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)

	March 31, 2013			December 31, 2012
Assets
Cash and cash equivalents	$	713,160		$	237,606
Restricted cash and cash equivalents	722,104			896,396
Securities	502,196			533,520
Corporate loans, net (includes $107,395 and $128,289 loans held for sale as of March 31, 2013 and December 31, 2012, respectively)	5,838,164			5,947,857
Equity investments, at estimated fair value ($9,746 and $7,187 pledged as collateral as of March 31, 2013 and December 31, 2012, respectively)	185,047			161,621
Oil and gas properties, net	297,516			289,929
Derivative assets	21,694			23,207
Interest and principal receivable	38,977			46,960
Other assets	254,653			221,783
Total assets	$	8,573,511		$	8,358,879
Liabilities
Collateralized loan obligation secured notes	$	5,058,520		$	5,122,338
Collateralized loan obligation junior secured notes to affiliates	193,921			296,557
Credit facilities	46,089			107,789
Convertible senior notes	—			166,028
Senior notes	362,202			362,178
Junior subordinated notes	283,517			283,517
Accounts payable, accrued expenses and other liabilities	40,952			25,931
Accrued interest payable	17,794			20,519
Accrued interest payable to affiliates	5,577			6,632
Related party payable	21,706			10,998
Derivative liabilities	100,176			117,270
Total liabilities	6,130,454			6,519,757
Shareholders’ Equity
Preferred shares, no par value, 50,000,000 shares authorized and 14,950,000 and zero issued and outstanding at March 31, 2013 and December 31, 2012, respectively	—			—
Common shares, no par value, 500,000,000 shares authorized, and 204,784,871 and 178,437,078 shares issued and outstanding at March 31, 2013 and December 31, 2012, respectively	—			—
Paid-in-capital	3,311,481			2,762,584
Accumulated other comprehensive loss	(53,543		)	(70,226		)
Accumulated deficit	(814,881		)	(853,236		)
Total shareholders’ equity	2,443,057			1,839,122
Total liabilities and shareholders’ equity	$	8,573,511		$	8,358,879

See notes to condensed consolidated financial statements.

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KKR Financial Holdings LLC and Subsidiaries

Condensed Consolidated Statements of Operations

(Unaudited)

(Amounts in thousands, except per share information)

	For the three months ended March 31, 2013			For the three months ended March 31, 2012
Revenues:
Loan interest income	$	98,261		$	104,094
Securities interest income	14,862			22,576
Oil and gas revenue	23,805			11,053
Other	3,522			211
Total revenues	140,450			137,934
Investment costs and expenses:
Interest expense	41,880			40,715
Interest expense to affiliates	9,917			12,859
Provision for loan losses	11,068			46,498
Oil and gas production costs	7,908			2,873
Oil and gas depreciation, depletion and amortization	8,988			3,181
Other	1,288			1,666
Total investment costs and expenses	81,049			107,792
Other income:
Net realized and unrealized gain on investments	94,727			66,542
Net realized and unrealized (loss) gain on derivatives and foreign exchange	(8,852		)	9,149
Net loss on restructuring and extinguishment of debt	(20,269		)	(445		)
Other income	8,614			3,592
Total other income	74,220			78,838
Other expenses:
Related party management compensation	28,306			18,113
General, administrative and directors expenses	4,794			4,991
Professional services	1,727			1,896
Total other expenses	34,827			25,000
Income before income taxes	98,794			83,980
Income tax expense (benefit)	458			(4,068		)
Net income	$	98,336		$	88,048
Preferred share distributions	6,738			—
Net income available to common shareholders	$	91,598		$	88,048
Net income per common share:
Basic	$	0.46		$	0.49
Diluted	$	0.46		$	0.48
Weighted average number of common shares outstanding:
Basic	197,153			177,775
Diluted	197,153			182,247

See notes to condensed consolidated financial statements.

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KKR Financial Holdings LLC and Subsidiaries

Condensed Consolidated Statements of Changes in Shareholders’ Equity

(Unaudited)

(Amounts in thousands)

	Preferred Shares			Common Shares					Accumulated Other						Total
	Shares	Paid-In Capital		Shares		Paid-In Capital			Comprehensive Loss			Accumulated Deficit			Shareholders’ Equity
Balance at January 1, 2013	—	$	—	178,437		$	2,762,584		$	(70,226	)	$	(853,236	)	$	1,839,122
Net income	—	—		—		—			—			98,336			98,336
Other comprehensive income	—	—		—		—			16,683			—			16,683
Distributions declared on preferred shares	—	—		—		—			—			(6,738		)	(6,738		)
Distributions declared on common shares	—	—		—		—			—			(53,243		)	(53,243		)
Grant of restricted common shares	—	—		292		—			—			—			—
Issuance of common shares	—	—		30		321			—			—			321
Repurchase and cancellation of common shares	—	—		(25	)	(280		)	—			—			(280		)
Issuance of common shares in exchange for convertible notes	—	—		26,051		186,254			—			—			186,254
Issuance of preferred shares	14,950	361,622		—		—			—			—			361,622
Share-based compensation expense related to restricted common shares	—	—		—		980			—			—			980
Balance at March 31, 2013	14,950	$	361,622	204,785		$	2,949,859		$	(53,543	)	$	(814,881	)	$	2,443,057

See notes to condensed consolidated financial statements.

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KKR Financial Holdings LLC and Subsidiaries

Condensed Consolidated Statements of Cash Flows

(Unaudited)

(Amounts in thousands)

	For the three months ended March 31, 2013			For the three months ended March 31, 2012
Cash flows from operating activities:
Net income	$	98,336		$	88,048
Adjustments to reconcile net income to net cash provided by operating activities:
Net realized and unrealized (loss) gain on derivatives and foreign exchange	8,852			(9,149		)
Net loss on restructuring and extinguishment of debt	20,269			445
Write-off of debt issuance costs	4,080			386
Lower of cost or estimated fair value adjustment on corporate loans held for sale	4,749			(10,401		)
Provision for loan losses	11,068			46,498
Impairment charges	5,862			733
Share-based compensation	980			614
Net unrealized gain on residential mortgage-backed securities, carried at estimated fair value	(6,444		)	(3,047		)
Net realized and unrealized gain on investments	(98,894		)	(53,920		)
Depreciation and net amortization	(5,232		)	(16,146		)
Changes in assets and liabilities:
Interest receivable	1,921			6,583
Other assets	(12,881		)	(8,444		)
Related party payable	10,708			5,749
Accounts payable, accrued expenses and other liabilities	84			1,103
Accrued interest payable	(2,725		)	(4,877		)
Accrued interest payable to affiliates	(1,055		)	541
Net cash provided by operating activities	39,678			44,716
Cash flows from investing activities:
Principal payments from corporate loans	500,167			621,928
Principal payments from securities available-for-sale and other securities, at estimated fair value	54,819			18,791
Principal payments from residential mortgage-backed securities, at estimated fair value	2,523			1,552
Proceeds from sales of corporate loans	100,807			167,981
Proceeds from sales of securities available-for-sale and other securities, at estimated fair value	11,977			93,641
Proceeds from equity investments	2,007			3,216
Purchases of corporate loans	(434,408		)	(291,143		)
Purchases of securities available-for-sale and other securities, at estimated fair value	(20,990		)	(13,085		)
Purchases of equity and other investments	(32,345		)	(89,946		)
Net change in proceeds, purchases, and settlements of derivatives	(2,019		)	(6,243		)
Net change in restricted cash and cash equivalents	174,292			(424,330		)
Net cash provided by investing activities	356,830			82,362
Cash flows from financing activities:
Issuance of collateralized loan obligation secured notes	—			31,876
Retirement of collateralized loan obligation secured notes	(167,633		)	(93,888		)
Proceeds from credit facilities	—			28,500
Repayment of credit facilities	(61,700		)	—
Repayment of convertible senior notes	—			(23,495		)
Proceeds from senior notes	—			111,418
Net proceeds from issuance of preferred stock	361,622			—
Distributions on common shares	(53,243		)	(46,384		)
Repurchase and cancellation of common shares	—			(96		)
Other capitalized costs	—			(317		)
Net cash provided by financing activities	79,046			7,614
Net increase in cash and cash equivalents	475,554			134,692
Cash and cash equivalents at beginning of period	237,606			392,154
Cash and cash equivalents at end of period	$	713,160		$	526,846
Supplemental cash flow information:
Cash paid for interest	$	43,494		$	49,640
Net cash paid for income taxes	$	4,462		$	45
Non-cash investing and financing activities:
Issuance of restricted common shares	$	3,282		$	2,446
Loans transferred from held for investment to held for sale	$	21,388		$	46,077
Loans transferred from held for sale to held for investment	$	—		$	7,504
Preferred share distributions declared, not yet paid	$	6,738		$	—
Conversion of convertible senior notes to common shares	$	186,254		$	—

See notes to condensed consolidated financial statements.

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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, natural resources, special situations, mezzanine, 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, private equity, interests in joint ventures and partnerships, and working and royalty interests in oil and gas properties. The corporate loans that the Company holds are typically purchased via assignment or participation in the primary or secondary market.

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 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 (“VIEs”) and for which the Company is the primary beneficiary.

Certain prior period information has been reclassified to conform to the current year presentation to provide additional detailed information related to the Company’s oil and gas costs as a result of the growth in the Company’s oil and gas business. These costs were previously included in general, administrative and directors expenses.

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.

The Company uses historical experience and various other assumptions and information that are believed to be reasonable under the circumstances in developing its estimates and judgments. Estimates and assumptions about future events and their effects cannot be predicted with certainty and, accordingly, these estimates may change as new events occur, as more experience is acquired, as additional information is obtained and as the Company’s operating environment changes. While the Company believes that the estimates and assumptions used in the preparation of the condensed consolidated financial statements are appropriate, actual results could differ from those estimates.

Estimates of oil, natural gas and natural gas liquid (“NGL”) reserves and their values, future production rates and future costs and expenses are inherently uncertain, including many factors beyond the Company’s control. Reservoir engineering is a subjective process of estimating underground accumulations of oil, natural gas and NGL that cannot be measured in an exact manner. The accuracy of any reserve estimate is a function of many factors including the following: the quality and quantity of available data, the interpretation of that data, the accuracy of various mandated economic assumptions and the judgments of the individuals preparing

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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”), certain interests in joint ventures and partnerships 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 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. 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 and Corporate Loans, at Estimated Fair Value: Corporate debt securities and corporate loans, at estimated fair value 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 yield analysis techniques, where the key inputs are based on relative value analyses, which incorporate similar instruments from similar issuers. In addition, an illiquidity discount is applied where appropriate.

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 key financial inputs and recent public and private transactions for comparable investments. Key inputs used for the discounted cash flow approach include the weighted average cost of capital and assumed inputs used to calculate terminal values, such as earnings before interest, taxes, depreciation and amortization (“EBIDTA”) exit multiples. The fair value recorded for a particular investment will generally be within the range suggested by the two approaches. Upon completion of the valuations conducted, an illiquidity discount is applied where appropriate.

Interests in Joint Ventures and Partnerships: Interests in joint ventures and partnerships include certain equity investments related to the oil and gas and commercial real estate sectors. Interests in joint ventures and partnerships 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 an income (discounted cash flow) approach, in which various internal and external factors are considered and key inputs include the weighted average cost of capital. In addition, an illiquidity discount is applied where appropriate.

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. OTC derivatives are initially valued using quoted market prices, if available, or models using a series of techniques, including closed-form analytic formulae, such as the Black-Scholes option-pricing model, and/or simulation models in the absence of quoted market prices. Many pricing models employ methodologies that have pricing inputs observed from actively quoted markets, as is the case for generic interest rate swap and option contracts.

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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 loss.

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.

Other Securities, at Estimated Fair Value

The Company has elected the fair value option of accounting for certain securities 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 securities. Other securities, at estimated fair value are included within securities on the condensed consolidated balance sheets with unrealized gains and losses reported in net realized and unrealized gains on investments in the condensed consolidated statements of operations.

Residential Mortgage-Backed Securities, at Estimated Fair Value

The Company has elected the fair value option of accounting 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. RMBS, at estimated fair value are included within securities on the condensed consolidated balance sheets with unrealized gains and losses reported in net realized and unrealized gains on investments in the condensed consolidated statements of operations.

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 fair value, are managed based on overall value and potential returns. These equity investments carried at estimated fair value are presented separately on the condensed consolidated balance sheets with unrealized gains and losses reported in net realized and unrealized gains on investments in the condensed consolidated statements of operations.

Interests in Joint Ventures and Partnerships

The Company has elected the fair value option of accounting for certain non-controlling interests in joint ventures and partnerships, 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 interests. These interests in joint ventures and partnerships are presented within other assets on the condensed consolidated balance sheets with unrealized gains and losses reported in net realized and unrealized gains on investments in 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

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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 sheets with gains and losses reported in net realized and unrealized gains on investments on the condensed consolidated statement of operations.

Corporate Loans, Net

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 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 one or a combination of the following: a reduction of the stated interest rate; payment extensions; forgiveness of principal; or an exchange of assets. Such modifications typically qualify as troubled debt restructurings (“TDRs”). In order to determine whether the borrower is experiencing financial difficulty, an evaluation is performed including the following considerations: whether the borrower is or will be in payment default on any of his or her debt in the foreseeable future without the modification; whether there is a potential for a bankruptcy filing; whether there is a going-concern issue; or whether the borrower is unable to secure financing elsewhere. The Company may also identify receivables that are newly considered impaired and discloses the total amount of receivables and the allowance for credit losses as of the end of the period of adoption related to those receivables that are newly considered impaired.

Corporate loans which have been modified in a TDR are typically placed on non-accrual status, but can be moved to accrual status when, among other criteria, payment in full of all amounts due under the restructured terms is expected and the borrower has demonstrated a sustained period of repayment performance, typically six months.

TDRs are separately identified for impairment disclosures and are measured at either the fair market value or the present value of estimated future cash flows using the respective loan’s effective rate at inception. Impairments associated with TDRs are included within the allocated component of the Company’s allowance for loan losses.

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 TDR 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.

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 typically 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 an allowance 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 present value of expected future cash flows discounted at the loan’s effective interest rate, except as a practical expedient, the loan’s observable estimated fair value may be used. The Company also estimates the probable credit losses inherent in its unfunded loan commitments as of the balance sheet date. Any credit loss reserve for unfunded loan commitments is recorded in accounts payable, accrued expenses and other liabilities on the Company’s condensed consolidated balance sheets.

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 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 possible 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.

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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.

From time to time the Company also makes the determination to transfer certain of its corporate loans from held for sale back to held for investment. The decision to transfer a loan back to held for investment is generally as a result of the circumstances that led to the initial transfer to held for sale no longer being present. Such circumstances may include deteriorated market conditions often resulting in price depreciation or assets becoming illiquid, changes in restrictions on sales and certain loans amending their terms to extend the maturity, whereby the Company determined that selling the asset no longer met its investment objective and strategy. The loan is transferred from held for sale back to held for investment at the lower of its cost or estimated fair value, whereby a new cost basis is established based on this amount.

Interest income on corporate loans 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.

Corporate Loans, at Estimated Fair Value

The Company has elected the fair value option of accounting for certain corporate loans 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 corporate loans. Corporate loans carried at estimated fair value are included within corporate loans, net on the condensed consolidated balance sheets with unrealized gains and losses reported in net realized and unrealized gains on investments in the condensed consolidated statement of operations.

Oil and Natural Gas Properties

Oil and natural gas producing activities are accounted for under the successful efforts method of accounting. Under this method, exploration costs, other than the costs of drilling exploratory wells, are charged to expense as incurred. Costs that are associated with the drilling of successful exploration wells are capitalized if proved reserves are found. Lease acquisition costs are capitalized when incurred. Costs associated with the drilling of exploratory wells that do not find proved reserves, geological and geophysical costs and costs of certain nonproducing leasehold costs are expensed as incurred.

Expenditures for repairs and maintenance are charged to expense as incurred.

The capitalized costs of producing oil and natural gas properties are depleted on a field-by-field basis using the units-of production method based on the ratio of current production to estimated total net proved oil, natural gas and NGL reserves. Proved developed reserves are used in computing depletion rates for drilling and development costs and total proved reserves are used for depletion rates of leasehold costs.

Estimated dismantlement and abandonment costs for oil and natural gas properties, net of salvage value, are capitalized at their estimated net present value and amortized on a unit-of-production basis over the remaining life of the related proved developed reserves.

Oil and Gas Revenue Recognition

Oil, natural gas and NGL revenues are recognized when production is sold to a purchaser at fixed or determinable prices, when delivery has occurred and title has transferred and collectability of the revenue is reasonably assured. The Company follows the sales method of accounting for natural gas revenues. Under this method of accounting, revenues are recognized based on volumes

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sold, which may differ from the volume to which we are entitled based on the Company’s working interest. An imbalance is recognized as a liability only when the estimated remaining reserves will not be sufficient to enable the under-produced owners to recoup its entitled share through future production. Under the sales method, no receivables are recorded when the Company has taken less than its share of production and no payables are recorded when the Company has taken more than its share of production.

Long-Lived Assets

The Company evaluates its proved oil and natural gas properties and related equipment and facilities for impairment on a field-by-field basis, whenever events or changes in circumstances indicate that the carrying amounts of such properties may not be recoverable. The determination of recoverability is made based upon estimated undiscounted future net cash flows. The amount of impairment loss, if any, is determined by comparing the fair value, as determined by a discounted cash flow analysis, with the carrying value of the related asset. The factors used to determine fair value include, but are not limited to, estimates of proved reserves, future commodity pricing, future production estimates, anticipated capital expenditures, future operating costs and a discount rate commensurate with the risk on the properties and cost of capital. Unproved oil and natural gas properties are assessed periodically and, at a minimum, annually on a property-by-property basis, and any impairment in value is recognized when incurred.

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 condensed 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 within other assets on the condensed consolidated balance sheets.

Preferred Shares

Distributions on the Company’s 7.375% Series A LLC Preferred Shares (“Series A LLC Preferred Shares”) are cumulative and payable quarterly when and if declared by the Company’s board of directors at a 7.375% rate per annum. The Company accrues for the distribution upon declaration and is included within accounts payable, accrued expenses and other liabilities on the condensed consolidated balance sheets.

Derivative 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 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 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.

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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.

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. 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 owns equity interests in entities that have elected or intend to elect to be taxed as a real estate investment trust (a “REIT”) under the Internal Revenue Code of 1986, as amended (the “Code”). 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 consolidated financial statements and the United States federal income tax basis of assets and liabilities as of each 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.

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

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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.

Earnings Per Common Share

The Company presents both basic and diluted earnings per common share (“EPS”) 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 available to common shareholders by the weighted average number of common shares, including vested restricted common shares, outstanding for the period. The Company calculates EPS using the more dilutive of the two-class method or the if-converted method. The two-class method 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, preferred shares and participating securities based on their respective rights to receive dividends. Diluted earnings per common share (“Diluted EPS”) reflects the potential dilution of common share options, unvested restricted common shares and convertible senior notes using the treasury method or if-converted method.

