UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM N-CSR

CERTIFIED SHAREHOLDER REPORT OF REGISTERED
MANAGEMENT INVESTMENT COMPANIES

Investment Company Act file number 811-21750

Kayne Anderson Energy Total Return Fund, Inc.

(Exact name of registrant as specified in charter)

1800 Avenue of the Stars, Second Floor, Los Angeles, California		90067
(Address of principal executive offices)		(Zip code)

David Shladovsky, Esq.
KA Fund Advisors, LLC, 1800 Avenue of the Stars, Second Floor, Los Angeles, California 90067

(Name and address of agent for service)

Registrant’s telephone number, including area code: (310) 556-2721

Date of fiscal year end: November 30, 2008

Date of reporting period: November 30, 2008

     Form N-CSR is to be used by management investment companies to file reports with the Commission not later than 10 days after the transmission to stockholders of any report that is required to be transmitted to stockholders under Rule 30e-1 under the Investment Company Act of 1940 (17 CFR 270.30e-1). The Commission may use the information provided on Form N-CSR in its regulatory, disclosure review, inspection, and policymaking roles.

     A registrant is required to disclose the information specified by Form N-CSR, and the Commission will make this information public. A registrant is not required to respond to the collection of information contained in Form N-CSR unless the Form displays a currently valid Office of Management and Budget (“OMB”) control number. Please direct comments concerning the accuracy of the information collection burden estimate and any suggestions for reducing the burden to Secretary, Securities and Exchange Commission, 450 Fifth Street, NW, Washington, DC 20549-0609. The OMB has reviewed this collection of information under the clearance requirements of 44 U.S.C. § 3507.

 

 

Item 1. Reports to Stockholders.

     The report of Kayne Anderson Energy Total Return Fund, Inc. (the “Registrant”) to stockholders for the year ended November 30, 2008 is attached below.

CONTENTS

 

 

 

CAUTIONARY NOTE REGARDING FORWARD-LOOKING STATEMENTS: This report contains “forward-looking statements” as defined under the U.S. federal securities laws. Generally, the words “believe,” “expect,” “intend,” “estimate,” “anticipate,” “project,” “will” and similar expressions identify forward-looking statements, which generally are not historical in nature. Forward-looking statements are subject to certain risks and uncertainties that could cause actual results to materially differ from the Fund’s historical experience and its present expectations or projections indicated in any forward-looking statement. These risks include, but are not limited to, changes in economic and political conditions; regulatory and legal changes; energy industry risk; commodity pricing risk; leverage risk; valuation risk; non-diversification risk; interest rate risk; tax risk; and other risks discussed in the Fund’s filings with the SEC. You should not place undue reliance on forward-looking statements, which speak only as of the date they are made. The Fund undertakes no obligation to update or revise any forward- looking statements made herein. There is no assurance that the Fund’s investment objectives will be attained.

January 27, 2009

 

Dear Fellow Stockholders:

 

Fiscal year 2008 was a terrible year by almost any measure, with the collapse of the credit markets, the disappearance of many of Wall Street’s most prominent firms and the onset of a worldwide recession. Calendar year 2008 was the worst year for the Dow Jones Industrial Average since 1931 and the worst year for the S&P 500 Index since 1937. We’ve seen substantial declines in the MLP market and across all of the energy sub-sectors in which we invest.

 

For many of the sectors in which we invest, fiscal 2008 was a rollercoaster ride, with the first half of the year marked by all-time highs and the second half by multi-year lows. For the fiscal year, the Alerian MLP Index declined 38.7%, the Canadian Royalty Trust Index declined 24.1%, the Marine Transportation Index was down 68.5%, and the Coal Index was down 53.7%. However, these disappointing annual returns mask a strong first half of the year, during which the Canadian Royalty Trust Index was up 29.4%, and the Coal Index was up 63.4%. However, with the decline in commodity prices starting in July and the turbulence in the capital markets starting in September, these indices experienced sharp and violent declines.

