-collateralization test (“OC Test”) as outlined in its respective indenture. As of September 30, 2011, all of these CLOs were in compliance with certain compliance tests (specifically, their respective OC Tests). As CLO 2007-A and CLO 2007-1 came into compliance during 2010, both CLOs resumed paying mezzanine and/or subordinate note holders, including us.

On July 6, 2011, we entered into amendments to CLO 2011-1 to upsize the transaction to $600.0 million, whereby CLO 2011-1 can borrow up to a total of $450.0 million through the non-recourse loan secured by the assets held in CLO 2011-1. Concurrent with the amendment to increase the size of CLO 2011-1, the transaction was amended to reduce the par value ratio test (“PVR Test”) from 133.33% to 120.0% and to extend the maturity until August 15, 2018. Under CLO 2011-1, if the PVR Test is below 120.0%, up to 50% of all interest collections that otherwise are payable to us are used to amortize the senior loan amount outstanding by the lower of the amount required to bring the PVR Test into compliance and the outstanding loan amount. Similarly, if the PVR Test is below 120.0%, the principal collections that otherwise would be payable to us are used to amortize the senior loan amount outstanding by the lower of the amount required to bring the PVR Test into compliance and the outstanding loan amount. Once the total portfolio held by CLO 2011-1 is reduced below 35% of the total committed transaction size, all principal proceeds received by CLO 2011-1 are used to amortize the senior loan. As of September 30, 2011, we had $439.4 million of borrowings outstanding under the CLO 2011-1 Agreement.

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Sources of Funds

CLO Transactions

As of September 30, 2011, we had six Cash Flow CLO transactions outstanding. An affiliate of our Manager owns an interest in the junior notes of both CLO 2007-1 and CLO 2007-A. The aggregate carrying amount of the junior notes in CLO 2007-1 and CLO 2007-A held by the affiliate of our Manager was $365.8 million as of September 30, 2011 and is reflected as collateralized loan obligation junior secured notes to affiliates on our condensed consolidated balance sheets.

In accordance with GAAP, we consolidate each of our CLO subsidiaries as we have the power to direct the activities of these VIEs, as well as the obligation to absorb losses of the VIEs and the right to receive benefits of the VIEs that could potentially be significant to the VIEs. We utilize CLOs to fund our investments in corporate loans and corporate debt securities.

The indentures governing our Cash Flow CLOs include numerous compliance tests, the majority of which relate to the CLO’s portfolio.

For CLO 2011-1, which we closed on March 31, 2011, we receive all remaining interest collections on a quarterly basis after administrative expenses and interest expense on the senior loan are paid, unless the PVR Test is below 120.0%, in which case up to 50% of all interest collections that otherwise would be payable to us are used to amortize the senior loan amount outstanding by the lower of the amount required to bring the PVR Test into compliance and the outstanding loan amount. Similarly, 25% of all principal collections received by CLO 2011-1 are distributed to us unless the PVR Test is below 120.0%, in which case the principal collections that otherwise would be payable to us are used to amortize the senior loan amount outstanding by the lower of the amount required to bring the PVR Test into compliance and the outstanding loan amount. Once the total portfolio held by CLO 2011-1 is reduced below 35% of the total committed transaction size, all principal proceeds received by CLO 2011-1 are used to amortize the senior loan. For purposes of the calculation, collateral value is the par value of the assets unless an asset is in default or is a CCC-rated asset in excess of the CCC-rated asset limit percentage specified for CLO 2011-1.

The following table summarizes the PVR Test for CLO 2011-1. This information is based on the September 2011 monthly report which is prepared by the independent third party trustee for CLO 2011-1:

(dollar amounts in thousands)	CLO 2011-1
Portfolio total	$	569,509
Par value test minimum	120.0		%
Par value test ratio	135.1		%
Cushion / (Excess)	$	66,491
Par value portfolio collateral value	$	593,781
Outstanding Loan balance	$	439,409

In the case of our other Cash Flow CLOs, which slightly vary from CLO 2011-1’s compliance tests, in the event that a portfolio profile test is not met, the indenture places restrictions on the ability of the CLO’s manager to reinvest available principal proceeds generated by the collateral in the CLOs until the specific test has been cured. In addition to the portfolio profile tests, the indentures for these CLOs include OC Tests which set the ratio of the collateral value of the assets in the CLO to the tranches of debt for which the test is being measured, as well as interest coverage tests. For purposes of the calculation, collateral value is the par value of the assets unless an asset is in default, is a discounted obligation, or is a CCC-rated asset in excess of the percentage of CCC-rated asset limit specified for each CLO.