NOTE 3. EARNINGS PER COMMON SHARE

The following table presents a reconciliation of basic and diluted net income per common share for the three months ended March 31, 2013 and 2012 (amounts in thousands, except per share information), as well as the distributions declared per common share during the quarters ended March 31, 2013 and 2012:

	Three months ended March 31, 2013		Three months ended March 31, 2012
Net income	$	98,336	$	88,048
Less: Preferred share distributions	6,738		—
Net income available to common shareholders	$	91,598	$	88,048
Less: Dividends and undistributed earnings allocated to participating securities	338		297
Net income allocated to common shareholders	$	91,260	$	87,751
Basic:
Basic weighted average common shares outstanding	197,153		177,775
Net income per common share	$	0.46	$	0.49
Diluted:
Basic weighted average common shares outstanding	197,153		177,775
Dilutive effect of convertible senior notes(1)	—		4,472
Diluted weighted average common shares outstanding(2)	197,153		182,247
Net income per common share	$	0.46	$	0.48
Distributions declared per common share	$	0.26	$	0.26

(1) During the first quarter of 2013, $172.5 million of the Company’s outstanding convertible notes had been tendered for conversion and were settled with 26.1 million common shares.

(2) Potential anti-dilutive common shares excluded from diluted earnings per share related to common share options were 1,932,279 for the three months ended March 31, 2013 and 2012.

NOTE 4. SECURITIES

The Company accounts for securities based on the following categories: (i) securities available-for-sale, which are carried at estimated fair value, with unrealized gains and losses reported in accumulated other comprehensive loss; (ii) other securities, at estimated fair value, with unrealized gains and losses recorded in the condensed consolidated statements of operations; and (iii) RMBS, at estimated fair value, with unrealized gains and losses recorded in the condensed consolidated statements of operations.

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The following table summarizes the Company’s securities as of March 31, 2013, which are carried at estimated fair value (amounts in thousands):

	March 31, 2013
	Amortized Cost		Gross Unrealized Gains		Gross Unrealized Losses			Estimated Fair Value
Securities available-for-sale	$	335,968	$	25,039	$	(2,042	)	$	358,965
Other securities, at estimated fair value(1)	41,436		15,456		(689		)	56,203
Residential mortgage-backed securities, at estimated fair value(1)	162,483		4,423		(79,878		)	87,028
Total securities	$	539,887	$	44,918	$	(82,609	)	$	502,196

(1) Unrealized gains and losses are recorded in earnings.

The following table summarizes the Company’s securities as of December 31, 2012, which are carried at estimated fair value (amounts in thousands):

	December 31, 2012
	Amortized Cost		Gross Unrealized Gains		Gross Unrealized Losses			Estimated Fair Value
Securities available-for-sale	$	394,821	$	27,281	$	(9,809	)	$	412,293
Other securities, at estimated fair value(1)	27,991		9,768		(374		)	37,385
Residential mortgage-backed securities, at estimated fair value(1)	171,385		3,762		(91,305		)	83,842
Total securities	$	594,197	$	40,811	$	(101,488	)	$	533,520

(1) Unrealized gains and losses are recorded in earnings.

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 March 31, 2013 and December 31, 2012 (amounts in thousands):

	Less Than 12 months					12 Months or More					Total
	Estimated Fair Value		Unrealized Losses			Estimated Fair Value		Unrealized Losses			Estimated Fair Value		Unrealized Losses
March 31, 2013
Corporate debt securities	$	33,970	$	(665	)	$	27,809	$	(1,377	)	$	61,779	$	(2,042	)
December 31, 2012
Corporate debt securities	$	45,900	$	(4,398	)	$	37,500	$	(5,411	)	$	83,400	$	(9,809	)

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 the three months ended March 31, 2013 and 2012, the Company recognized losses totaling $5.9 million and $0.7 million, respectively, for corporate debt securities that it determined to be other-than-temporarily impaired. The Company intends to sell these securities and as a result, the entire amount is recorded through earnings in net realized and unrealized gain on investments in the condensed consolidated statements of operations.

For common and preferred stock, the Company considers many factors when evaluating whether an impairment is other-than-temporary, including its intent and ability to hold the common and preferred stock for a period of time sufficient for recovery to cost. If the Company believes it will not recover the cost basis based on its intent or ability, an other-than-temporary loss will be recorded through earnings in net realized and unrealized gain on investments in the condensed consolidated statements of operations.

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During the three months ended March 31, 2012, the Company recognized no losses for common and preferred stock that it determined to be other-than-temporarily impaired. As of March 31, 2013, the Company had no investments in common or preferred stock.

As of both March 31, 2013 and December 31, 2012, the Company had no corporate debt securities in default.

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

	For the three months ended March 31, 2013		For the three months ended March 31, 2012
Gross realized gains	$	2,150	$	7,581
Gross realized losses	—		—
Net realized gains(1)	$	2,150	$	7,581

(1) Excludes net realized gains from paydowns and restructurings totaling $1.6 million, including a $1.0 million premium on bond redemption, and $16.2 million, including a $0.8 million premium on bond redemption, for the three months ended March 31, 2013 and 2012, respectively. Also excludes an impairment charge of $5.9 million and $0.7 million for investments which were determined to be other-than-temporarily impaired for the three months ended March 31, 2013 and 2012, respectively.

Concentration Risk

The Company’s securities available-for-sale portfolio has certain credit risk concentrated in a limited number of issuers. As of March 31, 2013, approximately 55% of the estimated fair value of the Company’s securities available-for-sale portfolio was concentrated in ten issuers, with the three largest concentrations of securities available-for-sale in securities issued by Avaya, Inc., iPayment, Inc. and Supervalu, Inc., which combined represented $78.2 million, or approximately 22% of the estimated fair value of the Company’s securities available-for-sale. As of December 31, 2012, approximately 54% of the estimated fair value of the Company’s securities available-for-sale portfolio was concentrated in ten issuers, with the three largest concentrations of securities available-for-sale in securities issued by Sanmina Corporation, Avaya, Inc. and iPayment, Inc., which combined represented $87.0 million, or approximately 21% of the estimated fair value of the Company’s securities available-for-sale.

Pledged Assets

Note 7 to these condensed consolidated financial statements describes the Company’s borrowings under which the Company has pledged securities for borrowings. The following table summarizes the estimated fair value of securities available-for-sale pledged as collateral as of March 31, 2013 and December 31, 2012 (amounts in thousands):

	As of March 31, 2013		As of December 31, 2012
Pledged as collateral for collateralized loan obligation secured debt and junior secured notes to affiliates	$	310,941	$	354,088
Total	$	310,941	$	354,088

As of March 31, 2013 and December 31, 2012, no other securities, at estimated fair value or RMBS were pledged as collateral for the Company’s borrowings.

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NOTE 5. CORPORATE LOANS AND ALLOWANCE FOR LOAN LOSSES

The Company accounts for loans based on the following categories (i) corporate loans held for investment, which are measured based on their outstanding principal plus or minus unaccreted purchase discounts and unamortized purchase premiums, net of an allowance for loan losses; (ii) corporate loans held for sale, which are measured at lower of cost or estimated fair value; and (iii) corporate loans, at estimated fair value, which are measured at fair value.

The following table summarizes the Company’s corporate loans as of March 31, 2013 (amounts in thousands):

	March 31, 2013
	Corporate Loans			Corporate Loans Held for Sale			Corporate Loans, at Estimated Fair Value			Total Corporate Loans
Principal(1)	$	6,022,573		$	171,321		$	59,539		$	6,253,433
Net unamortized discount	(128,618		)	(45,131		)	(20,202		)	(193,951		)
Total amortized cost	5,893,955			126,190			39,337			6,059,482
Lower of cost or fair value adjustment	—			(18,795		)	—			(18,795		)
Allowance for loan losses	(206,227		)	—			—			(206,227		)
Unrealized gains	—			—			3,704			3,704
Net carrying value	$	5,687,728		$	107,395		$	43,041		$	5,838,164

(1) Principal amount is net of cumulative charge-offs and other adjustments totaling $38.3 million as of March 31, 2013.

The following table summarizes the Company’s corporate loans as of December 31, 2012 (amounts in thousands):

	December 31, 2012
	Corporate Loans			Corporate Loans Held for Sale			Corporate Loans, at Estimated Fair Value			Total Corporate Loans
Principal(1)	$	6,143,599		$	231,231		$	56,931		$	6,431,761
Net unamortized discount	(136,438		)	(88,895		)	(23,277		)	(248,610		)
Total amortized cost	6,007,161			142,336			33,654			6,183,151
Lower of cost or fair value adjustment	—			(14,047		)	—			(14,047		)
Allowance for loan losses	(223,472		)	—			—			(223,472		)
Unrealized gains	—			—			2,225			2,225
Net carrying value	$	5,783,689		$	128,289		$	35,879		$	5,947,857

(1) Principal amount is net of cumulative charge-offs and other adjustments totaling $51.6 million as of December 31, 2012.

Allowance for Loan Losses

As of March 31, 2013 and December 31, 2012, the Company had an allowance for loan losses of $206.2 million and $223.5 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 months ended March 31, 2013 and 2012 (amounts in thousands):

	For the three months ended March 31, 2013			For the three months ended March 31, 2012
Allowance for loan losses:
Beginning balance	$	223,472		$	191,407
Provision for loan losses	11,068			46,498
Charge-offs	(28,313		)	(2,098		)
Ending balance	$	206,227		$	235,807

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The following table summarizes the ending balances of the allowance and corporate loans portfolio by basis of impairment method as of March 31, 2013 and December 31, 2012 (amounts in thousands):

	March 31, 2013		December 31, 2012
Allowance for loan losses:
Ending balance: individually evaluated for impairment	$	206,227	$	223,472
Ending balance: collectively evaluated for impairment	—		—
Ending balance: loans acquired with deteriorated credit quality	—		—
	$	206,227	$	223,472
Corporate loans (recorded investment)(1):
Ending balance: individually evaluated for impairment	$	5,914,332	$	6,029,059
Ending balance: collectively evaluated for impairment	—		—
Ending balance: loans acquired with deteriorated credit quality	—		—
	$	5,914,332	$	6,029,059

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

As of March 31, 2013, the allocated component of the allowance for loan losses totaled $86.9 million and relates to investments in certain loans issued by four issuers with an aggregate par amount of $551.8 million and an aggregate recorded investment of $522.1 million. Of the allocated component totaling $86.9 million, $54.5 million related to Texas Competitive Electric Holdings Company LLC (“TXU”), which had an aggregate amortized cost of $311.4 million as of March 31, 2013. As of December 31, 2012, the allocated component of the allowance for loan losses totaled $94.9 million and relates to investments in certain loans issued by six issuers with an aggregate par amount of $484.1 million and an aggregate recorded investment of $445.4 million.

The following table summarizes the Company’s recorded investment and unpaid principal balance in impaired loans, as well as the related allowance for credit losses as of March 31, 2013 and December 31, 2012 (amounts in thousands):

	March 31, 2013						December 31, 2012
	Recorded Investment(1)		Unpaid Principal Balance		Related Allowance		Recorded Investment(1)		Unpaid Principal Balance		Related Allowance
With no related allowance recorded	$	—	$	—	$	—	$	6,490	$	19,931	$	—
With an allowance recorded	522,121		551,785		86,944		438,947		464,214		94,863
Total	$	522,121	$	551,785	$	86,944	$	445,437	$	484,145	$	94,863

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

The following table summarizes the Company’s average recorded investment in impaired loans and interest income recognized for the three months ended March 31, 2013 and 2012 (amounts in thousands):

	For the three months ended March 31, 2013				For the three months ended March 31, 2012
	Average Recorded Investment(1)		Interest Income Recognized		Average Recorded Investment(1)		Interest Income Recognized
With no related allowance recorded	$	3,245	$	—	$	—	$	—
With an allowance recorded	480,534		4,274		68,860		803
Total	$	483,779	$	4,274	$	68,860	$	803

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

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As of March 31, 2013 and December 31, 2012, 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 (i) other loans held for investment, (ii) corporate loans held for sale and (iii) loans carried at estimated fair value, which are not reflected in the table above. Any of these three classifications may include those loans modified in a TDR, which are typically designated as being non-accrual (see “Troubled Debt Restructurings” section below).

The following table summarizes the Company’s recorded investment in non-accrual loans as of March 31, 2013 and December 31, 2012 (amounts in thousands):

	March 31, 2013		December 31, 2012
Loans held for investment(1)	$	561,550	$	445,437
Loans held for sale	75,608		90,840
Loans at estimated fair value	1,172		—
Total non-accrual loans	$	638,330	$	536,277

(1) Includes $522.1 million of impaired loans held for investment.

For the three months ended March 31, 2013, the amount of interest income recognized using the cash-basis method during the time within the period that the loans were on non-accrual was $8.0 million, which included $4.3 million for impaired loans that were held for investment and $3.7 million for non-accrual loans held for sale. For the three months ended March 31, 2012, the amount of interest income recognized using the cash-basis method during the time within the period that the loans were impaired was $4.4 million, which included $0.8 million for impaired loans that were held for investment and $3.6 million for non-accrual loans held for sale.

The Company did not have any corporate loans past due at both March 31, 2013 and 2012.

The unallocated component of the allowance for loan losses totaled $119.3 million and $128.6 million as of March 31, 2013 and December 31, 2012, 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 March 31, 2013 and December 31, 2012 (amounts in thousands):

Internally Assigned Grade	Capital Hierarchy	Recorded Investment March 31, 2013(1)		Recorded Investment December 31, 2012(1)
High	Senior Secured Loan	$	228,938	$	525,562
	Second Lien Loan	288,237		287,892
	Subordinated	10,452		10,621
		$	527,627	$	824,075
Moderate	Senior Secured Loan	$	882,390	$	826,107
	Second Lien Loan	27,517		27,585
	Subordinated	—		38,374
		$	909,907	$	892,066
Low	Senior Secured Loan	$	3,794,317	$	3,716,831
	Second Lien Loan	55,405		68,917
	Subordinated	104,955		81,733
		$	3,954,677	$	3,867,481
	Total Unallocated	$	5,392,211	$	5,583,622
	Total Allocated	522,121		445,437
	Total Loans Held for Investment	$	5,914,332	$	6,029,059

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

During the three months ended March 31, 2013 and 2012, the Company recorded charge-offs totaling $28.3 million and $2.1 million, respectively, comprised primarily of loans modified in TDRs and loans transferred to loans held for sale, respectively.

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Loans Held For Sale and the Lower of Cost or Fair Value Adjustment

As of March 31, 2013 and December 31, 2012, the Company had $107.4 million and $128.3 million of loans held for sale, respectively. During the three months ended March 31, 2013 and 2012, the Company transferred $21.4 million and $46.1 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 months ended March 31, 2013 and 2012, the Company transferred zero and $7.5 million amortized cost amount, respectively, from loans held for sale back to loans held for investment at the lower of cost or estimated fair value. These transfers back to held for investment occurred as the circumstances that led to the initial transfer to held for sale were no longer present. Such circumstances may include deteriorated market conditions often resulting in price depreciation or assets becoming illiquid, changes in restrictions on sales and certain loans amending their terms to extend the maturity, whereby the Company determined that selling the asset no longer met its investment objective and strategy.

The Company recorded a $4.7 million net charge to earnings for the three months ended March 31, 2013 for the lower of cost or estimated fair value adjustment for certain loans held for sale, which had a carrying value of $107.4 million as of March 31, 2013. Comparatively, the Company reduced the lower of cost or market valuation allowance by $10.4 million for the three months ended March 31, 2012 for certain loans held for sale, which had a carrying value of $297.7 million as of March 31, 2012.

Defaulted Loans

As of March 31, 2013, the Company did not have any corporate loans that were in default. As of December 31, 2012, the Company held two corporate loans that were in default with a total amortized cost of $50.4 million from one issuer and were included in the loans that comprised the allocated component of the Company’s allowance for loan losses.

Troubled Debt Restructurings

The recorded investment balance of TDRs totaled $65.6 million related to four TDRs and $25.5 million related to one TDR at March 31, 2013 and December 31, 2012, respectively. Loans whose terms have been modified in a TDR are typically placed on non-accrual status, but can be moved to accrual status when, among other criteria, payment in full of all amounts due under the restructured terms is expected and the borrower has demonstrated a sustained period of repayment performance, typically six months. As of March 31, 2013 and December 31, 2012, $65.6 million and $25.5 million of TDRs were included in non-accrual loans, respectively (see “Allowance for Loan Losses” section above). As of March 31, 2013 and December 31, 2012, the allowance for loan losses included specific reserves of $1.9 million and $0.5 million related to TDRs, respectively. As of March 31, 2013, there were no commitments to lend additional funds to the borrowers whose loans had been modified in a TDR.

The following table presents the aggregate balance of loans by loan class whose terms have been modified in a TDR during the three months ended March 31, 2013 and 2012. There were three new TDRs during the three months ended March 31, 2013 and no loans were modified in a TDR during the three months ended March 31, 2012. The modifications in the first quarter of 2013 involved conversions of the loans into one of the following: (i) new term loans with extended maturities and fixed, rather than floating, interest rates, (ii) equity carried at estimated fair value, (iii) or a combination of equity and loans carried at estimated fair value. The modification involving an extension of maturity date was for an additional four-year period with a higher coupon.

	Three months ended March 31, 2013					Three months ended March 31, 2012
	Number of loans	Pre-modification outstanding recorded investment(1)		Post-modification outstanding recorded investment(1)(2)		Number of loans	Pre-modification outstanding recorded investment(1)		Post-modification outstanding recorded investment(1)
Troubled debt restructurings:
Loans held for investment	2	$	68,358	$	39,430	—	$	—	$	—
Loans held for sale	—	—		—		—	—		—
Loans at estimated fair value	1	1,670		1,229		—	—		—
Total	3	$	70,028	$	40,659	—	$	—	$	—

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

(2) Excludes equity received from the TDRs with an estimated fair value of $2.1 million.

Prior to the restructurings, two of the new TDRs described above were already identified as impaired and had specific allocated reserves, while the third was a loan carried at estimated fair value. Upon restructuring the two impaired loans held for investment, the difference between the recorded investment of the pre-modified loans and the estimated fair value of the new assets was charged-off against the allowance for loan losses. The TDRs resulted in $26.8 million of charge-offs for the three months ended March 31, 2013, which comprised 95% of the total $28.3 million of charge-offs recorded during the first quarter of 2013.

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As of March 31, 2013, no loans modified as TDRs were in default within a twelve month period subsequent to their original restructuring.

The Company modified $1.0 billion and $457.1 million amortized cost of corporate loans during the three months ended March 31, 2013 and 2012, respectively, that did not qualify as TDRs. These modifications involved changes in existing rates and maturities to prevailing market rates/maturities for similar instruments and did not qualify as TDRs 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.

Concentration Risk

The Company’s corporate loan portfolio has certain credit risk concentrated in a limited number of issuers. As of March 31, 2013, approximately 48% 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, TXU and Modular Space Corporation, which combined represented $996.7 million or approximately 16% of the aggregated amortized cost basis of the Company’s corporate loans. As of December 31, 2012, approximately 46% 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, TXU and Modular Space Corporation, which combined represented $1.0 billion, or approximately 16% of the aggregated amortized cost basis of the Company’s corporate loans.

Pledged Assets

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 and corporate loans held for sale pledged as collateral as of March 31, 2013 and December 31, 2012 (amounts in thousands):

	As of March 31, 2013		As of December 31, 2012
Pledged as collateral for collateralized loan obligation secured debt and junior secured notes to affiliates	$	5,836,459	$	5,804,026
Total	$	5,836,459	$	5,804,026

As of March 31, 2013 and December 31, 2012, no corporate loans, at estimated fair value were pledged as collateral for the Company’s borrowings.