 

During our fiscal fourth quarter, the Alerian MLP Index declined 33.0%, which is approximately two times greater than the Alerian MLP Index’s greatest annual decline. During this same period, the Canadian Royalty Trust sector were down 41.6%, the Marine Transportation sector was down 63.2%, and the Coal sector was down 67.2%.

 

In addition to the weak absolute performance, there was record volatility in every sector. From 1996 to the end of our fiscal third quarter in 2008, there were only two days when the Alerian MLP Index changed by more than 6%. During the fiscal fourth quarter, there have been nine days with changes exceeding 6%. Similarly, the Canadian Royalty Trust sector, the Marine Transportation sector and the Coal sector were each approximately four times more volatile during our fiscal fourth quarter than over the last five years.

 

The reasons for the poor performance across the Fund’s sub-sectors are numerous and interrelated. The collapse of the credit markets was a critical factor leading to the worldwide recession, which in turn was a critical factor in the collapse of commodity prices. The sharp and substantial decline in energy prices meaningfully impacted each of the sub-sectors in which we invest. Prior to 2008, oil prices had never been above $100 per barrel. From their peak in July 2008 through the end of the calendar year, oil prices declined by more than $100/barrel or 69%. Likewise, natural gas prices declined by 58%; NGL (natural gas liquids) prices declined by 73%; and coal prices declined by approximately 58%.

 

Our largest sector, the MLP segment, was impacted by commodity prices, technical factors and the Lehman Brothers bankruptcy. While much of the MLP revenue stream is fee-based and not dependent on commodity prices, some MLPs are exposed directly and indirectly to commodity prices. While these MLPs had hedged a significant portion of their direct exposure, the magnitude of the decline in commodity prices had a material impact on their operating performance and consequently their stock price performance.

 

Clearly, the weak performance of the broader capital markets had a significant impact on buyers of MLP securities, both retail and institutional. Since 2005, a significant amount of the new capital invested in MLPs came from hedge funds, both dedicated hedge funds and multi-strategy funds. The well-publicized troubles in the hedge fund industry and the reduced sources of leverage for hedge funds caused these institutions to sell a significant portion of their MLP holdings. To a lesser extent, closed-end funds with MLP exposure (including KYE), were required to sell MLPs to maintain their leverage ratios. Finally, as overall markets declined, retail investors were reducing portfolio leverage, reducing exposure to equity securities and moving to cash. Quite simply, there was an abundance of sellers and there were very few buyers.

 

The Lehman Brothers bankruptcy also had a distinct, negative impact on the MLP market. Lehman Brothers was one of the leading underwriters of MLPs over the past several years, and its retail system was a large holder of MLPs. Lehman Brothers was also a large owner of MLPs for its own account and managed a dedicated MLP hedge

 

KAYNE ANDERSON ENERGY TOTAL RETURN FUND, INC.
LETTER TO STOCKHOLDERS — (CONTINUED)

 

fund that was forced to liquidate a significant portion of its holdings. We believe that a substantial amount of the selling pressure on MLPs during September and October was the result of the Lehman Brothers bankruptcy filing.

 

As a result of the severe declines in MLP prices, MLP yields set all-time highs during our fiscal fourth quarter. The average yield (weighted by market capitalization) at November 30, 2008 was 11.7% compared to 6.4% at the end of fiscal 2007. Likewise, the spread between MLP yields and the 10-year U.S. Treasury bond yield rose to 874 basis points, compared to an average of 238 basis points over the last five years.

 

The Canadian Royalty Trust sector was influenced the most by energy price movements during the year as their cash flows and dividends are directly tied to oil and natural gas prices. These trusts performed very well through the first half of the year, as commodity prices reached their peak in early July. As commodity prices fell, the Kayne Anderson Royalty Trust Index began to weaken, ultimately declining 24.1% for fiscal year 2008 and down 46.1% since its peak in June.