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

A discount obligation is an asset with a purchase price of less than a particular percentage of par. The discount obligation amounts are specified in each 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 CLO specifies a CCC-threshold for the percentage of total assets in the CLO that can be rated CCC. All assets in excess of the CCC threshold specified for the respective CLO are also included in the OC Tests at market value and not par.

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Defaults of assets in CLOs, ratings downgrade of assets in CLOs to CCC, price declines of CCC assets in excess of the proscribed CCC threshold amount, and price declines in assets classified as discount obligations may reduce the over-collateralization ratio such that a CLO is not in compliance. If a CLO is not in compliance with an OC Test, cash flows normally payable to the holders of junior classes of notes will be used by the CLO to amortize the most senior class of notes until such point as the OC Test is brought back into compliance. While being out of compliance with an OC Test would not impact our investment portfolio or results of operations, it would impact our unrestricted cash flows available for operations, new investments and dividend distributions. As of September 30, 2011, all of our CLOs were in compliance with their respective OC Tests. The following table summarizes several of the material tests and metrics for each of our CLOs. This information is based on the September 2011 monthly reports which are prepared by the independent third party trustee for each CLO:

·Investments: The par value of 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 investments to interest expense on the senior debt issued by the CLO per the respective CLO’s indenture.

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

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

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

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

·Actual senior OC Test: Actual senior over-collateralization amount as of the September 2011 report date.

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

·Subordinated OC Test minimum: Minimum subordinated over-collateralization requirement per the respective CLO’s indenture.

·Actual subordinated OC Test: Actual subordinated over-collateralization amount as of the September 2011 report date.

·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	$	938,337		$	959,406		$	1,037,468		$	3,338,936		$	1,173,464
Senior IC ratio minimum	115.0		%	125.0		%	115.0		%	115.0		%	120.0		%
Actual senior IC ratio	566.6		%	755.0		%	390.7		%	797.9		%	572.2		%
CCC amount	$	72,695		$	96,097		$	184,117		$	578,930		$	182,816
CCC percentage of portfolio	7.7		%	10.0		%	17.7		%	17.3		%	15.6		%
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	134.8		%	134.0		%	161.4		%	180.0		%	147.1		%
Cushion / (Excess)	$	102,951		$	77,875		$	111,304		$	371,110		$	210,243
Subordinated OC Test minimum	106.2		%	106.9		%	114.0		%	120.1		%	109.9		%
Actual subordinated OC Test	112.7		%	118.3		%	137.7		%	125.4		%	120.2		%
Cushion / (Excess)	$	51,930		$	91,337		$	169,325		$	134,395		$	96,312

Credit Facilities

Senior Secured Credit Facility

On May 3, 2010, we entered into a credit agreement for a four-year $210.0 million asset-based revolving credit facility (the “2014 Facility”), maturing on May 3, 2014, that is subject to, among other things, the terms of a borrowing base derived from the value of eligible specified financial assets. The borrowing base is subject to certain caps and concentration limits customary for financings of this type. We may obtain additional commitments under the 2014 Facility so long as the aggregate amount of

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commitments at any time does not exceed $600.0 million. On May 5, 2010, we obtained additional commitments of $40.0 million, bringing the total amount of commitments under the 2014 Facility to $250.0 million.

We have the right to prepay loans under the 2014 Facility in whole or in part at any time. Loans under the 2014 Facility bear interest at a rate equal to LIBOR plus 3.25% per annum. The 2014 Facility contains customary covenants applicable to us, including a restriction from making annual distributions to holders of common shares in excess of 65% of our estimated annual taxable income.

As of September 30, 2011, we had no borrowings outstanding under the 2014 Facility.

Asset-Based Borrowing Facility

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

On May 13, 2011, we entered into an amendment to the 2015 Natural Resources Facility, increasing the commitment from $49.7 million to $81.1 million.

As of September 30, 2011, we had $38.3 million of borrowings outstanding under the 2015 Natural Resources Facility. In addition, under the 2015 Natural Resources Facility, we had a letter of credit outstanding totaling $1.0 million.

As of September 30, 2011, we believe we were in compliance with the covenant requirements for both credit facilities above.