NOTE 6. NATURAL RESOURCES ASSETS

Natural Resources Properties

The following table summarizes the Company’s oil and gas properties as of March 31, 2013 and December 31, 2012 (amounts in thousands):

	As of March 31, 2013			As of December 31, 2012
Proved oil and natural gas properties (successful efforts method)	$	331,792		$	315,446
Unproved oil and natural gas properties	2,719			2,596
Less: Accumulated depreciation, depletion and amortization	(36,995		)	(28,113		)
Oil and gas properties, net	$	297,516		$	289,929

For the three months ended March 31, 2013 and 2012, the Company recorded zero and $0.1 million, respectively, of impairments which are included in net realized and unrealized gain on investments in the condensed consolidated statements of operations.

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NOTE 7. BORROWINGS

Certain information with respect to the Company’s borrowings as of March 31, 2013 is summarized in the following table (dollar amounts in thousands):

	Outstanding Borrowings		Weighted Average Borrowing Rate		Weighted Average Remaining Maturity (in days)	Collateral(1)
CLO 2005-1 senior secured notes	$	374,482	0.69	%	1,487	$	405,834
CLO 2005-2 senior secured notes	432,932		0.65		1,701	565,936
CLO 2006-1 senior secured notes	566,661		0.68		1,973	803,977
CLO 2007-1 senior secured notes	2,075,040		0.84		2,967	2,310,115
CLO 2007-1 junior secured notes(2)	296,925		—		2,967	330,562
CLO 2007-A senior secured notes	580,409		1.48		1,659	677,212
CLO 2007-A junior secured notes(3)	26,164		—		1,659	30,527
CLO 2011-1 senior debt	322,020		1.65		1,963	401,169
CLO 2012-1 senior secured notes	362,387		2.58		4,277	304,139
CLO 2012-1 junior secured notes(4)	21,500		—		4,277	17,793
Total collateralized loan obligation secured debt	5,058,520					5,847,264
CLO 2007-1 junior secured notes to affiliates(5)	162,430		—		2,967	180,831
CLO 2007-A junior secured notes to affiliates(6)	31,491		—		1,659	36,743
Total collateralized loan obligation junior secured notes to affiliates	193,921					217,574
Senior secured credit facility	—		2.53		974	—
2015 Asset-based borrowing facility	46,089		2.20		949	224,378
2018 Asset-based borrowing facility(7)	—		—		1,794	—
Total credit facilities	46,089					224,378
8.375% Senior notes	250,751		8.38		10,456	—
7.500% Senior notes	111,451		7.50		10,581	—
Junior subordinated notes	283,517		5.42		8,622	—
Total borrowings	$	5,944,249				$	6,289,216

(1) Collateral for borrowings consists of the estimated fair value of certain corporate loans, securities available-for-sale and equity investments at estimated fair value. Also includes the carrying value of oil and gas assets.

(2) CLO 2007-1 junior secured notes consist of $291.1 million of mezzanine notes with a weighted average borrowing rate of 3.4% 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 $21.6 million of mezzanine notes with a weighted average borrowing rate of 7.1% 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 2012-1 junior secured notes represent subordinated notes that do not have a contractual coupon rate, but instead receive a pro rata amount of the net distributions from CLO 2012-1.

(5) CLO 2007-1 junior secured notes to affiliates consist of $32.1 million of mezzanine notes with a weighted average borrowing rate of 9.8% 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.

(6) CLO 2007-A junior secured notes to affiliates consist of $21.0 million of mezzanine notes with a weighted average borrowing rate of 7.8% 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.

(7) Borrowing rates range from 1.75% to 2.75% plus LIBOR per annum based on the amount outstanding.

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Certain information with respect to the Company’s borrowings as of December 31, 2012 is summarized in the following table (dollar amounts in thousands):

	Outstanding Borrowings		Weighted Average Borrowing Rate		Weighted Average Remaining Maturity (in days)	Collateral(1)
CLO 2005-1 senior secured notes	$	427,317	0.69	%	1,577	$	510,187
CLO 2005-2 senior secured notes	470,516		0.66		1,791	618,000
CLO 2006-1 senior secured notes	601,091		0.69		2,063	846,365
CLO 2007-1 senior secured notes	2,075,040		0.86		3,057	2,298,373
CLO 2007-1 junior secured notes(2)	209,555		—		3,057	232,109
CLO 2007-A senior secured notes	601,375		1.50		1,749	698,569
CLO 2007-A junior secured notes(3)	10,179		—		1,749	11,824
CLO 2011-1 senior debt	343,485		1.67		2,053	421,584
CLO 2012-1 senior secured notes(4)	362,280		2.58		4,367	40,180
CLO 2012-1 junior secured notes(4)	21,500		—		4,367	2,351
Total collateralized loan obligation secured debt	5,122,338					5,679,542
CLO 2007-1 junior secured notes to affiliates(5)	249,115		—		3,057	275,927
CLO 2007-A junior secured notes to affiliates(6)	47,442		—		1,749	55,110
Total collateralized loan obligation junior secured notes to affiliates	296,557					331,037
Senior secured credit facility	—		2.56		1,064	—
2015 Asset-based borrowing facility	107,789		2.71		1,039	227,415
Total credit facilities	107,789					227,415
7.5% Convertible senior notes	166,028		7.50		1,476	—
8.375% Senior notes	250,735		8.38		10,546	—
7.500% Senior notes	111,443		7.50		10,671	—
Junior subordinated notes	283,517		5.43		8,712	—
Total borrowings	$	6,338,407				$	6,237,994

(2) CLO 2007-1 junior secured notes consist of $203.7 million of mezzanine notes with a weighted average borrowing rate of 2.8% 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 $5.6 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 2012-1 junior secured notes represent subordinated notes that do not have a contractual coupon rate, but instead receive a pro rata amount of the net distributions from CLO 2012-1. In addition to the fair value of collateral, CLO 2012-1 held $357.7 million of principal cash as of December 31, 2012 as it was closed on December 21, 2012.

(5) CLO 2007-1 junior secured notes to affiliates consist of $118.8 million of mezzanine notes with a weighted average borrowing rate of 6.3% 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.

(6) CLO 2007-A junior secured notes to affiliates consist of $36.9 million of mezzanine notes with a weighted average borrowing rate of 7.5% 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.

CLO Debt

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, both CLO 2005-1 and CLO 2005-2 ended their reinvestment periods in the second quarter of 2011, and CLO 2006-1 ended its reinvestment period during the third quarter of 2012. As a result, principal proceeds from the assets held in each of these transactions are generally used to amortize the outstanding balance of senior notes outstanding. During the three months ended March 31, 2013, an aggregate $146.2 million of original CLO 2007-A, CLO 2005-1, CLO 2005-2 and CLO 2006-1 senior notes were repaid. During the three months ended March 31, 2012, $88.8 million of original CLO 2007-A, CLO 2005-1 and CLO 2005-2 senior notes were repaid. CLO 2007-1 and CLO 2012-1 will end their reinvestment periods during May 2014 and December 2016, respectively. CLO 2011-1 does not have a reinvestment period and all principal proceeds from holdings in CLO 2011-1 are used to amortize the transaction. During the three months ended March 31, 2013 and 2012, $21.5 million and $5.1 million, respectively, of original CLO 2011-1 senior notes were repaid.

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On December 21, 2012, the Company closed CLO 2012-1, a $412.4 million secured financing transaction maturing December 16, 2024. The Company issued $367.5 million par amount of senior secured notes to unaffiliated investors, of which $342.5 million was floating rate with a weighted-average coupon of three-month LIBOR plus 2.09% and $25.0 million was fixed rate at 2.39%. The Company also issued $21.5 million of subordinated notes to unaffiliated third party investors. CLO 2012-1’s debt is collateralized by the investments that are owned by CLO 2012-1, and as a result, those investments are not available to the Company, its creditors or shareholders.

During the three months ended March 31, 2012, the Company issued $42.0 million par amount of CLO 2007-1 class D notes for proceeds of $31.9 million.

Credit Facilities

Senior Secured Credit Facility

On November 30, 2012, the Company entered into a credit agreement for a three-year $150.0 million revolving credit facility, maturing on November 30, 2015 (the “2015 Facility”). The Company may obtain additional commitments under the 2015 Facility so long as the aggregate amount of commitments at any time does not exceed $350.0 million. The Company has the right to prepay loans under the 2015 Facility in whole or in part at any time. In connection with entering into the 2015 Facility, the Company terminated the commitments under its existing asset-based revolving credit facility. Loans under the 2015 Facility bear interest at a rate equal to, at the Company’s option, LIBOR plus 2.25% per annum, or an alternate base rate plus 1.25% per annum. The 2015 Facility contains customary covenants, including ones that require the Company to satisfy a net worth financial test and maintain certain ratios relating to leverage and consolidated total assets. In addition, the 2015 Facility contains customary negative covenants applicable to the Company. As of March 31, 2013 and December 31, 2012, the Company had no borrowings outstanding under the 2015 Facility.

Asset-Based Borrowing Facilities

On December 7, 2012, the Company’s five-year nonrecourse, asset-based revolving credit facility (the “2015 Natural Resources Facility”), maturing on November 5, 2015, was adjusted and reduced to $126.1 million, 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. As of March 31, 2013 and December 31, 2012, the Company had $46.1 million and $107.8 million, respectively, of borrowings outstanding under the 2015 Natural Resources Facility.

In addition, on February 27, 2013, the Company entered into a separate credit agreement for a five-year $6.0 million non-recourse, asset-based revolving credit facility, maturing on February 27, 2018 (the “2018 Natural Resources Facility”), 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 Company has the right to prepay loans under the 2018 Natural Resources Facility in whole or in part at any time. Loans under the 2018 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 2018 Natural Resources Facility contains customary covenants applicable to the Company. As of March 31, 2013, the Company had no borrowings outstanding under the 2018 Natural Resources Facility.

As of March 31, 2013 and December 31, 2012, the Company believes it was in compliance with the covenant requirements for its credit facilities.

Convertible Debt

7.5% Convertible Senior Notes

On January 18, 2013, in accordance with the indenture relating to the Company’s $172.5 million 7.5% convertible senior notes due January 15, 2017 (“7.5% Notes”), the Company issued a conversion rights termination notice (“Termination Notice”) to holders of the 7.5% Notes whereby it terminated the right to convert the 7.5% Notes to common shares. The conversion rate as of January 18, 2013 was equal to 141.8256 common shares for each $1,000 principal amount of 7.5% Notes, plus an additional 9.2324 common shares per $1,000 principal amount to account for the make-whole premium. Holders of $172.5 million 7.5% Notes submitted their notes for conversion for which the Company satisfied by physical settlement with 26.1 million common shares.

In accordance with accounting for convertible debt instruments that may be settled in cash upon conversion, the Company had 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 was included in paid-in-capital on the Company’s consolidated balance sheet as of December 31, 2012. The remaining liability component of $166.0 million, included within convertible senior notes on the Company’s consolidated balance sheets as of December 31, 2012, was comprised of the principal $172.5 million less the unamortized debt discount of $6.5 million as of December 31, 2012. The total debt discount amortization recognized for the three months ended March 31, 2012 was $0.3 million, at the effective interest rate of 8.6%. For the three months ended March 31, 2013 and 2012, the total interest expense recognized on the 7.5% Notes was $0.5 million and $3.2 million, respectively.

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7.0% Convertible Senior Notes

During the three months ended March 31, 2012, the Company repurchased $23.1 million par amount of its 7.0% convertible senior notes due July 15, 2012 (the “7.0% Notes”). These transactions resulted in the Company recording a loss of $0.4 million and a $0.2 million write-off of unamortized debt issuance costs. On July 13, 2012, the Company repaid in full its $112.0 million of outstanding 7.0% Notes, which matured on July 15, 2012.

Senior Notes

On March 20, 2012, the Company issued $115.0 million par amount of 7.500% senior notes due March 20, 2042 (“7.500% Senior Notes”), resulting in net proceeds of $111.4 million. Interest on the 7.500% Senior Notes is payable quarterly in arrears on June 20, September 20, December 20 and March 20 of each year.

NOTE 8. DERIVATIVE 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.

The table below summarizes the aggregate notional amount and estimated net fair value of the derivative instruments as of March 31, 2013 and December 31, 2012 (amounts in thousands):

	As of March 31, 2013						As of December 31, 2012
	Notional			Estimated Fair Value			Notional			Estimated Fair Value
Cash Flow Hedges:
Interest rate swaps	$	497,833		$	(79,445	)	$	503,833		$	(90,618	)
Free-Standing Derivatives:
Commodity swaps	—			946			—			7,056
Credit default swaps—protection sold	—			—			—			19
Credit default swaps—protection purchased	(118,247		)	(802		)	(47,321		)	(1,140		)
Foreign exchange forward contracts	(259,266		)	(8,001		)	(338,313		)	(20,975		)
Foreign exchange options	130,207			5,350			130,207			8,277
Common stock warrants	—			3,470			—			3,318
Total				$	(78,482	)				$	(94,063	)

Cash Flow Hedges

The Company uses interest rate 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 interest rate swaps as cash flow hedges. As of March 31, 2013 and December 31, 2012, the Company had interest rate swaps with notional amounts totaling $497.8 million and $503.8 million, respectively. Changes in the estimated fair value of the interest rate swaps are recorded through accumulated other comprehensive loss, with gains or losses representing hedge ineffectiveness, if any, recognized in earnings during the reporting period.

The following table presents the net gains recognized in accumulated other comprehensive loss related to derivatives in cash flow hedging relationships for the three months ended March 31, 2013 and 2012 (amounts in thousands):

	Three months ended March 31, 2013		Three months ended March 31, 2012
Net gains recognized in accumulated other comprehensive loss on cash flow hedges	$	11,158	$	14,592

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 months ended March 31, 2013 and 2012, the Company did not recognize any ineffectiveness in income on the condensed consolidated statements of operations from its cash flow hedges.

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

Commodity Derivatives

In an effort to minimize the effects of the volatility of oil, natural gas and NGL 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 following table summarizes open positions as of March 31, 2013, and represents, as of such date, derivatives in place through December 31, 2016, on expected annual production volumes:

	2013		2014		2015		2016
Natural gas positions:
Fixed price swaps:
Hedged volume (MMMBtu)	5,188		5,821		4,277		1,805
Average price ($/MMBtu)	$	3.83	$	4.34	$	4.73	$	4.44
Natural gas liquid positions:
Fixed price swaps:
Hedged volume (MBbls)	149		129		—		—
Average price ($/Bbl)	$	35.56	$	20.90	$	—	$	—
Oil positions:
Fixed price swaps:
Hedged volume (MBbls)	111		159		4		—
Average price ($/Bbl)	$	91.77	$	89.97	$	95.55	$	—

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 reference entity) of the underlying credit instrument referenced in the CDS. Typical credit events include bankruptcy, dissolution or insolvency of the reference entity, failure to pay and restructuring of the obligations of the reference entity.

As of both March 31, 2013 and December 31, 2012, the Company had sold protection with a notional amount of zero. In addition, as of March 31, 2013 and December 31, 2012, the Company had purchased protection with a notional amount of $118.2 million and $47.3 million, respectively. The Company sells or purchases 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. In addition, the Company may purchase protection to hedge economic exposure to declines in value of certain credit positions. The Company purchases its protection from banks and broker dealers, other financial institutions and other counterparties.

Foreign Exchange Derivatives

The Company holds certain positions that are denominated in a foreign currency, whereby movements in foreign currency exchange rates may impact earnings if the United States dollar significantly strengthens or weakens against foreign currencies. In an effort to minimize the effects of these fluctuations on earnings, the Company will from time to time enter into foreign exchange

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options or foreign exchange forward contracts related to the assets denominated in a foreign currency. As of March 31, 2013 and December 31, 2012, the net contractual notional balance of our foreign exchange options and forward contracts totaled $129.1 million and $208.1 million, respectively, all of which related to certain of our foreign currency denominated corporate debt holdings.

Free-Standing Derivatives Income (Loss)

The amounts recorded in net realized and unrealized (loss) gain on derivatives and foreign exchange on the condensed consolidated financial statements for the three months ended March 31, 2013 and 2012 are as follows (amounts in thousands):

	Three months ended March 31, 2013									Three months ended March 31, 2012
	Realized gains (losses)(1)			Unrealized gains (losses)			Total			Realized gains (losses)(1)			Unrealized gains (losses)		Total
Commodity swaps	$	1,109		$	(6,109	)	$	(5,000	)	$	938		$	3,796	$	4,734
Credit default swaps	(2,643		)	1,470			(1,173		)	(5,669		)	7,720		2,051
Foreign exchange forward contracts and options	(911		)	(1,920		)	(2,831		)	(105		)	1,592		1,487
Net realized and realized (losses) gains	$	(2,445	)	$	(6,559	)	$	(9,004	)	$	(4,836	)	$	13,108	$	8,272

(1) Includes related income and expense on the derivatives.

NOTE 9. ACCUMULATED OTHER COMPREHENSIVE LOSS

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

	Three months ended March 31, 2013 (1)
	Net unrealized gains on available-for-sale securities		Net unrealized losses on cash flow hedges			Total
Beginning balance	$	17,472	$	(87,698	)	$	(70,226	)
Other comprehensive income before reclassifications	2,412		11,158			13,570
Amounts reclassified from accumulated other comprehensive loss(2)	3,113		—			3,113
Net current-period other comprehensive income	5,525		11,158			16,683
Ending balance	$	22,997	$	(76,540	)	$	(53,543	)

(1) The Company’s gross and net of tax amounts are the same.

(2) Includes an impairment charge of $5.9 million for investments which were determined to be other-than-temporary for the three months ended March 31, 2013. These reclassified amounts are included in net realized and unrealized gain on investments on the condensed consolidated statements of operations.

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, subject to certain conditions, 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 March 31, 2013 and December 31, 2012, the Company had committed to purchase corporate loans with aggregate commitments totaling $219.3 million and $254.2 million, respectively. In addition, the Company participates in certain

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contingent financing arrangements, whereby the Company is committed to provide funding of up to a specific predetermined amount at the discretion of the borrower or has entered into an agreement to acquire interests in certain assets. As of March 31, 2013 and December 31, 2012, the Company had unfunded financing commitments for corporate loans totaling $5.6 million and $9.8 million, respectively. The Company did not have any significant losses as of March 31, 2013, nor does it expect any significant losses related to those assets for which it committed to purchase and fund.

The Company participates in joint ventures and partnerships alongside KKR and its affiliates through which the Company contributes capital for assets, including development projects related to the Company’s interests in joint ventures and partnerships that hold commercial real estate and natural resources investments. The Company estimated these future contributions to range from approximately $245.0 million to $285.0 million as of March 31, 2013 and $203.0 million as of December 31, 2012.

Guarantees

As of March 31, 2013, the Company had an investment in a real estate entity, which was financed with non-recourse debt totaling $92.0 million. Under non-recourse debt, the lender generally does not have recourse against any other assets owned by the borrower or any related parties of the borrower, except for certain specified exceptions listed in the respective loan documents including customary “bad boy” acts. In connection with the investment, joint and several non-recourse “bad boy” guarantees were provided for losses relating solely to specified bad faith acts that damage the value of the real estate being used as collateral. The Company does not expect any related losses. As of both March 31, 2013 and December 31, 2012, the Company also had financial guarantees related to its natural resources investments totaling $17.9 million for which the Company does not expect any significant losses.