 

Canadian Royalty Trusts typically hedge less than half of their production and are thus significantly exposed to commodity price volatility. Although hedges that were put in place during peak pricing helped soften the price decline for some of the trusts, the precipitous drop in commodity prices has led to dividend cuts from 15 out of 21 trusts since September 2008. Since the commodity price peak in early July, Canadian Royalty Trusts have cut dividends by an average of 29%. We believe that existing dividend levels are more sustainable in the current commodity price environment and expect to see a reduced number of cuts for the remainder of calendar 2009.

 

The Marine Transportation sector was impacted directly by the worldwide economic slowdown. After performing well during the first half of the year, the liquid and dry bulk markets were hurt by lower shipments of crude oil, petroleum products, coal and iron ore. The Baltic Dry Index (a measure of dry bulk rates) fell over 89% as the global economic crisis curtailed trade and industrial production worldwide. As a result, the Kayne Anderson Marine Transportation index declined by 68.5% during the fiscal year. Even though we focus on companies with a strong book of charter business, we have seen twelve companies either reduce or suspend their dividends in this sector since September 2008. Despite expectations for a modest rebound in charter rates during 2009, continued dividend cuts are anticipated for certain of the marine transportation companies due to high leverage levels, large capital expenditure programs and uncertainty over the global economy.

 

The Coal sector, which also is impacted directly by commodity prices, also began the year strong, as coal prices climbed to record levels by July 2008. However, with declining prices and the slowing worldwide economy, the Kayne Anderson Coal Index declined 76.8% from its peak at the end of June and ended the fiscal year down 53.7%. From their July peak, Central Appalachia steam coal prices fell $83.50/ton, or 58.3%. As a result, current steam coal prices have dropped below the marginal production cost for some Central Appalachian mines. The metallurgical coal market was significantly impacted by the decline in steel production resulting from the global economic slowdown. As a result, metallurgical coal prices declined from over $300 per ton in July to less than $125 per ton in December. Another key issue for the Coal sector is the regulatory environment, which has made it increasingly difficult for companies to obtain necessary mining permits in Central Appalachia. Notwithstanding these challenges, coal accounts for approximately 50% of U.S. electricity generation and is critical to meeting domestic power needs.

 

Fiscal 2008 was also a very challenging year from a liability management perspective. As many of you know, in mid-February the auction rate market ceased functioning as normal. As a result, our Auction Rate Preferred Shares (ARPs), like most other auction rate securities, failed to generate sufficient investor interest at the maximum allowable rates. While this is commonly referred to as “failing,” our ARPs continued to pay dividends/distributions at the contracted rate and we maintained our AAA rating while the ARPs were outstanding.

 

We embarked on a very extensive effort to find a long-term solution to the problems in the auction rate market that would balance the interests of both our common and preferred stockholders. In May 2008, we entered into a new committed $200 million unsecured revolving credit facility, and in August 2008, we completed a private

 

KAYNE ANDERSON ENERGY TOTAL RETURN FUND, INC.
LETTER TO STOCKHOLDERS — (CONTINUED)

 

placement of $225 million of unsecured senior notes with several large insurance companies. The proceeds of these two financings, plus borrowings under our credit facility, were used to redeem the entire $300 million of ARPs.

 

Due to the significant decline in the market value of the sub-sectors in which we invest, we faced ongoing challenges during the fiscal fourth quarter to comply with asset coverage tests set forth in our debt covenants and the Investment Company Act of 1940. As a result, during the second half of the year, we delevered our balance sheet as needed to remain in compliance with these tests. From September 2008 through December 2008, we repaid $66 million of bank debt and redeemed $60 million of unsecured senior notes. This was certainly a difficult period, but we were pleased to have successfully demonstrated our ability to preserve the dividend/distribution to common stockholders and our commitment to remain in compliance with all debt covenants.