Convertible Debt

On January 15, 2010, we issued $172.5 million of 7.5% convertible senior notes due January 15, 2017 (“7.5% Notes”). The 7.5% Notes bear interest at a rate of 7.5% per year on the principal amount, accruing from January 15, 2010. Interest is payable semiannually in arrears on January 15 and July 15 of each year, beginning on July 15, 2010. The 7.5% Notes will mature on January 15, 2017 unless previously redeemed, repurchased or converted in accordance with their terms prior to such date. Holders of the 7.5% Notes may convert their notes at the applicable conversion rate at any time prior to the close of business on the business day immediately preceding the stated maturity date subject to our right to terminate the conversion rights of the notes. We may satisfy our obligation with respect to the 7.5% Notes tendered for conversion by delivering to the holder either cash, common shares, no par value, issued by us or a combination thereof. The initial conversion rate for each $1,000 principal amount of 7.5% Notes was 122.2046 common shares, which is equivalent to an initial conversion price of approximately $8.18 per share. The conversion rate is adjusted under certain circumstances, including the occurrence of certain fundamental change transactions and the payment of a quarterly cash distribution in excess of $0.05 per share, but will not be adjusted for accrued and unpaid interest on the 7.5% Notes. As of September 30, 2011, the conversion rate for each $1,000 principal amount of 7.5% Notes was 130.0516 common shares.

On August 23, 2011, we repurchased $45.1 million par amount of our 7.0% convertible senior notes due July 15, 2012. This transaction resulted in us recording a loss of $1.7 million and a write-off of $0.1 million of unamortized debt issuance costs during the third quarter of 2011. As of September 30, 2011, we had committed to purchase an additional $1.2 million par amount of our 7.0% Notes. As of September 30, 2011, the conversion rate for each $1,000 principal amount of the notes was 32.2581, which is equivalent to a conversion price of approximately $31.00 per common share.

During 2010, we repurchased $95.2 million par amount of our 7.0% Notes. These transactions resulted in us recording a gain of $1.3 million, which was partially offset by a write-off of $0.6 million of unamortized debt issuance costs during 2010.

Off-Balance Sheet Commitments

As of September 30, 2011, we had committed to purchase corporate loans with aggregate commitments totaling $101.6 million. In addition, we participate in certain financing arrangements, including revolvers and delayed draw facilities, whereby we are committed to provide funding at the discretion of the borrower up to a specific predetermined amount. As of September 30, 2011, we had unfunded financing commitments totaling $8.2 million for corporate loans and $7.7 million for private equity investments. We do not expect material losses related to the corporate loans and private equity investments for which we commit to purchase and fund.

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Partnership Tax Matters

Non-Cash “Phantom” Taxable Income

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

Qualifying Income Exception

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

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

Tax Consequences of Investments in Natural Resources

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

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

Our Investment Company Act Status

Section 3(a)(1)(A) of the Investment Company Act of 1940 (the “Investment Company Act”) defines an investment company as any issuer that is, holds itself out as being, or proposes to be, primarily engaged in the business of investing, reinvesting or trading in securities and Section 3(a)(1)(C) of the Investment Company Act defines an investment company as any issuer that is engaged or proposes to engage in the business of investing, reinvesting, owning, holding or trading in securities and owns or proposes to acquire “investment securities” (within the meaning of the Investment Company Act) having a value exceeding 40% of the value of the issuer’s total assets (exclusive of United States government securities and cash items) on an unconsolidated basis (the “40% test”). Excluded from the term “investment securities” are, among others, securities issued by majority-owned subsidiaries unless the subsidiary is an investment company or relies on the exceptions from the definition of an investment company provided by Section 3(c)(1) or Section 3(c)(7) of the Investment Company Act (a “fund”). The Investment Company Act defines a “majority-owned subsidiary” of a person as any company 50% or more of the outstanding voting securities (i.e., those securities presently entitling the holder thereof to vote for the election of directors of the company) of which are owned by that person, or by another company that is, itself, a majority-owned subsidiary of that person.

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

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

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

We sometimes refer to our subsidiaries that rely on Rule 3a-7 under the Investment Company Act as “CLO subsidiaries.” Rule 3a-7 under the Investment Company Act is available to certain structured financing vehicles that are engaged in the business of holding financial assets that, by their terms, convert into cash within a finite time period and that issue fixed income securities entitling holders to receive payments that depend primarily on the cash flows from these assets, provided that, among other things, the structured finance vehicle does not engage in certain portfolio management practices resembling those employed by management