NOTE 11. SHAREHOLDERS’ EQUITY

Preferred Shares

On January 17, 2013, the Company issued 14.95 million of Series A LLC Preferred Shares for gross proceeds of $373.8 million, and net proceeds of $362.0 million. The Series A LLC Preferred Shares trade on the New York Stock Exchange (“NYSE”) under the ticker symbol “KFN.PR” and began trading on January 28, 2013. Distributions on the Series A LLC Preferred Shares are cumulative and are payable, when, as, and if declared by the Company’s board of directors, quarterly on January 15, April 15, July 15 and October 15 of each year, beginning April 15, 2013, at a rate per annum equal to 7.375%.

Common Shares

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 March 31, 2013, the 2007 Share Incentive Plan authorizes a total of 8,839,625 shares that may be used to satisfy awards under the 2007 Share Incentive Plan. On February 14, 2013, the Compensation Committee of the board of directors granted the Manager 292,009 restricted common shares subject to graded vesting over three years with the final vesting date of March 1, 2016.

The following table summarizes restricted common share transactions:

	Manager		Directors	Total
Unvested shares as of January 1, 2013	438,937		92,253	531,190
Issued	292,009		—	292,009
Vested	(146,312	)	—	(146,312	)
Forfeited	—		—	—
Unvested shares as of March 31, 2013	584,634		92,253	676,887

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 $11.07 and $9.21 per share at March 31, 2013 and 2012, respectively. There were $5.3 million and $3.9 million of total unrecognized compensation costs related to unvested restricted common shares granted as of March 31, 2013 and 2012, respectively. These costs are expected to be recognized through 2016.

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The following table summarizes common share option transactions:

	Number of Options	Weighted Average Exercise Price
Outstanding as of January 1, 2013	1,932,279	$	20.00
Granted	—	—
Exercised	—	—
Forfeited	—	—
Outstanding as of March 31, 2013	1,932,279	$	20.00

As of March 31, 2013 and 2012, 1,932,279 common share options were exercisable. As of March 31, 2013, the common share options were fully vested and expire in August 2014.

For the three months ended March 31, 2013 and 2012, the components of share-based compensation expense are as follows (amounts in thousands):

	For the three months ended March 31, 2013		For the three months ended March 31, 2012
Restricted shares granted to Manager	$	719	$	383
Restricted shares granted to certain directors	261		231
Total share-based compensation expense	$	980	$	614

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 months ended March 31, 2013, the Company incurred $9.6 million in base management fees. As of March 31, 2013, the Company had $3.2 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 $0.7 million for the three months ended March 31, 2013 (see Note 11). For the three months ended March 31, 2012, the Company incurred $7.0 million in base management fees. In addition, the Company recognized share-based compensation expense related to restricted common shares granted to the Manager of $0.4 million for the three months ended March 31, 2012 (see Note 11). Base management fees incurred and share-based compensation expense relating to common share options and restricted common shares granted to the Manager are included in related party management compensation on the condensed consolidated statements of operations.

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 NYSE 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 March 31, 2013 and 2012.

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NOTE 13. FAIR VALUE OF FINANCIAL INSTRUMENTS

Financial Instruments Not Carried at Estimated Fair Value

The following table presents the carrying value and estimated fair value, as well as the respective hierarchy classifications, of the Company’s financial assets and liabilities that are not carried at estimated fair value (excluding financial instruments which are carried at estimated fair value on a recurring basis) as of March 31, 2013 (amounts in thousands):

	As of March 31, 2013				Fair Value Hierarchy
	Carrying Amount		Estimated Fair Value		Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)
Assets:
Cash, restricted cash, and cash equivalents	$	1,435,264	$	1,435,264	$	1,435,264	$	—	$	—
Corporate loans, net of allowance for loan losses of $206,227 as of March 31, 2013(1)	5,687,728		5,800,465		—		5,360,906		439,559
Corporate loans held for sale(1)	107,395		130,720		—		107,356		23,364
Private equity investments, at cost(2)	405		2,115		—		—		2,115
Other assets	8,452		8,287		—		8,287		—
Liabilities:
Collateralized loan obligation secured debt	$	5,058,520	$	4,972,006	$	—	$	—	$	4,972,006
Collateralized loan obligation junior secured notes to affiliates	193,921		188,753		—		—		188,753
Credit facilities	46,089		46,089		—		—		46,089
Senior notes	362,202		429,157		429,157		—		—
Junior subordinated notes	283,517		134,351		—		—		134,351

(1) Corporate loans held for investment are carried at amortized cost net of allowance for loan losses, while corporate loans held for sale are carried at the lower of cost or estimated fair value. Refer to “Fair Value Measurements” below for a table presenting the corporate loans which are measured at fair value on a non-recurring basis.

(2) Included within other assets on the condensed consolidated balance sheets.

	As of December 31, 2012				Fair Value Hierarchy
	Carrying Amount		Estimated Fair Value		Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)
Assets:
Cash, restricted cash, and cash equivalents	$	1,134,002	$	1,134,002	$	1,134,002	$	—	$	—
Corporate loans, net of allowance for loan losses of $223,472 as of December 31, 2012	5,783,689		5,831,218		—		5,203,763		627,455
Corporate loans held for sale(1)	128,289		195,078		—		151,327		43,751
Private equity investments, at cost(2)	405		1,635		—		—		1,635
Other assets	17,148		16,777		—		16,439		338
Liabilities:
Collateralized loan obligation secured debt	$	5,122,338	$	5,020,115	$	—	$	—	$	5,020,115
Collateralized loan obligation junior secured notes to affiliates	296,557		290,948		—		—		290,948
Credit facilities	107,789		107,789		—		—		107,789
Convertible senior notes	166,028		268,238		—		268,238		—
Senior notes	362,178		412,126		412,126		—		—
Junior subordinated notes	283,517		134,351		—		—		134,351

(1) Corporate loans held for sale are carried at the lower of cost or estimated fair value. Refer to “Fair Value Measurements” below for a table presenting the corporate loans held for sale which are measured at fair value on a non-recurring basis.

(2) Included within other assets on the 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 March 31, 2013, 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 March 31, 2013
Assets:
Securities:
Securities available-for-sale	$	—	$	316,882	$	42,083	$	358,965
Other securities, at estimated fair value	—		52,966		3,237		56,203
Residential mortgage-backed securities	—		—		87,028		87,028
Total securities	—		369,848		132,348		502,196
Corporate loans, at estimated fair value	—		25,716		17,325		43,041
Equity investments, at estimated fair value	28,428		54,357		102,262		185,047
Derivatives:
Foreign exchange options	—		—		5,581		5,581
Commodity swaps	—		6,073		—		6,073
Common stock warrants	1,651		—		1,819		3,470
Foreign exchange forward contracts	—		6,514		—		6,514
Credit default swaps—protection purchased	—		56		—		56
Total derivatives	1,651		12,643		7,400		21,694
Other assets:
Interests in joint ventures and partnerships	—		—		169,931		169,931
Other assets	—		406		—		406
Total other assets	—		406		169,931		170,337
Total	$	30,079	$	462,970	$	429,266	$	922,315
Liabilities:
Securities sold, not yet purchased	$	1,235	$	—	$	—	$	1,235
Derivatives:
Interest rate swaps	—		79,445		—		79,445
Foreign exchange forward contracts	—		14,515		—		14,515
Credit default swaps—protection purchased	—		858		—		858
Commodity swaps	—		5,127		—		5,127
Foreign exchange options	—		—		231		231
Total derivatives	—		99,945		231		100,176
Total	$	1,235	$	99,945	$	231	$	101,411

The following table presents information about the Company’s assets measured at fair value on a non-recurring basis as of March 31, 2013, 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 March 31, 2013
Corporate loans held for investment(1)	$	—	$	58,423	$	—	$	58,423
Corporate loans held for sale(2)	—		50,068		3,939		54,007
Total	$	—	$	108,491	$	3,939	$	112,430

(1) Represents loans held for investment whose carrying amount was based on estimated fair value. Of the total $58.4 million, $19.0 million was related to loans held in the Company’s allocated component of the allowance for loan losses and $39.4 million was related to loans modified in a TDR.

(2) As of March 31, 2013, total loans held for sale had a carrying value of $107.4 million of which $54.0 million was carried at estimated fair value and the remaining $53.4 million carried at amortized cost. Of the $54.0 million carried at estimated fair value, $50.1 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 $3.9 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.

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The following table presents information about the Company’s financial assets and liabilities measured at fair value on a recurring basis as of December 31, 2012 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, 2012
Assets:
Securities:
Corporate debt securities	$	—	$	370,072	$	42,221	$	412,293
Other securities, at estimated fair value	—		34,476		2,909		37,385
Residential mortgage-backed securities	—		—		83,842		83,842
Total securities	—		404,548		128,972		533,520
Corporate loans, at estimated fair value	—		19,738		16,141		35,879
Equity investments, at estimated fair value	23,790		40,085		97,746		161,621
Derivatives:
Foreign exchange options	—		—		8,562		8,562
Commodity swaps	—		8,557		—		8,557
Common stock warrants	1,744		—		1,574		3,318
Foreign exchange forward contracts	—		2,615		—		2,615
Credit default swaps—protection sold	—		19		—		19
Credit default swaps—protection purchased	—		136		—		136
Total derivatives	1,744		11,327		10,136		23,207
Other assets:
Interests in joint ventures and partnerships	—		—		142,477		142,477
Other assets	—		319		—		319
Total other assets	—		319		142,477		142,796
Total	$	25,534	$	476,017	$	395,472	$	897,023
Liabilities:
Securities sold, not yet purchased	$	1,158	$	—	$	—	$	1,158
Derivatives:
Interest rate swaps	—		90,618		—		90,618
Foreign exchange forward contracts	—		23,590		—		23,590
Credit default swaps—protection purchased	—		1,276		—		1,276
Commodity swaps	—		1,501		—		1,501
Foreign exchange options	—		—		285		285
Total derivatives	—		116,985		285		117,270
Total	$	1,158	$	116,985	$	285	$	118,428

The following table presents information about the Company’s assets measured at fair value on a non-recurring basis as of December 31, 2012, 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, 2012
Corporate loans held for sale(1)	$	—	$	49,521	$	24,347	$	73,868
Total	$	—	$	49,521	$	24,347	$	73,868

(1) As of December 31, 2012, total loans held for sale had a carrying value of $128.3 million of which $73.9 million was carried at estimated fair value and the remaining $54.4 million carried at amortized cost. Of the $73.9 million carried at estimated fair value, $49.5 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 $24.3 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.

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Level 3 Fair Value Rollforward

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 March 31, 2013 (amounts in thousands):

	Securities Available- For-Sale: Corporate Debt Securities			Other Securities, at Estimated Fair Value		Residential Mortgage- Backed Securities			Corporate Loans, at Estimated Fair Value			Equity Investments, at Estimated Fair Value		Common Stock Warrants		Foreign Exchange Options, Net			Interests in Joint Ventures and Partnerships
Beginning balance as of January 1, 2013	$	42,221		$	2,909	$	83,842		$	16,141		$	97,746	$	1,574	$	8,277		$	142,477
Total gains or losses (for the period):
Included in earnings(1)	(117		)	328		5,721			(1,426		)	4,516		245		(2,927		)	6,679
Included in other comprehensive income	90			—		—			—			—		—		—			—
Transfers into Level 3(2)	—			—		—			—			—		—		—			—
Transfers out of Level 3(2)	—			—		—			—			—		—		—			—
Purchases	—			—		—			3,073			—		—		—			22,812
Sales	—			—		—			—			—		—		—			—
Settlements	(111		)	—		(2,535		)	(463		)	—		—		—			(2,037		)
Ending balance as of March 31, 2013	$	42,083		$	3,237	$	87,028		$	17,325		$	102,262	$	1,819	$	5,350		$	169,931
Change in unrealized gains or losses for the period included in earnings for assets held at the end of the reporting period(1)	$	(117	)	$	328	$	12,088		$	(1,722	)	$	4,516	$	245	$	(2,927	)	$	6,679

(1) Amounts are included in net realized and unrealized gain on investments or net realized and unrealized (loss) gain on derivatives and foreign exchange in the condensed consolidated statements of operations.

(2) There were no transfers between Level 1 or 2. The Company’s policy is to recognize transfers into and out of Level 3 at the end of the reporting period.

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 March 31, 2012 (amounts in thousands):

	Securities Available- For-Sale: Corporate Debt Securities			Other Securities, at Estimated Fair Value			Residential Mortgage- Backed Securities			Corporate Loans, at Estimated Fair Value		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, 2012	$	67,233		$	2,778		$	86,479		$	—	$	150,962	$	152	$	1,266	$	13,394		$	567
Total gains or losses (for the period):
Included in earnings(1)	550			(57		)	2,436			1,314		2,388		141		285		(1,240		)	109
Included in other comprehensive income	4,051			—			—			—		—		—		—		—			—
Transfers into Level 3(2)	—			—			—			—		—		—		—		—			—
Transfers out of Level 3(2)	—			—			—			—		—		—		—		—			—
Purchases	—			—			—			8,615		6,151		—		—		—			—
Sales	—			—			—			—		—		—		—		—			—
Settlements	(328		)	—			(1,552		)	—		—		—		—		—
Ending balance as of March 31, 2012	$	71,506		$	2,721		$	87,363		$	9,929	$	159,501	$	293	$	1,551	$	12,154		$	676
Change in unrealized gains or losses for the period included in earnings for assets held at the end of the reporting period(1)	$	550		$	(57	)	$	7,798		$	1,314	$	2,388	$	141	$	285	$	(1,240	)	$	109

(2) There were no transfers between Level 1 or 2. The Company’s policy is to recognize transfers into and out of Level 3 at the end of the reporting period.

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Valuation Techniques and Inputs for Level 3 Fair Value Measurements

The following table presents additional information about valuation techniques and inputs used for assets and liabilities, including derivatives, that are measured at fair value and categorized within Level 3 as of March 31, 2013 (dollar amounts in thousands):

Balance as of
March 31,
2013

Valuation
Techniques(1)

Unobservable
Inputs(2)

Range (Weighted
Average)(3)

Impact to
Valuation
from an
Increase in
Input(4)

Assets:

Securities available-for-sale:

42,083

Yield Analysis

Yield

12% - 16% (13%)

Decrease

Corporate debt securities

Discount margin

1100bps - 1530bps

Decrease

(930bps)

Net leverage

2x - 5x (4x)

Decrease

Illiquidity discount

3% (3%)

Decrease

EBITDA multiple

7x - 8x (7x)

Increase

Broker quotes

Offered quotes

75 - 105 (89)

Increase

Other securities, at estimated fair value

3,237

Yield Analysis

Yield

10% (10%)

Decrease

Illiquidity discount

5% (5%)

Decrease

EBITDA multiple

7x (7x)

Increase

Residential mortgage-backed securities

87,028

Discounted cash flows

Probability of default

0% - 21% (6%)

Decrease

Loss severity

18% - 75% (32%)

Decrease

Constant prepayment rate

1% - 35% (14%)

(5)

Corporate loans, at estimated fair value

17,325

Yield Analysis

Illiquidity discount

15% (15%)

Decrease

Net leverage

5x - 6x (6x)

Decrease

EBITDA multiple

9x - 10x (9x)

Increase

Broker quotes

Offered quotes

8 - 30 (29)

Increase

Equity investments, at estimated fair value (6)

102,262

Market comparables

LTM EBITDA multiple

7x - 13x (11x)

Increase

Forward EBITDA multiple

6x - 12x (10x)

Increase

Discounted cash flows

Weighted average cost of capital

7% - 15% (10%)

Decrease

LTM EBITDA exit multiple

7x - 13x (9x)

Increase

Common stock warrants

1,819

Market comparables

LTM EBITDA multiple

6x (6x)

Increase

Forward EBITDA multiple

6x (6x)

Increase

Illiquidity discount

15% (15%)

Decrease

Discounted cash flows

Weighted average cost of capital

9% (9%)

Decrease

LTM EBITDA exit multiple

8x (8x)

Increase

Foreign exchange options

5,581

Option pricing model

Forward and spot rates

0 - 2 (1)

(7)

Interests in joint ventures and partnerships

169,931

Discounted cash flows

Illiquidity discount

10% - 15% (10%)

Decrease

Weighted average cost of capital

13% - 25% (18%)

Decrease

Liabilities:

Foreign exchange options

231

Option pricing model

Forward and spot rates

0.02 (0.02)

(7)

(1) For the assets that have more than one valuation technique, the Company may rely on the techniques individually or in aggregate based on a weight ascribed to each one ranging from 0-100%. When determining the weighting ascribed to each valuation methodology, the Company considers, among other factors, the availability of direct market comparables, the applicability of a discounted cash flow analysis and the expected hold period and manner of realization for the investment. These factors can result in different weightings among the investments and in certain instances, may result in up to a 100% weighting to a single methodology. Broker quotes obtained for valuation purposes are reviewed by the Company through other valuation techniques.

(2) The significant unobservable inputs used in the fair value measurement of the Company’s assets and liabilities may include the last twelve months (“LTM”) EBITDA multiple, weighted average cost of capital, discount margin, probability of default, loss severity and constant prepayment rate. In determining certain of these inputs, management evaluates a variety of factors including economic, industry and market trends and developments; market valuations of comparable companies; and company specific developments including potential exit strategies and realization opportunities. Significant increases or decreases in any of these inputs in isolation could result in significantly lower or higher fair value measurement.

(3) Weighted average amounts are based on the estimated fair values.

(4) Unless otherwise noted, this column represents the directional change in the fair value of the Level 3 investments that would result from an increase to the corresponding unobservable input. A decrease to the unobservable input would have the opposite effect. Significant changes in these inputs in isolation could result in significantly higher or lower fair value measurements.

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(5) The impact of changes in prepayment speeds may have differing impacts depending on the seniority of the instrument. Generally, an increase in the constant prepayment speed will positively impact the overall valuation of traditional mortgage assets. In contrast, an increase in the constant prepayment rate will negatively impact the overall valuation of interest-only strips.

(6) When determining the illiquidity discount to be applied, the Company takes a uniform approach across its portfolio and generally applies a minimum 5% discount to all private equity investments carried at estimated fair value. The Company then evaluates such investments to determine if factors exist that could make it more challenging to monetize the investment and, therefore, justify applying a higher illiquidity discount. These factors generally include the salability of the investment, whether the issuer is undergoing significant restructuring activity or similar factors, as well as characteristics about the issuer including its size and/or whether it is experiencing, or expected to experience, a significant decline in earnings. Depending on the applicability of these factors, the Company determines the amount of any incremental illiquidity discount to be applied above the 5% minimum, and during the time the Company holds the investment, the illiquidity discount may be increased or decreased, from time to time, based on changes to these factors. The amount of illiquidity discount applied at any time requires considerable judgment about what a market participant would consider and is based on the facts and circumstances of each individual investment. Accordingly, the illiquidity discount ultimately considered by a market participant upon the realization of any investment may be higher or lower than that estimated by the Company in its valuations.

(7) The directional change from an increase in forward and spot rates varies and is dependent on the specific option.