 

2008 Performance

 

Fiscal 2008 was a very difficult year in terms of performance of the Fund’s portfolio. One of the measures we employ to evaluate our performance is Net Asset Value Return, which is equal to the change in net asset value per share plus the dividends/distributions paid during the period being measured, assuming reinvestment in our dividend reinvestment program. During fiscal 2008, our Net Asset Value Return was negative 46.6%. During this period, our Net Asset Value per share decreased from $29.01 to $13.43, and we paid cash dividends/distributions of $2.055 per share. Our stock price performed commensurate with our underlying investments, dropping approximately 59.2% during the year.

 

Throughout the turmoil the second half of fiscal 2008, we actively managed our portfolio across the various sub-sectors. We increased our exposure to MLPs to take advantage of their relatively stable distributions; increased exposure to energy related debt securities due to their attractive risk-adjusted returns; decreased exposure to Canadian Royalty Trusts to reduce our exposure to commodity prices; decreased investment levels in the Marine Transportation sector slightly due to weak overall performance of the sector and rotated out of dry bulk companies and into tanker companies. We also significantly reduced exposure to the Coal sector as coal prices fell.

 

2009 Outlook

 

As we look forward into 2009, we are focused on several key issues. One important issue is the availability of capital. As with many industries, capital availability for the MLP and broader energy sectors has diminished substantially over the last six months for both investment grade and non-investment grade companies. While a large capital expenditure program was once viewed as an asset that commanded a premium valuation because of the growth it would create, such programs are now often viewed as a liability. Several MLPs and Marine Transportation companies have capital programs that must be funded with external capital, and we are watching these companies closely to see if they can either (i) find outside capital and/or joint venture partners or (ii) successfully renegotiate their capital commitments and/or debt covenants. While we were encouraged by the recent investment grade debt offerings in the MLP sector, significant congestion in the capital markets must be cleared up before equity prices in our energy sub-sectors trade closer to historical valuation levels.

 

We are also monitoring very closely the commodity price environment and the impact — both direct and indirect — that commodity prices are having on the financial results of the Canadian Royalty Trusts sector, the Coal sector and the MLP sector. While we do not expect the recent decline in consumption of gasoline and other refined products to have a material impact on the MLP sector, a sustained period of curtailed drilling activity will reduce volumes gathered, processed and transported. Furthermore, lower commodity prices will have a negative impact on the unhedged portion of the revenue streams of certain natural gas gathering and processing companies.

 

We believe that the current capital markets and commodity price markets will cause cash distribution growth for MLPs to slow substantially in the first half of 2009. We believe that most MLP will be cautious in raising their distributions at a time when cash is king and liquidity is critical. While there may be isolated distribution cuts in the midstream sector, we believe such cuts will be limited unless the commodity price dislocation continues well beyond what we and other market participants anticipate.

 

KAYNE ANDERSON ENERGY TOTAL RETURN FUND, INC.
LETTER TO STOCKHOLDERS — (CONCLUDED)

 

Since the end of the quarter, many of the Canadian Royalty Trusts and certain of the Marine Transportation companies have reduced their dividends in response lower commodity prices and lower charter rates. While we believe there may be selective additional distributions cuts in the Canadian Royalty Trust sector, we believe such additional cuts will be more limited. In the Marine Transportation sector, we expect to see additional cuts from companies with high debt levels or without strong long-term charters. In general, we have focused on investing in the companies in this sector with high-quality long-term contracts and stable dividends.

 

The most frequent question that I receive is: “When will the market come back?” The recovery of each of our underlying sectors is largely dependent on the recovery of the financial sector, the global economy and the commodity markets. A full recovery to prior valuation levels could take some period of time. However, we can not forget that demand for energy products and services, both domestically and internationally, will continue to grow over the next several decades. As global economies begin to recover, resurging demand for energy sources will strengthen commodity prices and support oil, natural gas and coal production by the Canadian Royalty Trusts and Coal companies. Commodities will continue to be produced in areas that are exceedingly farther away from end users and existing infrastructure assets. Midstream MLPs and Marine Transportation companies — which provide the critical link between producers and consumers — will see demand for their services increase over time. As a result, we continue to be optimistic about the long-term prospects of both the energy infrastructure sector and the companies in our portfolio.