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

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

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

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

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

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

We have not requested approval or guidance from the SEC or its staff with respect to our Investment Company Act determinations, including, in particular: our treatment of any subsidiary as majority-owned; the compliance of any subsidiary with Section 3(c)(5)(C) or Section 3(c)(9) of, or Rule 3a-7 under, the Investment Company Act, including any subsidiary’s determinations with respect to the consistency of its assets or operations with the requirements thereof; or whether our interests in one or more subsidiaries constitute investment securities for purposes of the 40% test. If the SEC were to disagree with our treatment of one or more subsidiaries as being excepted from the Investment Company Act pursuant to Rule 3a-7, Section 3(c)(5)(C), Section 3(c)(9) or any other exception, with our determination that one or more of our other holdings do not constitute investment securities for purposes of the 40% test, or with our determinations as to the nature of the business in which we engage or the manner in which we hold ourselves out, we and/or one or more of our subsidiaries would need to adjust our operating strategies or assets in order for us to continue to pass the 40% test or register as an investment company, either of which could have a material adverse effect on us. Moreover, we may be required to adjust our operating strategy and holdings, or to effect sales of our assets in a manner that, or at a time or price at which, we would not otherwise choose, if there are changes in the laws or rules governing our Investment Company Act status or that of our subsidiaries, or if the SEC or its staff provides more specific or different guidance regarding the application of relevant provisions of, and rules under, the Investment Company Act. The SEC published on August 31, 2011 an advance notice of proposed rulemaking to potentially amend the conditions for reliance on Rule 3a-7 and the treatment of asset-backed issuers that rely on Rule 3a-7 under the Investment Company Act (the “3a-7 Release”).  The SEC, in the 3a-7 Release, requests public comment on the nature and operation of issuers that rely on Rule 3a-7 and indicates various steps it may consider taking in connection with Rule 3a-7, although it did not formally propose any changes to the rule.  Among the issues for which the SEC has requested comment in the 3a-7 Release is whether Rule 3a-7 should be modified so that parent companies of subsidiaries that rely on Rule 3a-7 should treat their interests in such subsidiaries as investment securities for purposes of the 40% test.  The SEC also published on August 31, 2011 a concept release seeking information about the nature of entities that invest in mortgages and mortgage-related pools and public comment on how the SEC staff’s interpretive positions in connection with Section 3(c)(5)(C) affect these entities, although it did not

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propose any new interpretive positions or changes to existing interpretive positions in connection with Section 3(c)(5)(C).  Any guidance or action from the SEC or its staff, including changes that the SEC may ultimately propose and adopt to the way Rule 3a-7 applies to entities or new or modified interpretive positions related to Section 3(c)(5)(C), could further inhibit our ability, or the ability of a subsidiary, to pursue our current or future operating strategies, which could have a material adverse effect on us.

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

Quantitative and Qualitative Disclosures About Market Risk

Foreign Currency Risks

From time to time, we may make investments that are denominated in a foreign currency through which we may be subject to foreign currency exchange risk. As of September 30, 2011, $350.6 million par amount, or 4.3%, of our corporate debt portfolio was denominated in foreign currencies, of which 71.4% was denominated in euros. In addition, as of September 30, 2011, $28.7 million par amount, or 20.7%, of our equity investments at estimated fair value was denominated in foreign currencies, of which 35.6% was denominated in Norwegian krone.

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

Credit Spread Exposure

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

Interest Rate Risk

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

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

Interest rate risk impacts our interest income, interest expense, prepayments, as well as the fair value of our investments, interest rate derivatives. We generally fund our variable rate investments with variable rate borrowings with similar interest rate reset frequencies. Based on our variable rate investments and variable rate borrowings as of September 30, 2011, we estimated that net interest income would be negatively impacted by approximately $3.3 million annually in the event interest rates were to increase by 1% and would be positively impacted by approximately $34.3 million annually in the event rates were to increase by 3%. These amounts are driven by the fact that as of September 30, 2011, approximately 31% of our corporate debt portfolio had LIBOR floors with a weighted average floor of 1.5%.

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We manage our interest rate risk using various techniques ranging from the purchase of floating rate investments to the use of interest rate derivatives. The use of interest rate derivatives is a component of our interest risk management strategy. The contractual notional balance of our amortizing interest rate swaps was $508.3 million as of September 30, 2011.