Balance as of
December 31,
2012

Valuation
Techniques(1)

Unobservable
Inputs(2)

Range (Weighted
Average)(3)

Impact to
Valuation
from an
Increase in
Input(4)

Assets:

Securities available-for-sale:

42,221

Yield Analysis

Yield

11% - 46% (16%)

Decrease

Corporate debt securities

Discount margin

1100bps - 4550bps

Decrease

(1450bps)

Net leverage

3x - 13x (6x)

Decrease

Illiquidity discount

3% (3%)

Decrease

EBITDA multiple

6x - 8x (7x)

Increase

Broker quotes

Offered quotes

69 - 105 (88)

Increase

Other securities, at estimated fair value

2,909

Yield Analysis

Yield

10% (10%)

Decrease

Residential mortgage-backed securities

83,842

Discounted cash flows

Probability of default

0% - 21% (6%)

Decrease

Loss severity

18% - 80% (30%)

Decrease

Constant prepayment rate

1% - 35% (13%)

(5)

Corporate loans, at estimated fair value

16,141

Yield Analysis

Illiquidity discount

15% (15%)

Decrease

Net leverage

8x - 9x (9x)

Decrease

EBITDA multiple

9x - 10x (10x)

Increase

Broker quotes

Offered quotes

8 - 40 (39)

Increase

Equity investments, at estimated fair value (6)

97,746

Market comparables

LTM EBITDA multiple

7x - 12x (10x)

Increase

Forward EBITDA multiple

6x - 12x (10x)

Increase

Discounted cash flows

Weighted average cost of capital

6% - 16% (10%)

Decrease

LTM EBITDA exit multiple

7x - 12x (9x)

Increase

Common stock warrants

1,574

Market comparables

LTM EBITDA multiple

7x (7x)

Increase

Forward EBITDA multiple

7x (7x)

Increase

Illiquidity discount

15% (15%)

Decrease

Discounted cash flows

Weighted average cost of capital

12% (12%)

Decrease

LTM EBITDA exit multiple

7x (7x)

Increase

Foreign exchange options

8,562

Option pricing model

Forward and spot rates

0 - 2 (1)

(7)

Interests in joint ventures and partnerships

142,477

Discounted cash flows

Illiquidity discount

10% - 15% (10%)

Decrease

Weighted average cost of capital

13% - 30% (18%)

Decrease

Liabilities:

Foreign exchange options

285

Option pricing model

Forward and spot rates

0.02 (0.02)

(7)

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(3) Weighted average amounts are based on the estimated fair values.

(7) The directional change from an increase in forward and spot rates varies and is dependent on the specific option.

NOTE 14. SEGMENT REPORTING

Operating segments are defined as components of a company in which separate financial information is available and reviewed by the chief operating decision maker or group in determining how to allocate resources and assessing performance. The Company operates its business through multiple reportable business segments. Effective September 30, 2012, based on the growing significance of natural resources, the Company changed the basis of presentation from reporting solely the credit (“Credit”) and other segments (“Other”) to reporting Credit, natural resources (“Natural Resources”) and Other. Prior period balances have been reclassified for comparative purposes.

The Company’s segments are differentiated primarily by their investment focuses. The Credit segment consists primarily of below investment grade corporate debt comprised of senior secured and unsecured loans, mezzanine loans, private and public equity investments, and distressed and stressed debt securities. The Natural Resources segment, which was previously included within Other, consists of non-operated working and overriding royalty interests in oil and natural gas properties. The Other segment includes all other portfolio holdings, consisting solely of commercial real estate. The segments currently reported are consistent with the way decisions regarding the allocation of resources are made, as well as how operating results are reviewed by the Company.

The Company evaluates the performance of its segments based on several net income components. Net income includes (i) revenues, (ii) related investment costs and expenses, (iii) other income (loss), which is comprised primarily of unrealized and realized gains and losses on investments and derivatives, and (iv) other expenses, including related party management compensation and general and administrative expenses. Certain corporate assets and expenses that are not directly related to the individual segments, including interest expense and related costs on borrowings, base management fees and professional services are allocated to individual segments based on the carrying value of the assets within those segments. These allocations are calculated based on the investment portfolio balance in each respective segment as of the most recent period-end. Certain other corporate assets and expenses, including prepaid insurance, incentive fees, insurance expenses, directors’ expenses and share-based compensation expense are not allocated to individual segments in the Company’s assessment of segment performance. Collectively, these items are included as reconciling items between reported segment amounts and consolidated totals.

The following table shows data of reportable segments reconciled to amounts reflected in the condensed consolidated financial statements for the three months ended March 31, 2013 and 2012 (amounts in thousands):

	Credit					Natural Resources					Other				Reconciling Items(1)						Total Consolidated
For the three months ended March 31	2013		2012			2013			2012		2013		2012		2013			2012			2013		2012
Total revenues	$	115,149	$	126,881		$	23,805		$	11,053	$	1,496	$	—	$	—		$	—		$	140,450	$	137,934
Total investment costs and expenses	61,399		99,396			19,469			8,396		181		—		—			—			81,049		107,792
Total other income (loss)	93,926		74,642			(4,746		)	4,641		5,309		—		(20,269		)	(445		)	74,220		78,838
Total other expenses	13,968		12,533			1,630			1,260		124		—		19,105			11,207			34,827		25,000
Income tax expense (benefit)	457		(4,068		)	—			—		1		—		—			—			458		(4,068		)
Net income (loss)	$	133,251	$	93,662		$	(2,040	)	$	6,038	$	6,499	$	—	$	(39,374	)	$	(11,652	)	$	98,336	$	88,048

(1) Consists of certain expenses not allocated to individual segments including incentive fees of $17.2 million and $9.7 million for the three months ended March 31, 2013 and 2012, respectively and losses on restructuring and extinguishment of debt of $20.3 million and $0.4 million for the three months ended March 31, 2013 and 2012, respectively. The remaining reconciling items include insurance expenses, directors’ expenses and share-based compensation expense.

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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. 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, 2013. 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, natural resources, special situations, mezzanine, commercial real estate and private equity. Our holdings across these strategies primarily consist of below investment grade syndicated corporate loans, also known as leveraged loans, high yield debt securities, private equity, interests in joint ventures and partnerships, and working and royalty interests in oil and gas properties. The corporate loans that we hold are typically purchased via assignment or participation in the primary or secondary market.

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 seven 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”), KKR Financial CLO 2011-1, Ltd. (“CLO 2011-1”) and KKR Financial CLO 2012-1, Ltd. (“CLO 2012-1”) (collectively the “Cash Flow CLOs”). 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 (“NYSE”) under the symbol “KFN”. 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 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 (“KAM”), pursuant to a management agreement (the “Management Agreement”). KAM is a wholly-owned subsidiary of Kohlberg Kravis Roberts & Co. L.P. (“KKR”).

Business Environment

The first quarter of 2013 provided positive returns, albeit modest in comparison to 2012. Specifically, the S&P/LSTA Loan Index returned 2.1% for the first quarter of 2013 (as compared to 3.8% for the first quarter of 2012) and the Merrill Lynch High Yield Master II index returned 2.9% for the first quarter of 2013 (as compared to 5.1% for the first quarter of 2012). During the first quarter of 2013, we experienced a rally in U.S. Treasury Rates and a slight compression of credit spreads. Separately, we saw the average three-month London interbank offered rate (“LIBOR”) rate decrease to 0.29% for the three months ended March 31, 2013 from 0.51% for the three months ended March 31, 2012. Due to the low interest rates, the number of assets offering an income premium, or

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LIBOR floor, continued to climb. As of March 31, 2013, 56.5% of our floating corporate debt portfolio had a weighted average LIBOR floor of 1.3% compared to 51.6% with a weighted average floor of 1.4% as of December 31, 2012 and 33.5% with a weighted average floor of 1.4% as of March 31, 2012.

In addition to our financial assets consisting primarily of bank loans and high yield bonds, which are impacted by factors such as LIBOR, we hold oil and natural gas assets, which are impacted by the relevant commodity prices. Commodity price volatility will impact our net income through total revenues and net realized and unrealized gains and losses on our commodity swaps. In addition, revenue earned on our oil and natural gas properties are dependent on volumes produced and price. The Henry Hub spot natural gas price increased to $4.09 per million British thermal units (“MMBtu”) as of March 28, 2013, from $2.02 per MMBtu as of March 30, 2012. Separately, the WTI Cushing crude oil spot price decreased to $97.24 per barrel (“Bbl”) as of March 28, 2013, from $103.03 per Bbl as of March 30, 2012.

Summary of Results

Our net income available to common shareholders for the three months ended March 31, 2013 totaled $91.6 million (or $0.46 per diluted common share), as compared to net income of $88.0 million (or $0.48 per diluted common share), for the three months ended March 31, 2012. Additional discussion around our results, as well as the components of net income for our reportable segments for the three months ended March 31, 2013 and 2012 are detailed further below under “Results of Operations.”

Book value per share decreased $0.15 to $10.16 as of March 31, 2013 from $10.31 as of December 31, 2012. The decrease in book value per share from December 31, 2012 was attributable to the issuance of 26.1 million common shares related to the conversion of $172.5 million of our the 7.5% convertible senior notes due January 15, 2017 (the “7.5% Notes”) during the three months ended March 31, 2013, as well as the distribution to shareholders during the three months ended March 31, 2013 of $0.26 per common share, partially offset by earnings for the three months ended March 31, 2013 of $0.46 per common share.

Cash Distributions to Shareholders

On April 30, 2013, our board of directors declared a cash distribution for the quarter ended March 31, 2013 on our common shares of $0.21 per common share. The distribution is payable on May 28, 2013 to common shareholders of record as of the close of business on May 14, 2013.

On March 26, 2013, our board of directors declared a cash distribution of $0.450694 per share on our 7.375% Series A LLC Preferred Shares (‘‘Series A LLC Preferred Shares’’). The distribution was paid on April 15, 2013 to preferred shareholders as of the close of business on April 8, 2013.

The amount and timing of our distributions to our common and preferred shareholders, including any special distributions to our common shareholders, is determined by our board of directors and is based upon a review of various factors including current market conditions, our liquidity needs, legal and contractual restrictions on the payment of distributions, including those under the terms of our preferred shares which would impact common shareholders, the amount of ordinary taxable income or loss earned by us, 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.

We note, however, because of the tax rules applicable to partnerships, the gains or losses recognized by a common shareholder on the sale of assets held by us may be higher or lower depending upon the purchase price the shareholder paid for our common shares. Holders of Series A LLC Preferred Shares will not be allocated any gains or loss from any sale of our assets. Shareholders may have taxable income or tax liability attributable to our shares for a taxable year that is greater than our cash distributions for such taxable year. See “Non-Cash ‘Phantom’ Taxable Income” below for further discussion about taxable income allocable to holders of our shares. We may not declare or pay distributions on our common shares unless all accrued distributions have been declared and paid, or set aside for payment, on our Series A LLC Preferred Shares.

Funding Activities

Preferred Offering

On January 17, 2013, we issued 14.95 million of Series A LLC Preferred Shares for gross proceeds of $373.8 million, and net proceeds of $362.0 million. The Series A LLC Preferred Shares trade on the NYSE under the ticker symbol “KFN.PR” and began trading on January 28, 2013. Distributions on the Series A LLC Preferred Shares are cumulative and are payable, when, as, and if declared by our board of directors, quarterly on January 15, April 15, July 15 and October 15 of each year, and began April 15, 2013, at a rate per annum equal to 7.375%.

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· 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.

· 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.

· Commercial real estate: Our commercial real estate strategy consists of deploying capital to domestic and foreign opportunities through debt or equity interests, as well as participation in joint ventures and partnerships, in commercial real estate properties and fixed income instruments.

· 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.

Refer to “Results of Operations—Investment Portfolio” below for a reconciliation of these six core strategies, which differ from our reportable segments, to the line items on our condensed consolidated balance sheets.

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 March 31, 2013, our Cash Flow CLOs, which were structured as financing vehicles engaged in holding primarily corporate debt investments, held $6.3 billion par amount or $6.1 billion estimated fair value of corporate debt investments. Our corporate debt investments held through our Cash Flow CLOs consist of the following as of March 31, 2013:

· Corporate loans: Corporate loans consist of bank loans that are held through our CLOs with an aggregate par value of $6.0 billion and estimated fair value of $5.7 billion. Corporate loans held through our CLO transactions have a weighted average coupon of 4.9%, of which 99.0% of the corporate loans are floating rate with a weighted average coupon spread to LIBOR of 4.1%. The remaining 1.0% are fixed rate with a weighted average coupon of 7.3%.

· Corporate debt securities: Corporate debt securities consist of high yield bonds held through our CLOs with an aggregate par amount of $314.7 million and estimated fair value of $310.9 million. Corporate debt securities held through our CLO transactions have a weighted average coupon of 9.2%, of which 96.1% of the corporate debt securities are fixed rate with a weighted average coupon of 9.4%. The remaining 3.9% are floating rate with a weighted average coupon spread to LIBOR of 2.2%.

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

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 March 31, 2013, the contractual notional balance of our amortizing interest rate swaps was $372.8 million.

As of March 31, 2013, these Cash Flow CLOs had aggregate secured debt outstanding totaling $5.1 billion held by unaffiliated third parties and aggregate junior secured notes outstanding totaling $193.9 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. We hold the majority or all of the subordinated notes in each of the Cash Flow CLOs and we consolidate all of the Cash Flow CLOs. All income and losses related to the assets in these Cash Flow CLOs are reflected on our condensed consolidated statement of operations even though a minority interest in three of our CLO transactions is not held by us.

An affiliate of our Manager has entered into separate management agreements with our Cash Flow CLOs and is entitled to receive fees for the services performed as collateral manager. The indentures governing the CLO transactions stipulate the reinvestment period during which the collateral 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, both CLO 2005-1 and CLO 2005-2 ended their reinvestment periods in the second quarter of 2011 and CLO 2006-1 ended its reinvestment period in the third quarter of 2012. As a result, principal proceeds from the assets held in each of these transactions are generally used to amortize the outstanding balance of senior notes outstanding. During the three months ended March 31, 2013, an aggregate $146.2 million of

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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 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 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.

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, and certain interests in joint ventures and partnerships and certain financial instruments classified as derivatives.

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. Our 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. 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.

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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.

Residential Mortgage-Backed Securities at Estimated Fair Value: RMBS are initially valued at transaction price and are subsequently valued using a third party valuation servicer. The most significant inputs to the valuation of these instruments are default and loss expectations and constant prepayment rates.

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 issued 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 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.

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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 March 31, 2013, share-based compensation totaled $1.0 million. As of March 31, 2013, a $1 increase in the price of our common shares would have increased our future share-based compensation expense by approximately $0.6 million and this future share-based compensation expense would be recognized over the remaining vesting periods of our outstanding restricted common shares. As of March 31, 2013, the common share options were fully vested and expire in August 2014. As of March 31, 2013, future unamortized share-based compensation totaled $5.3 million, of which $2.8 million, $1.9 million and $0.6 million will be recognized in 2013, 2014 and beyond, respectively.

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 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.

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 March 31, 2013, the estimated fair value of our net derivative liabilities totaled $78.5 million.

Impairments

Securities Available-for-Sale: 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.

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.

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This process involves a considerable amount of judgment by our management. As of March 31, 2013, we had aggregate unrealized losses on our securities classified as available-for-sale of approximately $2.0 million, which if not recovered may result in the recognition of future losses. During the three months ended March 31, 2013, we recorded charges for impairments of securities that we determined to be other-than-temporary totaling $5.9 million.

Long Lived Assets: We evaluate our proved oil and natural gas properties and related equipment and facilities for impairment on a field-by-field basis, whenever events or changes in circumstances indicate that the carrying amounts of such properties may not be recoverable. The determination of recoverability is made based upon estimated undiscounted future net cash flows. The amount of impairment loss, if any, is determined by comparing the fair value, as determined by a discounted cash flow analysis, with the carrying value of the related asset. The factors used to determine fair value include, but are not limited to, estimates of proved reserves, future commodity pricing, future production estimates, anticipated capital expenditures, future operating costs and a discount rate commensurate with the risk on the properties and cost of capital. Unproved oil and natural gas properties are assessed periodically and, at a minimum, annually on a property-by-property basis, and any impairment in value is recognized when incurred.

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 typically 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 and generally consist of leveraged loans.

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 present value of expected future cash flows discounted at the loan’s effective interest rate, except as a practical expedient, the loan’s observable estimated fair value may be used. We also estimate the probable credit losses inherent in our unfunded loan commitments as of the balance sheet date. Any credit loss reserve for unfunded loan commitments is recorded in accounts payable, accrued expenses and other liabilities on our condensed consolidated balance sheets.

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 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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RESULTS OF OPERATIONS

Consolidated Results

The following table presents the consolidated results by segments for the three months ended March 31, 2013 and 2012 (amounts in thousands):

	Credit					Natural Resources					Other				Reconciling Items(1)						Total Consolidated
For the three months ended March 31	2013		2012			2013			2012		2013		2012		2013			2012			2013		2012
Total revenues	$	115,149	$	126,881		$	23,805		$	11,053	$	1,496	$	—	$	—		$	—		$	140,450	$	137,934
Total investment costs and expenses	61,399		99,396			19,469			8,396		181		—		—			—			81,049		107,792
Total other income (loss)	93,926		74,642			(4,746		)	4,641		5,309		—		(20,269		)	(445		)	74,220		78,838
Total other expenses	13,968		12,533			1,630			1,260		124		—		19,105			11,207			34,827		25,000
Income tax expense (benefit)	457		(4,068		)	—			—		1		—		—			—			458		(4,068		)
Net income (loss)	$	133,251	$	93,662		$	(2,040	)	$	6,038	$	6,499	$	—	$	(39,374	)	$	(11,652	)	$	98,336	$	88,048

Net income for the three months ended March 31, 2013 was $98.3 million, consisting of revenues totaling $140.5 million, investment costs and expenses totaling $81.0 million, other income totaling $74.2 million and other expenses totaling $34.8 million. Comparatively, net income for the three months ended March 31, 2012 was $88.0 million, consisting of revenues totaling $137.9 million, investment costs and expenses totaling $107.8 million, other income totaling $78.8 million and other expenses totaling $25.0 million.

Revenues

For the three months ended March 31, 2013 compared to the three months ended March 31, 2012

Revenues consist primarily of interest income and discount accretion from our investment portfolio, as well as oil and gas revenue from our working and royalty interests in oil and gas properties. Revenues increased $2.5 million from the three months ended March 31, 2012 to 2013 due to $12.8 million of incremental oil and gas revenue as a result of the acquisition and development of additional working and royalty interests in 2012 and $3.3 million of additional dividend income. These increases were partially offset by a reduction in loan and securities interest income of $8.3 million and discount accretion of $5.2 million from the three months ended March 31, 2012 to 2013.

Investment Costs and Expenses

For the three months ended March 31, 2013 compared to the three months ended March 31, 2012

Investment costs and expenses include interest expense, provision for loan losses, oil and gas production costs, depreciation, depletion and amortization expense (“DD&A”) related to oil and gas properties, and other investment expenses. Investment costs and expenses decreased $26.7 million from the three months ended March 31, 2012 to 2013 primarily due to a $35.4 million decrease in provision for loan losses offset by a $10.8 million increase in both oil and gas production costs and DD&A as a result of the acquisition and development of additional working and royalty interests in 2012.

Other Income

For the three months ended March 31, 2013 compared to the three months ended March 31, 2012

Other income decreased $4.6 million from the three months ended March 31, 2012 to 2013 primarily as a result of a $19.8 million increase in loss on restructuring and extinguishment of debt related to the conversion of our convertible notes combined with an $18.0 million negative change to total net realized and unrealized (loss) gain on derivatives and foreign exchange, largely offset by a $28.2 million increase in net realized and unrealized gains on investments and a $4.8 million increase in trade-related fee income.

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The following discussion and analysis regarding our results of operations is based on our reportable segments. Certain prior period information has been reclassified to conform to the current year presentation to provide additional detailed financial information as a result of the growth in our natural resources segment.