 

We look forward to continuing to execute on our business plan of achieving high after-tax total returns by investing in a diversified portfolio across MLPs, Canadian Royalty Trusts, Marine Transportation and Other Energy Companies. We invite you to visit our website at www.kaynefunds.com for the latest updates.

 

Sincerely,

 

 

Kevin S. McCarthy

Chairman of the Board of Directors,

President and Chief Executive Officer

 

 

Portfolio Investments by Category*

 

 

* As a percentage of total investments

 

Top Ten Holdings by Issuer

 

 

This discussion contains forward looking statements and good faith estimates. The reader is referred to the disclosure on such matters at the beginning of this annual report.

 

Overview

 

Kayne Anderson Energy Total Return Fund, Inc. (the “Fund”) is a non-diversified, closed-end fund with an investment objective to obtain a high total return with an emphasis on current income by investing primarily in securities of companies engaged in the energy industry. The Fund’s investments include master limited partnerships and limited liability companies taxed as partnerships (“MLPs”), MLP affiliates, U.S. and Canadian royalty trusts and income trusts (collectively, “royalty trusts”), marine transportation companies, and other companies that derive at least 50% of their revenues from operating assets used in, or providing energy-related services for, the exploration, development, production, gathering, transporting, processing, storing, refining, distributing, mining or marketing of natural gas, natural gas liquids (including propane), crude oil, refined petroleum products or coal. It is the Fund’s intention to be treated as and to qualify each year for special tax treatment afforded a Regulated Investment Company under Subchapter M of the Internal Revenue Code. As long as the Fund meets certain requirements that govern its source of income, diversification of assets and timely distribution of earnings to stockholders, the Fund will not be subject to U.S. federal income tax.

 

At November 30, 2008, the Fund’s long-term investments were $554 million, compared to $1.3 billion at November 30, 2007. At November 30, 2008, equity and fixed income investments were 84% and 16%, respectively, of the Fund’s long-term investments.

 

At November 30, 2008, the Fund’s long-term investments were as follows:

 

 

MLP equity securities, which are generally treated as partnerships for federal income tax purposes, comprised 28.5% of the Fund’s long-term investments as of November 30, 2008. As a limited partner in the MLPs, the Fund is allocated its pro rata share of the MLP’s taxable income. During the fiscal year ended November 30, 2008, the Fund estimated that 90% of the MLP distributions received would be treated as a return of capital for tax purposes. During fiscal 2008, certain of the Fund’s royalty trusts and marine transportation companies had dividends or distributions that were estimated to be a return of capital for tax purposes. For financial reporting purposes, the Fund reflects its dividends and distributions net of the return of capital portion. As a result, only 10% of the cash distributions from MLPs received during the fiscal period and only a portion of the dividends and distributions received from certain non-MLP equity investments are included in investment income. The portion of the dividends and distributions that we received that are treated as a return of capital are reflected as a reduction in the cost basis of the Fund’s portfolio securities, which has the effect of increasing realized and unrealized gains by that same amount.

 

KAYNE ANDERSON ENERGY TOTAL RETURN FUND, INC.
MANAGEMENT DISCUSSION — (CONCLUDED)
FOR THE FISCAL YEAR ENDED NOVEMBER 30, 2008

 

Financial Review

 

During the fiscal year ended November 30, 2008, the Fund had a net decrease in net assets resulting from operations of $426.0 million before dividends/distributions to preferred stockholders of $10.8 million. The components of this decrease are (i) net investment income of $28.6 million, (ii) net realized losses of $38.8 million, and (iii) net change in unrealized losses of $415.8 million.