Derivative Risk

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

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

The following table summarizes the estimated net fair value of our derivative instruments held at September 30, 2011 and December 31, 2010 (amounts in thousands):

	As ofSeptember 30, 2011						As of December 31, 2010
	Notional			Estimated Fair Value			Notional			Estimated Fair Value
Cash Flow Hedges:
Interest rate swaps	$	508,333		$	(100,849	)	$	483,333		$	(58,365	)
Free-Standing Derivatives:
Commodity swaps	—			3,322			—			(226		)
Credit default swaps—protection sold	33,500			(3,653		)	13,500			492
Total rate of return swaps	—			159			—			104
Foreign exchange forward contracts	(231,582		)	(16,004		)	(154,405		)	(17,296		)
Foreign exchange options	130,207			15,909			130,207			14,791
Common stock warrants	—			3,225			—			3,453
Total	$	440,458		$	(97,891	)	$	472,635		$	(57,047	)

For our derivatives, our credit exposure is directly with our counterparties and continues until the maturity or termination of such contracts. The following table sets forth the fair values of our primary derivative investments by remaining contractual maturity as of September 30, 2011 (amounts in thousands):

	Less than 1 year			1 - 3 years			3 - 5 years			More than 5 years			Total
Cash Flow Hedges:
Cash flow interest rate swaps	$	(2,845	)	$	—		$	—		$	(98,004	)	$	(100,849	)
Free-Standing Derivatives:
Commodity swaps	1,164			1,408			750			—			3,322
Credit default swaps—protection sold	106			(33		)	(3,726		)	—			(3,653		)
Total rate of return swaps	159			—			—			—			159
Foreign exchange forward contracts	(52		)	(15,992		)	40			—			(16,004		)
Foreign exchange options	—			15,909			—			—			15,909
Total	$	(1,468	)	$	1,292		(2,936		)	$	(98,004	)	$	(101,116	)

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Counterparty Risk

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

Management Estimates

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

Item 3.  Quantitative and Qualitative Disclosures about Market Risk

See discussion of quantitative and qualitative disclosures about market risk in “Quantitative and Qualitative Disclosures About Market Risk” section of Management’s Discussion and Analysis of Financial Condition and Results of Operations.

Item 4.  Controls and Procedures

The Company’s management evaluated, with the participation of the Company’s principal executive and principal financial officer, the effectiveness of the Company’s disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (the “Exchange Act”)) as of September 30, 2011. Based on their evaluation, the Company’s principal executive and principal financial officer concluded that the Company’s disclosure controls and procedures as of September 30, 2011 were designed and were functioning effectively to provide reasonable assurance that the information required to be disclosed by the Company in reports filed under the Exchange Act is (i) recorded, processed, summarized, and reported within the time periods specified in the SEC’s rules and forms, and (ii) accumulated and communicated to management, including the principal executive and principal financial officers, as appropriate, to allow timely decisions regarding disclosure.

There has 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 months ending September 30, 2011, that has materially affected, or is reasonably likely to materially affect, the Company’s internal control over financial reporting.

PART II. OTHER INFORMATION

Item 1. Legal Proceedings

None.

Item 1A. Risk Factors

For a discussion of our potential risks and uncertainties, see the information under the heading “Risk Factors” in our Annual Report on Form 10-K for the fiscal year ended December 31, 2010, filed with the SEC on February 28, 2011, which is accessible on the Securities and Exchange Commission’s website at www.sec.gov. The information presented below updates, and should be read in conjunction with, the risk factors and information disclosed in our Annual Report on Form 10-K and subsequent current reports filed with the SEC.

If the SEC were to disagree with our Investment Company Act determinations, our business could be adversely affected.

We have not requested approval or guidance from the SEC with respect to our Investment Company Act determinations, including, in particular: our treatment of any subsidiary as majority-owned; the compliance of any subsidiary with Section 3(c)(5)(C) or Section 3(c)(9) of, or Rule 3a-7 under, the Investment Company Act, including any subsidiary’s determinations with respect to the consistency of its assets or operations with the requirements thereof; or whether our interests in one or more subsidiaries constitute investment securities for purposes of the 40% test. If the SEC were to disagree with our treatment of one or more subsidiaries as being excepted from the Investment Company Act pursuant to Rule 3a-7, Section 3(c)(5)(C), Section 3(c)(9) or any other exception, with our determination that one or more of our other holdings do not constitute investment securities for purposes of the 40% test, or with