Credit Segment

The following table presents the net income components of our credit segment for the three months ended March 31, 2013 and 2012 (amounts in thousands):

	For the three months ended March 31, 2013			For the three months ended March 31, 2012
Revenues:
Corporate loans and securities interest income	$	93,795		$	102,126
Residential mortgage-backed securities interest income	2,959			2,962
Net discount accretion	16,370			21,582
Dividend income	1,963			164
Other	62			47
Total revenues	115,149			126,881
Investment costs and expenses:
Interest expense:
Collateralized loan obligation secured notes	19,064			18,263
Credit facilities	216			546
Convertible senior notes	4,175			5,941
Senior notes	7,103			5,537
Junior subordinated notes	3,619			3,838
Interest rate swaps	5,736			5,585
Other interest expense	87			76
Total interest expense	40,000			39,786
Interest expense to affiliates	9,917			12,859
Provision for loan losses	11,068			46,498
Other	414			253
Total investment costs and expenses	61,399			99,396
Other income:
Realized and unrealized (loss) gain on derivatives and foreign exchange:
Credit default swaps	(1,173		)	2,051
Total rate of return swaps	—			141
Common stock warrants	153			736
Foreign exchange(1)	(2,831		)	1,487
Total realized and unrealized (loss) gain on derivatives and foreign exchange	(3,851		)	4,415
Net realized and unrealized gain on residential mortgage-backed securities, at estimated fair value	6,444			3,047
Net realized and unrealized gain on investments(2)	88,912			64,310
Net realized and unrealized (loss) gain on securities sold, not yet purchased	(77		)	11
Impairment of securities available for-sale and private equity at cost	(5,862		)	(733		)
Other income	8,360			3,592
Total other income	93,926			74,642
Other expenses:
Related party management compensation:
Base management fees	8,928			6,806
CLO management fees	849			1,057
Total related party management compensation	9,777			7,863
Professional services	1,435			1,725
Other general and administrative	2,756			2,945
Total other expenses	13,968			12,533
Income before income taxes	133,708			89,594
Income tax expense (benefit)	457			(4,068		)
Net income	$	133,251		$	93,662

(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.

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Revenues

For the three months ended March 31, 2013 compared to the three months ended March 31, 2012

Revenues decreased $11.7 million from $126.9 million for the three months ended March 31, 2012 to $115.1 million for the three months ended March 31, 2013. The decrease was primarily attributable to an $8.3 million decline in corporate loans and securities interest income earned due to declining average par balances in the corporate debt portfolio. The weighted average par balances for our corporate bond portfolio declined by $413.5 million, from $858.2 million to $444.7 million for the three months ended March 31, 2012 and 2013, respectively. The weighted average par balances for our corporate loan portfolio declined by $461.4 million from $7.0 billion to $6.5 billion for the three months ended March 31, 2012 and 2013, respectively. This reduction was the result of fewer purchases during 2012 and 2013 as the majority of our CLOs have ended their reinvestment periods. CLO 2006-1 ended its reinvestment period during the third quarter of 2012, while CLO 2005-1, CLO 2005-2 and CLO 2007-A ended their reinvestment periods in 2011 and 2010. Refer to “Investment Portfolio Overview” above for further discussion on the principal proceeds from the assets held in each of these CLO transactions used to amortize the outstanding balance of the CLO senior notes outstanding. The smaller portfolio outweighed the higher yields earned on our portfolio. The average three-month LIBOR rate decreased to 0.29% for the three months ended March 31, 2013, from 0.51% for the three months ended March 31, 2012. However, offsetting this decline was an increase in the percentage of our floating rate corporate debt portfolio with LIBOR floors to 56.5% as of March 31, 2013 with a weighted average floor of 1.3%, from 33.5% as of March 31, 2012 with a weighted average floor of 1.4%.

In addition, net discount accretion declined by $5.2 million as a net result of (i) a $6.0 million decline in recurring accretion income due to a smaller overall corporate debt portfolio and comparatively smaller discounts on the remaining portfolio, partially offset by (ii) a $0.8 million increase in accelerated discount accretion as a result of greater paydowns during the first quarter of 2013 compared to 2012.

These negative changes were partially offset by a $1.8 million increase in dividend income from the three months ended March 31, 2012 to March 31, 2013.

Investment Costs and Expenses

For the three months ended March 31, 2013 compared to the three months ended March 31, 2012

Total investment costs and expenses decreased $38.0 million, from $99.4 million for the three months ended March 31, 2012 to $61.4 million for the three months ended March 31, 2013. The decrease was primarily attributable to a reduction in the provision for loan losses and a decrease in interest expense to affiliates. Provision for loan losses decreased $35.4 million from $46.5 million for the three months ended March 31, 2012 to $11.1 million for the three months ended March 31, 2013. The decrease in provision for loan losses was attributable to a comparatively larger provision for loan losses recorded in the first quarter of 2012 as a result of an increase in the unallocated component of our allowance for loan losses based on a review of our unimpaired, held for investment loan portfolio, with particular sensitivity to the loans that we have designated as high risk within our internally assigned risk grades.

Other Income

For the three months ended March 31, 2013 compared to the three months ended March 31, 2012

Total other income increased $19.3 million from $74.6 million for the three months ended March 31, 2012 to $93.9 million for the three months ended March 31, 2013. This increase was largely driven by a $24.6 million increase in net realized and unrealized gain on investments coupled with a $4.8 million increase in other income, partially offset by an $8.3 million negative change related to total realized and unrealized (loss) gain on derivatives and foreign exchange and a $5.1 million increase in impairment losses recorded for securities available-for-sale that we determined to be other-than-temporarily impaired. These changes are described in further detail below.

First, realized and unrealized gains on our corporate debt portfolio increased year over year. Specifically, gains on our corporate loan portfolio increased $36.7 million from $20.2 million for the three months ended March 31, 2012 to $56.9 million for the three months ended March 31, 2013. Included in the $56.9 million of gains was $48.3 million from the sale of one of our largest corporate loan positions. Additionally, gains on equity investments at estimated fair value increased $17.7 million from $7.1 million for the three months ended March 31, 2012 to $24.7 million for the three months ended March 31, 2013. These realized and unrealized gains were partially offset by (i) a $16.4 million decrease in gains on securities available-for-sale from $26.6 million for the three months ended March 31, 2012 to $10.1 million for the three months ended March 31, 2013 and (ii) a $15.2 million negative change in the lower of cost or estimated fair market value adjustment to corporate loans held for sale from a $10.4 million reduction in adjustment recorded during the three months ended March 31, 2012 to a $4.7 million charge recorded during the three months ended March 31, 2013. As of March 31, 2013 and 2012, our loans held for sale had a carrying value of $107.4 million and $297.7 million, respectively.

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Second, for the three months ended March 31, 2012, net realized and unrealized gain on derivatives and foreign exchange totaled $4.4 million, as compared to a $3.9 million loss for the three months ended March 31, 2013. The variance was primarily attributable to adverse movements in exchange rates related to our foreign exchange contracts and Euro-denominated investments.

Other Expenses

For the three months ended March 31, 2013 compared to the three months ended March 31, 2012

Other expenses increased $1.4 million from $12.5 million for the three months ended March 31, 2012 to $14.0 million for the three months ended March 31, 2013, primarily due to an increase of $2.1 million of base management fees pursuant to the Management Agreement. Base management fees increased primarily due to an increase in “equity” resulting from the issuance of preferred and common shares during the first quarter of 2013 and net income earned during 2012 and 2013.

Natural Resources Segment

The following table presents the net (loss) income components of our natural resources segment for the three months ended March 31, 2013 and 2012 (amounts in thousands):

	For the three months ended March 31, 2013			For the three months ended March 31, 2012
Revenues:
Oil and gas revenue:
Natural gas sales	$	7,048		$	2,605
Oil sales	12,344			5,731
Natural gas liquids sales	3,627			2,714
Other	786			3
Total revenues	23,805			11,053
Investments costs and expenses:
Interest expense:
Credit facilities	827			487
Convertible senior notes	244			172
Junior subordinated notes	212			111
Senior notes	415			160
Total interest expense	1,698			930
Oil and gas production costs:
Lease operating expenses	4,128			1,912
Workover expenses	1,037			320
Transportation and marketing expenses	1,269			—
Severance and ad valorem taxes	1,474			641
Total oil and gas production costs	7,908			2,873
Oil and gas depreciation, depletion and amortization	8,988			3,181
Other	875			1,412
Total investment costs and expenses	19,469			8,396
Other income:
Net realized and unrealized (loss) gain on derivatives and foreign exchange:
Commodity swaps	(5,000		)	4,734
Net realized and unrealized loss on investments(1)	—			(93		)
Other income	254			—
Total other (loss) income	(4,746		)	4,641
Other expenses:
Related party management compensation:
Base management fees	522			197
Professional services	275			171
Insurance	39			—
Other general and administrative	794			892
Total other expenses	1,630			1,260
(Loss) income before income taxes	(2,040		)	6,038
Income tax expense	—			—
Net (loss) income	$	(2,040	)	$	6,038

(1) Includes impairment of oil and gas properties

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Our oil and gas results depend substantially on natural gas and oil prices and production levels, as well as drilling and operating costs. The price we realize for our production is affected by our hedging activities. In order to help mitigate the potential exposure and effects of changing commodity prices on our revenues and cash flows from operations, we have entered into commodity swaps for a portion of our working interests. Our policy has been to hedge a majority of the total estimated oil, natural gas and NGL production on our working interests for a specified amount of time. Our commodity derivatives are described further below under “Other (Loss) Income”.

Production and Sales Statistics

	For the three months ended March 31, 2013		For the three months ended March 31, 2012
Average daily production:
Natural gas (Mcf/d)	25,069		14,665
Oil (Bbls/d)	1,267		538
NGL (Bbls/d)	1,584		888
Total (Mcfe/d)(1)	42,175		23,221
Weighted average prices (hedged)(2):
Natural gas (MMBtu)	$	3.54	$	2.74
Oil (Bbl)	$	108.17	$	117.98
NGL (Bbl)	$	26.64	$	33.27
Weighted average prices (unhedged)(3):
Natural gas (MMBtu)	$	3.12	$	1.97
Oil (Bbl)	$	108.24	$	118.29
NGL (Bbl)	$	25.45	$	33.96
Average Henry Hub and WTI spot prices:
Natural gas (MMBtu)	$	3.49	$	2.44
Oil (Bbl)	$	94.33	$	102.98
Costs per Mcfe of production:
Lease operating expenses	$	1.09	$	0.91
Transportation and marketing expenses	$	0.33	$	—
General and administrative expenses	$	0.44	$	1.09
Depreciation, depletion and amortization	$	2.37	$	1.52
Taxes, other than income taxes	$	0.39	$	0.31

(1) Calculated using a ratio of six Mcf of natural gas to one Bbl of oil, condensate or NGLs.

(2) Includes the effect of realized gains on derivatives of approximately $1.1 million and $0.9 million for the three months ended March 31, 2013 and 2012, respectively.

(3) Does not include the effect of realized gains (losses) on derivatives.

Revenues

For the three months ended March 31, 2013 compared to the three months ended March 31, 2012

Revenue increased $12.8 million from $11.1 million for the three months ended March 31, 2012 to $23.8 million for the three months ended March 31, 2013 due to the increase in production resulting from the acquisitions of producing oil and natural gas properties in 2012 described further below under “Investment Portfolio—Other Holdings”, as well as the drilling and completion of existing undeveloped working interest and overriding royalty interest property. As of March 31, 2013 and December 31, 2012, our working and overriding royalty interests had a carrying value of $305.1 million and $297.0 million, respectively, as compared to $211.1 million as of March 31, 2012.

Average daily production increased 82% from the three months ended March 31, 2012 to 2013 primarily due to acquisitions of producing properties during 2012 and drilling and completion of properties during 2012 and 2013.

Investment Costs and Expenses

Investment costs and expenses consist of production costs, DD&A and other expenses related to acquisitions.

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Production costs represent costs incurred to operate and maintain our wells, or lease operating expenses, as well as transportation and marketing costs. Lease operating expenses include expenses such as labor, rented equipment, field office, saltwater disposal, maintenance, tools and supplies and workover expenses. As we continue to acquire working interests in oil and natural gas properties, lease operating expenses will continue to increase in conjunction with an increase in oil, natural gas and NGL production. Furthermore, we have agreements with third parties to act as managers of certain of our oil and natural gas properties. Services provided by these third party managers include making the business and operational decisions related to the production and sale of oil, natural gas and NGLs, collection and disbursement of revenues, operating expenses, general and administrative expenses and other necessary and useful services for the operation of the assets. Again, as the overall number of oil and natural gas properties increase, the related costs to manage these properties increase correspondingly.

Production costs also include severance and ad valorem taxes, which increase or decrease primarily when prices of oil and natural gas increase or decrease, but are also affected by changes in production, as well as property values.

DD&A represents recurring charges related to the exhaustion of mineral reserves for our natural resources investments. DD&A is calculated using the units-of-production method, which depletes capitalized costs of producing oil and natural gas properties based on the ratio of current production to estimated total net proved oil, natural gas and NGL reserves, and total net proved developed oil, natural gas and NGL reserves. Our depletion expense is affected by factors including reserve revisions primarily related to well performance, commodity prices, additional capital expended to develop new wells and reserve additions resulting from development activity.

For the three months ended March 31, 2013 compared to the three months ended March 31, 2012

As described above, we acquired additional producing oil and natural gas properties during 2012 and thus, the costs associated with operating and managing the wells increased. Production costs increased $5.0 million from $2.9 million for the three months ended March 31, 2012 to $7.9 million for the three months ended March 31, 2013. Most notably was the increase in lease operating expenses of $2.2 million and transportation and marketing expenses of $1.3 million related to an increase in well count and production. Similarly, DD&A increased $5.8 million from $3.2 million for the three months ended March 31, 2012 to $9.0 million for the three months ended March 31, 2013 due to an increase in production and depletable costs that resulted from 2012 acquisitions and drilling and completion of additional wells.

Other (Loss) Income

For the three months ended March 31, 2013 compared to the three months ended March 31, 2012

Total other (loss) income decreased $9.4 million from other income of $4.6 million for the three months ended March 31, 2012 to other loss of $4.7 million for the three months ended March 31, 2013, primarily attributable to negative mark-to-market changes on our commodity swaps.

We have entered into receive-fixed, pay-floating commodity derivative contracts, specifically oil, natural gas and certain NGL product swaps, for certain years through 2016. Our unhedged production may expose us to commodity price declines or alternatively, provide the potential upside from commodity price increases. Our price hedging strategy and future hedging transactions, including the prices at which we hedge our production, are dependent upon several factors, including expected production and commodities prices at the time we enter into these transactions.

Net realized and unrealized (loss) gain on commodity swaps negatively changed from a gain of $4.7 million for the three months ended March 31, 2012 to a loss of $5.0 million for the three months ended March 31, 2013. Unrealized gains and losses on commodity swaps result from changes in commodity prices from period to period, as well as changes in market valuations of derivatives as future commodity price expectations change compared to the contract prices on the derivatives. If the expected future commodity prices increase compared to the contract prices on the derivatives, unrealized losses are recognized; if the expected future commodity prices decrease compared to the contract prices on the derivatives, unrealized gains are recognized. The fair value of our open derivative contracts decreased $10.2 million from a net asset $11.2 million as of March 31, 2012 to a net asset of $0.9 million as of March 31, 2013 primarily due to new contracts entered into subsequent to March 31, 2012 whose contract prices are less than future commodity prices as of March 31, 2013, and the settlement of contracts during 2012 and 2013.

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Other Expenses

For the three months ended March 31, 2013 compared to the three months ended March 31, 2012

Total other expenses increased $0.4 million from $1.3 million for the three months ended March 31, 2012 to $1.6 million for the three months ended March 31, 2013, primarily due to additional allocated corporate expenses, including base management fees and professional services expenses. As mentioned above, corporate expenses are allocated based on the investment portfolio balance in each respective segment.

Other Segments

The following table presents the net income components of our other segments for the three months ended March 31, 2013 and 2012 (amounts in thousands):

	For the three months ended March 31, 2013		For the three months ended March 31, 2012
Revenues:
Dividend income	$	1,496	$	—
Total revenues	1,496		—
Investment costs and expenses:
Interest expense	181		—
Total investment costs and expenses	181		—
Other income:
Net realized and unrealized gain on investments	5,309		—
Total other income	5,309		—
Other expenses:
Related party management compensation:
Base management fees	107		—
Professional services	17		—
Total other expenses	124		—
Income before income taxes	6,500		—
Income tax expense	1		—
Net income	$	6,499	$	—

Revenues

For the three months ended March 31, 2013 compared to the three months ended March 31, 2012

Revenues totaled $1.5 million for the three months ended March 31, 2013. As of March 31, 2013, our commercial real estate holdings had a carrying value of $79.9 million and are included within other assets on our condensed consolidated balance sheets. We began acquiring commercial real estate investments during the second quarter of 2012 and as such, there are zero balances for the three months ended March 31, 2012.

Investment Costs and Expenses

For the three months ended March 31, 2013 compared to the three months ended March 31, 2012

Investment costs and expenses totaled $0.2 million for the three months ended March 31, 2013. Certain corporate assets and expenses that are not directly related to a segment, including interest expense and related costs on borrowings are allocated to individual segments based on the investment portfolio balance in each segment as of the most recent period-end. We began acquiring commercial real estate investments during the second quarter of 2012 and as such, there are zero balances for the three months ended March 31, 2012.

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Other Income

For the three months ended March 31, 2013 compared to the three months ended March 31, 2012

Other income totaled $5.3 million for the three months ended March 31, 2013. As our commercial real estate holdings are recorded at estimated fair value on our condensed consolidated balance sheets, the $5.3 million represented net unrealized gains on our holdings. We began acquiring commercial real estate investments during the second quarter of 2012 and as such, there are zero balances for the three months ended March 31, 2012.

Other Expenses

For the three months ended March 31, 2013 compared to the three months ended March 31, 2012

Other expenses totaled $0.1 million for the three months ended March 31, 2013. The expenses incurred were comprised of certain corporate expenses that were not directly related to the segment, but were allocable costs based on the portfolio balance within the segment as of the most recent period-end. We began acquiring commercial real estate investments during the second quarter of 2012 and as such, there are zero balances for the three months ended March 31, 2012.

Income Tax Provision

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 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 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 end ending within or with their taxable year.

We hold equity interests in certain subsidiaries which have elected or intend to elect to be taxed as real estate investment trusts (“REIT subsidiaries”) under the Internal Revenue Code of 1986, as amended (the “Code”). 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 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 March 31, 2013 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.

Our REIT subsidiaries are not expected to incur a federal tax expense, but are subject to limited state income tax expense related to the 2013 tax year. For the three months ended March 31, 2013, we recorded $0.3 million of state tax expense for our domestic corporate subsidiaries. Additionally, we recorded $0.2 million of state and foreign tax expense for our non-corporate subsidiaries for the three months ended March 31, 2013. Accordingly, for the three months ended March 31, 2013, we recorded income tax expense of $0.5 million. As of March 31, 2013, cumulative tax liability net of deferred tax asset is included in accounts payable, accrued expenses and other liabilities on our consolidated balance sheet.

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Investment Portfolio

Our investment portfolio primarily consists of corporate debt holdings, consisting of corporate loans and corporate debt securities. The details of our corporate debt portfolio are discussed below under “Corporate Debt Portfolio”. Also included in our investment portfolio are our other holdings, including oil and gas working and royalty interests, equity investments, and interests in joint ventures and partnerships, which are all discussed below under “Other Holdings”.

The following table summarizes the carrying value of our investment portfolio by strategy as of March 31, 2013 (amounts in thousands):

	Bank Loans & High Yield Bonds		Natural Resources		Special Situations		Mezzanine		Commercial Real Estate		Private Equity		Total
Corporate loans(1)	$	5,896,394	$	—	$	64,342	$	83,655	$	—	$	—	$	6,044,391
Securities(2)	329,418		—		85,750		—		—		—		415,168
Equity investments, at estimated fair value(3)	56,300		12,493		33,128		8,264		—		74,862		185,047
Oil and gas properties, net	—		297,516		—		—		—		—		297,516
Other assets(4)	—		77,932		27,394		330		79,909		75		185,640
Total	$	6,282,112	$	387,941	$	210,614	$	92,249	$	79,909	$	74,937	$	7,127,762

(1) Includes loans held for sale and loans at estimated fair value. Amounts presented are gross of allowance for loan losses totaling $206.2 million as of March 31, 2013.

(2) Excludes our investments in RMBS with an estimated fair value of $87.0 million and securities sold, not yet purchased with an estimated fair value of $1.2 million.

(3) 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.

(4) Includes interests in joint ventures and partnerships.

The table above reconciles our assets as presented on our condensed consolidated balance sheets to our six core strategies, which differs from our reportable segments. For segment reporting purposes, the majority of our corporate debt portfolio and equity investments, at estimated fair value are included within our Credit segment. Our Natural Resources and Other segments include our oil and natural gas properties and commercial real estate investments, respectively. Our Natural Resources segment excludes the private equity and interests in joint ventures and partnerships focused on the oil and gas sector (included in equity investments, at estimated fair value and other assets on our condensed consolidated balance sheets).

Corporate Debt Portfolio

Our corporate debt investment portfolio primarily consists of investments in corporate loans and corporate 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 primarily floating rate indexed to either one-month or three-month LIBOR. Our investments in corporate debt securities primarily consist of fixed rate 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.

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Corporate Loans

Our corporate loan portfolio had an aggregate par value of $6.3 billion as of March 31, 2013 and $6.5 billion as of December 31, 2012. 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 March 31, 2013 and December 31, 2012. 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. We also have certain loans that we elected to carry at estimated fair value.

Corporate Loans

(Amounts in thousands)

	March 31, 2013(1)									December 31, 2012(1)
	Par		Carrying Value			Amortized Cost		Estimated Fair Value		Par		Carrying Value			Amortized Cost		Estimated Fair Value
Senior secured	$	5,713,868	$	5,532,189		$	5,532,189	$	5,504,149	$	5,761,308	$	5,575,437		$	5,575,437	$	5,494,676
Second lien	399,198		386,157			386,157		316,203		457,333		433,020			433,020		334,191
Subordinated	178,654		141,136			141,136		153,875		264,722		174,694			174,694		233,308
Subtotal	6,291,720		6,059,482			6,059,482		5,974,227		6,483,363		6,183,151			6,183,151		6,062,175
Lower of cost or fair value adjustment	—		(18,795		)	—		—		—		(14,047		)	—		—
Allowance for loan losses	—		(206,227		)	—		—		—		(223,472		)	—		—
Unrealized gains	—		3,704			—		—		—		2,225			—		—
Total	$	6,291,720	$	5,838,164		$	6,059,482	$	5,974,227	$	6,483,363	$	5,947,857		$	6,183,151	$	6,062,175

(1) Includes loans held for sale and loans carried at estimated fair value.

As of March 31, 2013, $6.2 billion par amount, or 98.8%, of our corporate loan portfolio was floating rate and $73.3 million par amount, or 1.2%, was fixed rate. In addition, as of March 31, 2013, $212.0 million par amount, or 3.4%, of our corporate loan portfolio was denominated in foreign currencies, of which 54.5% was denominated in Euros. As of December 31, 2012, $6.5 billion par amount, or 99.7%, of our corporate loan portfolio was floating rate and $22.3 million par amount, or 0.3%, was fixed rate. In addition, as of December 31, 2012, $328.9 million par amount, or 5.1%, of our corporate loan portfolio was denominated in foreign currencies, of which 68.8% 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 5.0% as of March 31, 2013 and 5.3% as of December 31, 2012, and the weighted average coupon spread to LIBOR of our floating rate corporate loan portfolio was 4.2% as of March 31, 2013 and 4.5% as of December 31, 2012. The weighted average years to maturity of our floating rate corporate loans was 4.3 years as of both March 31, 2013 and December 31, 2012, respectively.

As of March 31, 2013, our fixed rate corporate loans had a weighted average coupon of 8.4% and a weighted average years to maturity of 4.0 years, as compared to 12.5% and 1.5 years, respectively, as of December 31, 2012.

Non-Accrual Loans

We hold certain corporate loans designated as being non-accrual, impaired and/or in default. Non-accrual loans consist of (i) corporate loans held for investment, including impaired loans, (ii) corporate loans held for sale and (iii) loans carried at estimated fair value. Any of these three classifications may include those loans modified in a TDR, which are typically designated as being non-accrual (see “Troubled Debt Restructurings” section below).

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.

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The following table summarizes our recorded investment in non-accrual loans as of March 31, 2013 and December 31, 2012 (amounts in thousands):

	March 31, 2013		December 31, 2012
Loans held for investment(1)	$	561,550	$	445,437
Loans held for sale	75,608		90,840
Loans at estimated fair value	1,172		—
Total non-accrual loans	$	638,330	$	536,277

(1) Includes $522.1 million of impaired loans held for investment.

The $102.1 million increase in non-accrual loans from $536.3 million as of December 31, 2012 to $638.3 million as of March 31, 2013 was primarily due to $154.7 million of additions to impaired loans, partially offset by $28.2 million of restructures and $22.7 million of sales of loans that occurred during the period. During the three months ended March 31, 2013 and 2012, we recognized $8.0 million and $4.4 million, respectively, of interest income from cash receipts for loans on non-accrual status.

Impaired Loans

Impaired loans consist of loans held for investment where we have determined that it is probable 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 on a recorded investment basis increased from $445.4 million as of December 31, 2012 to $522.1 million as of March 31, 2013 primarily due to $154.7 million of additions to impaired loans, partially offset by $68.8 million of loans that were extinguished through TDRs and $9.4 million of transfers from held-for-investment to held-for-sale.

Defaulted Loans

Defaulted loans consist of corporate loans that have defaulted under the contractual terms of their loan agreements. The balance of defaulted loans may be 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. In contrast, 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.

As of March 31, 2013, we did not have any corporate loans that were in default. As of December 31, 2012, we held two corporate loans that were in default with a total amortized cost of $50.4 million from one issuer and were included in the loans for which the allocated component of our allowance for loan losses was related to.

Troubled Debt Restructurings

The recorded investment balance of TDRs totaled $65.6 million related to four TDRs and $25.5 million related to one TDR at March 31, 2013 and December 31, 2012, respectively. Loans whose terms have been modified in a TDR are typically placed on non-accrual status, but can be moved to accrual status when, among other criteria, payment in full of all amounts due under the restructured terms is expected and the borrower has demonstrated a sustained period of repayment performance, typically six months. As of March 31, 2013 and December 31, 2012, $65.6 million and $25.5 million of TDRs were included in non-accrual loans, respectively (see “Non-Accrual Loans” section above). As of March 31, 2013 and December 31, 2012, the allowance for loan losses included specific reserves of $1.9 million and $0.5 million related to TDRs, respectively. As of March 31, 2013, there were no commitments to lend additional funds to the borrowers whose loans had been modified in a troubled debt restructuring.

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conversions of the loans into one of the following: (i) new term loans with extended maturities and fixed, rather than floating, interest rates, (ii) equity carried at estimated fair value, (iii) or a combination of equity and loans carried at estimated fair value. The modification involving an extension of maturity date was for an additional four-year period with a higher coupon.

	Three months ended March 31, 2013					Three months ended March 31, 2012
	Number of loans	Pre-modification outstanding recorded investment(1)		Post-modification outstanding recorded investment(1)(2)		Number of loans	Pre-modification outstanding recorded investment(1)		Post-modification outstanding recorded investment(1)
Troubled debt restructurings:
Loans held for investment	2	$	68,358	$	39,430	—	$	—	$	—
Loans held for sale	—	—		—		—	—		—
Loans at estimated fair value	1	1,670		1,229		—	—		—
Total	3	$	70,028	$	40,659	—	$	—	$	—

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

(2) Excludes equity received from the TDRs with an estimated fair value of $2.1 million.

As of March 31, 2013, no loans modified as TDRs were in default within a twelve month period subsequent to their original restructuring.

We modified $1.0 billion and $457.1 million amortized cost of corporate loans during the three months ended March 31, 2013 and 2012, respectively, that did not qualify as TDRs. These modifications involved changes in existing rates and maturities to prevailing market rates/maturities for similar instruments and did not qualify as TDRs 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.

Allowance for Loan Losses

The following table summarizes the changes in our allowance for loan losses for the three months ended March 31, 2013 and 2012 (amounts in thousands):

	For the three months ended March 31, 2013			For the three months ended March 31, 2012
Balance at beginning of year	$	223,472		$	191,407
Provision for loan losses	11,068			46,498
Charge-offs	(28,313		)	(2,098		)
Balance at end of year	$	206,227		$	235,807

As of March 31, 2013 and December 31, 2012, we had an allowance for loan loss of $206.2 million and $223.5 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.

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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 possible 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 March 31, 2013, the allocated component of our allowance for loan losses totaled $86.9 million and relates to investments in certain loans issued by four issuers with an aggregate par amount of $551.8 million and an aggregate recorded investment of $522.1 million. As of December 31, 2012, the allocated component of our allowance for loan losses totaled $94.9 million and relates to investments in certain loans issued by six issuers with an aggregate par amount of $484.1 million and an aggregate recorded investment of $445.4 million.

The unallocated component of our allowance for loan losses totaled $119.3 million and $128.6 million as of March 31, 2013 and December 31, 2012, respectively. As discussed above, we estimate the unallocated reserve by first categorizing our corporate loans held for investment portfolio based on their assigned risk grade and then based on the seniority of the loan in the issuer’s capital structure. Of the three internally assigned risk grades, as of March 31, 2013, we had loans issued from six issuers with an aggregate par value of $542.6 million and amortized cost amount of $525.8 million that we classified as high risk. Approximately 98.0% of the amortized cost balance of loans classified as high risk consisted of the following holdings: (i) $313.3 million amortized cost amount of loans issued by Modular Space Corporation; (ii) $97.9 million amortized cost amount of loans issued by Education Management LLC; (iii) $48.2 million amortized cost amount of loans issued by Springleaf Financial Funding Company; (iv) $39.4 million amortized cost amount of loans issued by Lodgenet Interactive Corporation; and, (v) $16.6 million amortized cost amount of loans issued by Altegrity Holdings.

At September 30, 2012, we transferred Texas Competitive Electric Holdings Company LLC (“TXU”), from the high risk grade of the unallocated component to the allocated component of our allowance for loan losses upon determination that the loans were impaired. Management believed it probable that we would be unable to collect all payments due in accordance with the contractual terms of the loan agreement. To calculate the recovery value of the loans, we estimated the loss as being the difference between our current cost basis of the loan, including accrued interest receivable, and the present value of expected future cash flows discounted using the effective discount rate. At March 31, 2013, the calculation resulted in a specific reserve of $54.5 million related to TXU, or an implied recovery value of approximately 80% of par. As of March 31, 2013, TXU had a total amortized cost of $311.4 million. In addition, we held TXU loans held for sale with a recorded investment of $29.8 million as of March 31, 2013.

During the three months ended March 31, 2013 and 2012, we recorded charge-offs totaling $28.3 million and $2.1 million, respectively, comprised primarily of loans modified in TDRs and loans transferred to loans held for sale, respectively.

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Loans Held For Sale and the Lower of Cost or Fair Value Adjustment

The following table summarizes the changes in our loans held for sale balance as of March 31, 2013 and 2012 (amounts in thousands):

	March 31, 2013			March 31, 2012
Loans Held for Sale:
Beginning balance	$	128,289		$	317,332
Transfers in	21,388			46,077
Transfers out	—			(7,504		)
Sales, paydowns, restructurings and other	(37,533		)	(68,598		)
Lower of cost or estimated fair value adjustment(1)	(4,749		)	10,401
Net carrying value	$	107,395		$	297,708

(1) Represents the recorded net adjustment to earnings for the respective period.

As of March 31, 2013, we had $107.4 million of loans held for sale, a decrease of $20.9 million from December 31, 2012 primarily due to the sale of certain loans and the transfer of loans to held for investment for those we determined we no longer had the intention of selling.

During the three months ended March 31, 2013 and 2012, we transferred $21.4 million and $46.1 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 months ended March 31, 2013 and 2012, we transferred zero and $7.5 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. Such circumstances include deteriorated market conditions often resulting in price depreciation or assets becoming illiquid, changes in restrictions on sales and certain loans amending their terms to extend the maturity, whereby we determined that selling the asset no longer met our investment objective and strategy.

We recorded a $4.7 million net charge to earnings for the three months ended March 31, 2013 for the lower of cost or estimated fair value adjustment for certain loans held for sale, which had a carrying value of $107.4 million as of March 31, 2013. Comparatively, we reduced the lower of cost or market valuation allowance by $10.4 million for the three months ended March 31, 2012 for certain loans held for sale, which had a carrying value of $297.7 million as of March 31, 2012.

Concentration Risk

Our corporate loan portfolio has certain credit risk concentrated in a limited number of issuers. As of March 31, 2013, approximately 48% 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, TXU and Modular Space Corporation, which combined represented $996.7 million or approximately 16% of the aggregated amortized cost basis of our corporate loans. As of December 31, 2012, approximately 46% 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, TXU and Modular Space Corporation, which combined represented $1.0 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 $424.6 million and $466.1 million as of March 31, 2013 and December 31, 2012, 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. Our corporate debt securities are included in securities on our condensed consolidated balance sheets.

The following table summarizes our corporate debt securities portfolio stratified by type as of March 31, 2013 and December 31, 2012:

Corporate Debt Securities

(Amounts in thousands)

	March 31, 2013(1)								December 31, 2012(1)
	Par		Carrying Value		Amortized Cost		Estimated Fair Value		Par		Carrying Value		Amortized Cost		Estimated Fair Value
Senior secured	$	201,901	$	189,273	$	178,226	$	189,273	$	218,872	$	211,716	$	201,360	$	211,716
Senior unsecured	167,403		169,264		147,724		169,264		191,737		183,003		169,961		183,003
Subordinated	55,277		56,631		51,454		56,631		55,453		54,959		51,491		54,959
Total	$	424,581	$	415,168	$	377,404	$	415,168	$	466,062	$	449,678	$	422,812	$	449,678

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Sources of Funds

Senior Notes Offerings

On March 20, 2012, we issued $115.0 million par amount of 7.500% Senior Notes, resulting in net proceeds of $111.4 million. The notes trade under the ticker symbol “KFI” on the NYSE. Interest on the 7.500% Senior Notes is payable quarterly in arrears on June 20, September 20, December 20 and March 20 of each year.

Cash Flow CLO Transactions

As of March 31, 2013, we had seven 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 is $193.9 million as of March 31, 2013 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 or 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.

On December 21, 2012, we closed CLO 2012-1, a $412.4 million secured financing transaction maturing December 16, 2024. We issued $367.5 million par amount of senior secured notes to unaffiliated investors, of which $342.5 million was floating rate with a weighted-average coupon of three-month LIBOR plus 2.09% and $25.0 million was fixed rate at 2.39%. We also issued $21.5 million of subordinated notes to unaffiliated third party investors. The investments that are owned by CLO 2012-1 collateralize the CLO 2012-1 debt, and as a result, those investments are not available to us, our creditors or shareholders.

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

In the case of CLO 2011-1, the agreement specifies a par value ratio test (“PVR Test”), whereby 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. 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, in which case the collateral value of such asset is the market value of such asset.

The following table summarizes the PVR Test for CLO 2011-1. This information is based on the March 2013 monthly report which is prepared by the independent third party trustee for CLO 2011-1:

(dollar amounts in thousands)	CLO 2011-1
Portfolio total	$	407,312
Par value test minimum	120		%
Par value test ratio	133.3		%
Cushion / (Excess)	$	42,936
Par value portfolio collateral value	$	429,360
Outstanding loan balance	$	322,020

In the case of our other Cash Flow CLOs, which 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.

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(dollar amounts in thousands)	CLO 2005-1			CLO 2005-2			CLO 2006-1			CLO 2007-1			CLO 2007-A			CLO 2012-1
Investments	$	580,577		$	621,163		$	926,131		$	3,359,452		$	880,492		$	401,026
Senior IC ratio minimum	115.0		%	125.0		%	115.0		%	115.0		%	120.0		%	115.0		%
Actual senior IC ratio	696.6		%	1027.1		%	562.5		%	760.4		%	759.2		%	151.6		%
CCC amount	$	94,658		$	86,659		$	216,710		$	553,851		$	203,301		$	—
CCC percentage of portfolio	16.3		%	14.0		%	23.4		%	16.5		%	23.1		%	—		%
CCC threshold percentage	5.0		%	7.5		%	7.5		%	7.5		%	7.5		%	7.5		%
Senior OC Test minimum	119.4		%	123.0		%	143.1		%	159.1		%	119.7		%	113.2		%
Actual senior OC Test	175.9		%	162.9		%	176.2		%	182.5		%	171.0		%	121.5		%
Cushion / (Excess)	$	176,765		$	148,769		$	162,944		$	414,808		$	249,243		$	27,466
Subordinated OC Test minimum	106.2		%	106.9		%	114.0		%	120.1		%	109.9		%	n/a
Actual subordinated OC Test	124.0		%	130.1		%	145.3		%	127.1		%	126.3		%	n/a
Cushion / (Excess)	$	78,948		$	108,323		$	187,032		$	178,093		$	107,859		n/a

During the three months ended March 31, 2012, we issued $42.0 million par amount of CLO 2007-1 class D notes for proceeds of $31.9 million.

Credit Facilities

Senior Secured Credit Facility

On November 30, 2012, we entered into a credit agreement for a three-year $150.0 million revolving credit facility, maturing on November 30, 2015. We may obtain additional commitments under the 2015 Facility so long as the aggregate amount of commitments at any time does not exceed $350.0 million. We have the right to prepay loans under the 2015 Facility in whole or in part at any time. In connection with entering into the 2015 Facility, we terminated the commitments under our prior asset-based revolving credit facility. Loans under the 2015 Facility bear interest at a rate equal to, at our option, LIBOR plus 2.25% per annum, or an alternate base rate plus 1.25% per annum. The 2015 Facility contains customary covenants, including ones that require us to satisfy a net worth financial test and maintain certain ratios relating to leverage and consolidated total assets. In addition, the 2015 Facility contains customary negative covenants applicable to us.

As of March 31, 2013, we had no borrowings outstanding under the 2015 Facility.

Asset-Based Borrowing Facilities

On December 7, 2012, our 2015 Natural Resources Facility, maturing on November 5, 2015, was adjusted and reduced to $126.1 million, 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. As of March 31, 2013, we had $46.1 million of borrowings outstanding under the 2015 Natural Resources Facility.