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our determinations as to the nature of the business in which we engage or the manner in which we hold ourselves out, we and/or one or more of our subsidiaries would need to adjust our operating strategies or assets in order for us to continue to pass the 40% test or register as an investment company, either of which could have a material adverse effect on us. Moreover, we may be required to adjust our operating strategy and holdings, or to effect sales of our assets in a manner that, or at a time or price at which, we would not otherwise choose, if there are changes in the laws or rules governing our Investment Company Act status or that of our subsidiaries, or if the SEC or its staff provides more specific or different guidance regarding the application of relevant provisions of, and rules under, the Investment Company Act. The SEC published on August 31, 2011 an advance notice of proposed rulemaking to potentially amend the conditions for reliance on Rule 3a-7 and the treatment of asset-backed issuers that rely on Rule 3a-7 under the Investment Company Act (the “3a-7 Release”).  The SEC, in the 3a-7 Release, requests public comment on the nature and operation of issuers that rely on Rule 3a-7 and indicates various steps it may consider taking in connection with Rule 3a-7, although it did not formally propose any changes to the rule. Among the issues for which the SEC has requested comment in the 3a-7 Release is whether Rule 3a-7 should be modified so that parent companies of subsidiaries that rely on Rule 3a-7 should treat their interests in such subsidiaries as investment securities for purposes of the 40% test. The SEC also published on August 31, 2011 a concept release seeking information about the nature of entities that invest in mortgages and mortgage-related pools and public comment on how the SEC staff’s interpretive positions in connection with Section 3(c)(5)(C) affect these entities, although it did not propose any new interpretive positions or changes to existing interpretive positions in connection with Section 3(c)(5)(C). Any guidance or action from the SEC or its staff, including changes that the SEC may ultimately propose and adopt to the way Rule 3a-7 applies to entities or new or modified interpretive positions related to Section 3(c)(5)(C), could further inhibit our ability, or the ability of a subsidiary, to pursue our current or future operating strategies, which could have a material adverse effect on us.  If the SEC or a court of competent jurisdiction were to find that we were required, but failed, to register as an investment company in violation of the Investment Company Act, we would have to cease business activities, we would breach representations and warranties and/or be in default as to certain of our contracts and obligations, civil or criminal actions could be brought against us, our contracts would be unenforceable unless a court were to require enforcement and a court could appoint a receiver to take control of us and liquidate our business, any or all of which would have a material adverse effect on our business.

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

Item 2. Unregistered Sales of Equity Securities and Use of Proceeds

On July 15, 2011, our non-employee directors deferred an immaterial amount of cash compensation in exchange for 4,099 phantom shares pursuant to the KKR Financial Holdings LLC Non-Employee Directors’ Deferred Compensation and Share Award Plan. In addition, on August 9, 2011, our non-employee directors received a total of 39,189 phantom shares in lieu of restricted shares pursuant to the KKR Financial Holdings LLC Non-Employee Directors’ Deferred Compensation and Share Award Plan. Each phantom share is the economic equivalent of one of our common shares. The phantom shares become payable, in cash or common shares, at the election of the Company, upon the earlier of (i) the first day of January following the applicable non-employee director’s termination of service as a director or (ii) an election date pre-selected by the applicable non-employee director, and in any event in cash or common shares, at the election of the applicable non-employee director, upon the occurrence of a change in control of the Company. The grants made to our non-employee directors were exempt from the registration requirements of the Securities Act pursuant to Section 4(2) thereof.

On August 9, 2011, the Compensation Committee of our board of directors granted to our non-employee directors an aggregate of 50,566 restricted common shares pursuant to our 2007 Share Incentive Plan. Each of these grants vests in one-third increments on the first three anniversaries of the date of grant. The grants made to our non-employee directors were exempt from the registration requirements of the Securities Act pursuant to Section 4(2) thereof. For further discussion of the 2007 Share Incentive Plan, see “Item 1. Financial Statements—Note 11. Common Shares, Restricted Shares and Share Options” of this Quarterly Report on Form 10-Q.

Item 3. Defaults Upon Senior Securities

None.

Item 4. (Removed and Reserved)

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Item 5. Other Information

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
101.INS	XBRL Instance Document.
101.SCH	XBRL Taxonomy Extension Schema Document.
101.CAL	XBRL Taxonomy Extension Calculation Linkbase Document.
101.DEF	XBRL Taxonomy Extension Definition Linkbase Document.
101.LAB	XBRL Taxonomy Extension Label Linkbase Document.
101.PRE	XBRL Taxonomy Extension Presentation Linkbase Document.

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SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, KKR Financial Holdings LLC has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.

	KKR Financial Holdings LLC
Signature	Title
/s/ WILLIAM C. SONNEBORN	Chief Executive Officer (Principal Executive Officer)
William C. Sonneborn
/s/ MICHAEL R. MCFERRAN	Chief Financial Officer (Principal Financial and Accounting
Michael R. McFerran	Officer)
Date: November 3, 2011

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