In addition, on February 27, 2013, we entered into a separate credit agreement for a five-year $6.0 million non-recourse, asset-based revolving credit facility, maturing on February 27, 2018 (the “2018 Natural Resources Facility”), that is subject to, among other things, the terms of a borrowing base derived from the value of eligible specified oil and gas assets. We have the right to prepay loans under the 2018 Natural Resources Facility in whole or in part at any time. Loans under the 2018 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 2018 Natural Resources Facility contains customary covenants applicable to us. As of March 31, 2013, we had no borrowings outstanding under the 2018 Natural Resources Facility.

As of March 31, 2013, we believe we were in compliance with the covenant requirements for our credit facilities discussed above.

Convertible Debt

In 2010, we issued $172.5 million of 7.5% Notes, which will mature on January 15, 2017 unless previously redeemed, repurchased or converted in accordance with their terms prior to such date. As of December 31, 2012, holders of the 7.5% Notes had the ability to 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. On January 18, 2013, in accordance with the indenture relating to the 7.5% Notes, we issued a Termination Notice to holders of the 7.5% Notes whereby we terminated the right to convert the 7.5% Notes to common shares. Per the indenture, we were able to terminate the conversion rights of the notes if the closing price of our shares exceeded 150% of the conversion price then in effect for 20 or more trading days in a period of 30 consecutive trading days ending on the trading day prior to the date on which we provide notice of the election to terminate the conversion rights. Holders of $172.5 million 7.5% Notes submitted their notes for conversion for which we satisfied by physical settlement with 26.1 million common shares, or 151.0580 shares per $1,000 principal amount of 7.5% Notes. As set forth in the Termination Notice, the 7.5% Notes were no longer convertible to common shares as of February 17, 2013.

During the first quarter of 2012, we repurchased $23.1 million par amount of our 7.0% Notes. These transactions resulted in us recording a loss of $0.4 million and a $0.2 million write-off of unamortized debt issuance costs. On July 13, 2012, we repaid in full our $112.0 million of outstanding 7.0% Notes, which matured on July 15, 2012.

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Perpetual Preferred Offering

On January 17, 2013, we issued 14.95 million of Series A LLC Preferred Shares for gross proceeds of $373.8 million, and net proceeds of $362.0 million. The Series A LLC Preferred Shares trade on the NYSE under the ticker symbol “KFN.PR” and began trading on January 28, 2013. Distributions on the Series A LLC Preferred Shares are cumulative and are payable, when, as, and if declared by our board of directors, quarterly on January 15, April 15, July 15 and October 15 of each year, beginning April 15, 2013, at a rate per annum equal to 7.375%.

Off-Balance Sheet Commitments

As of March 31, 2013, we had committed to purchase corporate loans with aggregate commitments totaling $219.3 million. In addition, we participate in certain financing arrangements, whereby we are committed to provide funding of up to a specific predetermined amount at the discretion of the borrower or have entered into an agreement to acquire interests in certain assets. As of March 31, 2013, we had unfunded financing commitments totaling $5.6 million for corporate loans.

We participate in joint ventures and partnerships alongside KKR and its affiliates through which we contribute capital for assets, including development projects related to our interests in joint ventures and partnerships that hold commercial real estate and natural resources investments. We estimated these future contributions to range from approximately $245.0 million to $285.0 million as of March 31, 2013, whereby approximately 30% was related to our natural resources segment and 35% was related to each of our credit and other segments.

As of March 31, 2013, we had an investment in a real estate entity, which was financed with non-recourse debt totaling $92.0 million. Under non-recourse debt, the lender generally does not have recourse against any other assets owned by the borrower or any related parties of the borrower, except for certain specified exceptions listed in the respective loan documents including customary “bad boy” acts. In connection with the investment, joint and several non-recourse “bad boy” guarantees were provided for losses relating solely to specified bad faith acts that damage the value of the real estate being used as collateral. As of March 31, 2013, we also had financial guarantees related to our natural resources investments totaling $17.9 million.

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 (which are treated as partnerships, disregarded entities or foreign corporations for United States federal income tax purposes), partnerships generally 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. We generally allocate our taxable income and loss using a monthly convention, which means that we determine our taxable income and losses for the taxable year to be allocated to our shares and then prorate that amount on a monthly basis. If the amount of cash distributed to our Series A LLC Preferred Shares in any year exceeds our gross ordinary income for such year, additional gross ordinary income will be allocated to the Series A LLC Preferred Shares in future years until such excess is eliminated. 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 common 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 tax purposes. A publicly traded partnership will be taxed as a partnership, however, 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.

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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 net 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 and Real Estate

As referenced above, we have made and may make certain investments in natural resources and real estate. It is likely that the income from natural resources 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 with the conduct of a United States trade or business. In addition, if any REIT subsidiary in which we own an interest recognizes gain on the disposition of a United States real property interest, or if we recognize gain on the disposition of a United States real property interest that we hold through a pass-through entity (including gain from the sale of stock in a REIT subsidiary that invests primarily in real estate), such gain will be treated as effectively connected with the conduct of a United States trade or business. Further, our investments in real estate through pass-through entities may generate operating income that is treated as effectively connected 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 federal income 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.

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 its 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. Moreover, if the fair market value of our investments in United States real property interests, which include our investments in natural resources, real estate and REIT subsidiaries that invest primarily in real estate, represent more than 10% of the total fair market value of our assets, our shares could be treated as United States real property interests. In such case, gain recognized by an investor who is a non-United States person on the sale or exchange of its shares would be treated for United States federal income tax purposes as effectively connected income (unless the gain is attributable to a class of our shares that is regularly traded on a securities market and the non-United States person owns 5% or less of the shares of that class). We do not believe that the fair market value of our investments in United States real property interests represents more than 10% of the total fair market value of our assets at this time. No assurance can be provided that our future investments in United States real property interests will not cause us to exceed the 10% threshold described above. If gain from the sale of our shares is treated as effectively connected income, the holder may be subject to United States federal income and/or withholding tax on the sale or exchange.

In addition, all holders of our shares will likely have state tax filing obligations in jurisdictions in which we have made investments in natural resources or real estate (other than through a REIT subsidiary). As a result, holders of our shares will likely be required to file state and local income tax returns and pay state and local income taxes in some or all of these various jurisdictions. Further, holders may be subject to penalties if they fail to comply with those requirements. Our current investments may cause our holders to have state tax filing obligations in the following states: Kansas, Louisiana, Mississippi, North Dakota, Ohio, Oklahoma, Pennsylvania and Texas. We may make investments in other states or non-U.S. jurisdictions in the future.

For holders of our shares that are regulated investment companies, to the extent that our income from our investments in natural resources and real estate exceeds 10% of our gross income, then we will likely be treated as a “qualified publicly traded partnership” for purposes of the income and asset diversification tests that apply to regulated investment companies. Because such qualification will depend on the nature of our future investments, no assurance can be provided that we will or will not be treated as a “qualified publicly traded partnership” in any particular year.

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OUR INVESTMENT COMPANY ACT STATUS

Section 3(a)(1)(A) of 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”).

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 whether any of our subsidiaries is majority-owned. We treat as majority-owned subsidiaries for purposes of the 40% test entities, including those that issue CLOs, in which we own at least 50% of the outstanding voting securities or that are otherwise structured consistent with applicable SEC staff guidance. Some of our majority-owned 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 for purposes of the Investment Company Act, 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, many of our majority-owned 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, the securities of those subsidiaries that we own and hold are not investment securities 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 our real estate subsidiaries, including those that are taxed as REITs for United States federal income tax purposes, generally rely 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 our subsidiaries that rely on Section 3(c)(5)(C) of the Investment Company Act, as our “real estate subsidiaries.” 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 subsidiaries 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 real estate subsidiaries classify 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 real estate subsidiaries consider 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 real estate subsidiaries 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 real estate subsidiaries’ investment in non-agency mortgage-backed securities is the “functional equivalent” of owning the underlying mortgage loans, our real estate subsidiaries 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 real estate subsidiaries as real estate-related assets. Therefore, based upon the specific terms and circumstances related to each non-agency mortgage-backed security that our real estate subsidiaries own, our real estate subsidiaries 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 real estate subsidiaries acquire 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 real estate subsidiaries 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 real estate subsidiaries 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 real estate subsidiaries own more than one subordinate class, then, to determine the classification of subordinate classes other than the first loss class, our real estate subsidiaries will consider whether such classes are contiguous with

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the first loss class (with no other classes absorbing losses after the first loss class and before any other subordinate classes that our real estate subsidiaries own), whether our real estate subsidiaries own the entire amount of each such class and whether our real estate subsidiaries 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 real estate subsidiaries would expect not to classify that particular class, or classes senior to that class, as qualifying real estate assets.

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 any non-majority-owned subsidiaries and 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 effective the date immediately prior to our becoming an investment company. 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, requested public comment on

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the nature and operation of issuers that rely on Rule 3a-7 and indicated 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 may 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.

OTHER REGULATORY ITEMS

In August 2012, the U.S. Commodities Futures Trading Commission (“CFTC”) adopted a series of rules to establish a new regulatory framework for swaps that may cause certain users of swaps to be deemed commodity pools or to register as commodity pool operators. In October 2012, the CFTC delayed the implementation of the relevant rules until December 31, 2012. Although we believe that KKR Financial Holdings LLC is not a commodity pool, we have requested confirmation of this conclusion from the CFTC. To the extent that any of our subsidiaries may be deemed to be a commodity pool, we believe they should satisfy certain exemptions to these rules available to privately offered entities. However, if the CFTC were to take the position that KKR Financial Holdings LLC is a commodity pool, our directors may be required to register as commodity pool operators. Such registration would add to our operating and compliance costs and could affect the manner in which we use swaps as part of our operating and hedging strategies.

IRAN SANCTIONS RELATED DISCLOSURE

Under the Iran Threat Reduction and Syrian Human Rights Act of 2012, which added Section 13(r) of the Exchange Act, we are required to include certain disclosures in our periodic reports if we or any of our “affiliates” knowingly engaged in certain specified activities during the period covered by the report. We are not presently aware that we and our consolidated subsidiaries have knowingly engaged in any transaction or dealing reportable under Section 13(r) of the Exchange Act during the quarter ended March 31, 2013. We note, however, that KKR & Co. L.P., an affiliate of our Manager, has informed us that it has included the disclosure reproduced below (relating to two companies in which its private equity funds have invested) in Exhibit 99.1 to its quarterly report on Form 10-Q as filed with the SEC on May 2, 2013 as required by Section 13(r) of the Exchange Act (the “KKR Disclosure”).

KKR Disclosure:

“A European subsidiary of a portfolio company in which our private equity funds have invested provided certain limited disaster recovery services and hosted co-location of some hardware at the portfolio company’s premises in London for Bank Saderat PLC, a bank incorporated and based in the United Kingdom. The company has informed us that the gross revenue and net profits attributable to these activities was approximately £16,300 and £5,700, respectively, for the fiscal year ended December 31, 2012 and less than £5,000 each for the quarter ended March 31, 2013. We have been advised that the subsidiary terminated this contract in the first quarter of 2013, and the portfolio company does not otherwise intend to enter into any Iran-related activity.”

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 March 31, 2013, $223.8 million par amount, or 3.3%, of our corporate debt portfolio was denominated in foreign currencies, of which 55.2% was denominated in Euros. In addition, as of March 31, 2013, $90.2 million aggregate cost, or 25.8%, of other assets, which includes our equity investments at estimated fair value and interests in joint ventures and partnerships, was denominated in foreign currencies, of which 13.7% was denominated in Euros and 34.3% was denominated in Canadian dollars.

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. As of March 31, 2013, the net contractual notional balance of our foreign exchange options and forward contracts totaled $129.1 million, all of which related to certain of our foreign currency denominated corporate debt holdings. Refer to “Derivative Risk” below for further discussion on our derivatives.

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.

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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, could have a material adverse impact on our 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 and liabilities. We generally fund our variable rate investments with variable rate borrowings with similar interest rate reset frequencies. Based on our variable rate investments and related variable rate borrowings as of March 31, 2013, we estimated that increases in interest rates would impact net income by approximately (amounts in thousands):

Change in interest rates	Annual Impact
Increase of 1.0%	$	(20,155	)
Increase of 2.0%	$	(5,156	)
Increase of 3.0%	$	10,107
Increase of 4.0%	$	25,371
Increase of 5.0%	$	40,635

As of March 31, 2013, approximately 56.5% of our corporate debt portfolio had LIBOR floors with a weighted average floor of 1.3%. Given these LIBOR floors, increases in short-term interest rates above a certain point between 2% and 3% will result in a greater impact as yields on interest-earning assets are expected to rise faster than the cost of funding sources. The simulation above assumes that the asset and liability structure of the consolidated balance sheet would not be changed as a result of the simulated changes in interest rates.

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 interest rate swaps was $497.8 million as of March 31, 2013. Of the $497.8 million, $372.8 million was related to two pay-fixed, receive-variable interest rate swaps through certain of our CLOs. These interest rate derivatives consisted of swaps to hedge a portion of the interest rate risk associated with our borrowings under the CLO senior secured notes. The remaining $125.0 million of interest rate swaps were used to hedge a portion of the interest rate risk associated with our floating rate junior subordinated notes. The objective of the interest rate swaps is to eliminate the variability of cash flows in the interest payments of these notes due to fluctuations in the indexed rate. Refer to “Derivative Risk” below for further discussion on our derivatives.

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 currently no regulatory requirement concerning the amount of collateral that a counterparty must post to secure its obligations under certain derivative instruments. Currently, 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

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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 aggregate notional amount and estimated net fair value of our derivative instruments held as of March 31, 2013 (amounts in thousands):

	As of March 31, 2013
	Notional			Estimated Fair Value
Cash Flow Hedges:
Interest rate swaps	$	497,833		$	(79,445	)
Free-Standing Derivatives:
Commodity swaps	—			946
Credit default swaps—protection sold	—			—
Credit default swaps—protection purchased	(118,247		)	(802		)
Foreign exchange forward contracts	(259,266		)	(8,001		)
Foreign exchange options	130,207			5,350
Common stock warrants	—			3,470
Total				$	(78,482	)

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 estimated net fair values of our primary derivative investments by remaining contractual maturity as of March 31, 2013 (amounts in thousands):

	Less than 1 year			1 - 3 years			3 - 5 years			More than 5 years			Total
Cash Flow Hedges:
Interest rate swaps	$	(2,905	)	$	—		$	—		$	(76,540	)	$	(79,445	)
Free-Standing Derivatives:
Commodity swaps	(1,290		)	2,075			161			—			946
Credit default swaps—protection sold	—			—			—			—			—
Credit default swaps—protection purchased	(99		)	—			(101		)	(602		)	(802		)
Foreign exchange forward contracts	4,720			(12,803		)	82			—			(8,001		)
Foreign exchange options	295			5,055			—			—			5,350
Total	$	721		$	(5,673	)	$	142		$	(77,142	)	$	(81,952	)

Commodity Price Risk

Certain of our natural resources holdings, including our working interests in producing oil and natural gas fields are subject to fluctuations in the prices of oil, natural gas and NGL, which may cause our revenues and cash flows to be volatile. As of March 31, 2013, natural gas comprised approximately 63.0% of our total working interest reserves, while NGL and oil comprised approximately 27.0% and 10.0%, respectively. In order to help mitigate the potential exposure and effects of changing commodity prices on our revenues and cash flows from operations, we have entered into, and expect to continue to use, commodity swaps for our working interests. Our policy has been to hedge a majority of the total estimated oil, natural gas and NGL production on our working interests for a specified amount of time. We currently use receive-fixed, pay-floating commodity derivative contracts, specifically oil, natural gas and certain NGL product swaps, for certain years through 2016. Our unhedged production may expose us to commodity price declines or alternatively, provide the potential upside from commodity price increases. Our price hedging strategy and future hedging transactions, including the prices at which we hedge our production, are dependent upon several factors, including expected production and commodities prices at the time we enter into these transactions.

We do not designate any of our commodity derivatives as cash flow hedges for accounting purposes. As such, the changes in fair value of these instruments are recorded in current period earnings. For the three months ended March 31, 2013, we had $1.1 million of commodity derivatives settlements, which are settled monthly. The estimated fair value of our commodity swaps as of March 31, 2013 totaled $0.9 million. As a significant portion of our commodity derivatives hedge the majority of our estimated natural gas production through 2015, a 40% decrease in the future prices of natural gas as compared to the future prices at March 31, 2013 would result in an estimated unhedged production value decrease of approximately $3.4 million or less for any year through 2015.

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PART II. OTHER INFORMATION

ITEM 1. LEGAL PRECEEDINGS

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, 2012, filed with the SEC on February 28, 2013, which is accessible on the Securities and Exchange Commission’s website at www.sec.gov.

ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS

On January 15, 2013, our non-employee directors deferred $0.1 million of cash compensation in exchange for 4,392 phantom shares pursuant to the KKR Financial Holdings LLC Non-Employee Directors’ Deferred Compensation and Share Award Plan. On February 28, 2013 and March 28, 2013, our non-employee directors deferred both $0.1 million of cash distribution in exchange for 9,973 and 2,424 phantom shares, respectively, 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 our election, 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 us. 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 February 14, 2013, the Compensation Committee of the board of directors granted the Manager 292,009 restricted common shares subject to graded vesting over three years with the final vesting date of March 1, 2016. The grant made to our Manager was exempt from the registration requirements of the Securities Act pursuant to Section 4(2) thereof.

Repurchases of Equity Securities

In March 2013, in privately negotiated transactions, we repurchased common shares previously awarded to certain of our officers by our Manager. During the quarter ended March 31, 2013, we did not have any publicly announced plans or programs to repurchase shares.

The following table sets forth information with respect to repurchases of our shares made during the quarter ended March 31, 2013:

	Total Number of Shares Repurchased	Average Price Paid per Share		Total Number of Shares Repurchased Under Publicly Announced Plans or Programs	Approximate Dollar Value of Shares that May Yet Be Repurchased Under the Plans or Programs

January 1, 2013 through January 31, 2013	—	$	—	—	$	—
February 1, 2013 through February 28, 2013	—	—		—	—
March 1, 2013 through March 31, 2013	25,204	11.09		—	—
Total	25,204			—	$	—

For a further description of our share repurchases see “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Shareholders’ Equity” in Item 2 of this Quarterly Report on Form 10-Q.

ITEM 3. DEFAULTS UPON SENIOR SECURITIES

None.

ITEM 4. MINE SAFETY DISCLOSURES

None.

ITEM 5. OTHER INFORMATION

None.

Delaware (State or other jurisdiction of incorporation or organization)		11-3801844 (I.R.S. Employer Identification No.)

555 California Street, 50th Floor San Francisco, CA (Address of principal executive offices)		94104 (Zip Code)

Large accelerated filer x		Accelerated filer o

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

		Page
Part I. FINANCIAL INFORMATION
Item 1.	Financial Statements	3
Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	44
Item 3.	Quantitative and Qualitative Disclosures about Market Risk	83
Item 4.	Controls and Procedures	83
Part II. OTHER INFORMATION
Item 1.	Legal Proceedings	84
Item 1A.	Risk Factors	84
Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds	84
Item 3.	Defaults Upon Senior Securities	84
Item 4.	Mine Safety Disclosure	84
Item 5.	Other Information	84
Item 6.	Exhibits	85

	2013		2012
Proved property	$	—	$	164,557
Unproved property	—		2,658
Other assets	—		16,789
Risk management liabilities	—		(1,037		)
Accounts payable and accrued liabilities	—		(9,030		)
Asset retirement obligation	—		(5,491		)
Total	$	—	$	168,446

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.

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: May 8, 2013