 

The Fund earned net investment income of $28.6 million during fiscal 2008. This consisted of net dividends and distributions of $37.5 million (net of $3.5 million of foreign taxes and the deduction of $28.9 million of cash dividends and distributions received by the Fund that were treated as a return of capital). Interest income on repurchase agreements and fixed income investments was $15.0 million. Expenses were $23.9 million, including $15.0 million of investment management fees and $6.6 million of interest and auction agent expenses.

 

Net realized losses during fiscal 2008 were $38.8 million, consisting of realized losses on investments of $34.1 million, gains on options of $6.6 million, losses of $10.7 million from payments pursuant to interest rate swap contracts and losses of $0.6 million on foreign currency transactions.

 

Net change in unrealized losses during fiscal 2008 was $415.8 million, consisting of unrealized losses on investments of $422.1 million, offset by gains on options of $1.0 million and an increase in the mark-to-market value of the interest rate swap contracts of $5.3 million.

 

As of November 30, 2008, the Fund had no outstanding borrowings under its credit facility and was not party to any interest rate swap contacts.

 

Dividends and Distributions

 

The Fund paid quarterly dividends/distributions totaling $66.2 million or $2.055 per share to its common stockholders during fiscal 2008. Payment of future distributions is subject to board approval, as well as meeting the covenants of the Fund’s senior debt and the asset coverage requirements of the Investment Company Act of 1940, as amended (the “1940 Act”).

 

Recent Events

 

On December 5, 2008, the Fund completed the repurchase of $60 million aggregate principal amount of its Senior Notes Series A, B and C (the “Senior Unsecured Notes”) at 103% of par value. The Fund utilized repurchase agreements and cash on hand to repurchase the Senior Unsecured Notes to comply with the asset coverage ratios as required by the Investment Company Act of 1940, as amended (the “1940 Act”).

 

On January 9, 2009, the Fund paid a cash dividend/distribution to its common stockholders in the amount of $0.52 per share, for a total of $17.0 million. Of this total, $5.3 million was reinvested into the Fund pursuant to the Fund’s dividend reinvestment plan. In connection with that reinvestment, 379,119 shares of common stock were issued.

 

On January 19, 2009, the Fund reduced the credit commitment under its unsecured revolving credit facility with J.P. Morgan Chase Bank, N.A. from $200 million to $125 million.

 

 

See accompanying notes to financial statements.

 

KAYNE ANDERSON ENERGY TOTAL RETURN FUND, INC.
SCHEDULE OF INVESTMENTS — (CONTINUED)
NOVEMBER 30, 2008
(amounts in 000’s)

 

 

 

See accompanying notes to financial statements.

 

KAYNE ANDERSON ENERGY TOTAL RETURN FUND, INC.
SCHEDULE OF INVESTMENTS — (CONTINUED)
NOVEMBER 30, 2008
(amounts in 000’s)

 

 

 

See accompanying notes to financial statements.

KAYNE ANDERSON ENERGY TOTAL RETURN FUND, INC.
SCHEDULE OF INVESTMENTS — (CONCLUDED)
NOVEMBER 30, 2008
(amounts in 000’s)

 

 

 

 

 

See accompanying notes to financial statements.

KAYNE ANDERSON ENERGY TOTAL RETURN FUND, INC.
STATEMENT OF ASSETS AND LIABILITIES
NOVEMBER 30, 2008
(amounts in 000’s, except share and per share amounts)

 

 

See accompanying notes to financial statements.

KAYNE ANDERSON ENERGY TOTAL RETURN FUND, INC.

STATEMENT OF OPERATIONS

FOR THE FISCAL YEAR ENDED NOVEMBER 30, 2008

(amounts in 000’s)

 

 

See accompanying notes to financial statements.

KAYNE ANDERSON ENERGY TOTAL RETURN FUND, INC.

STATEMENT OF CHANGES IN NET ASSETS APPLICABLE TO COMMON STOCKHOLDERS

(amounts in 000’s, except share amounts)

 

 

 

 

See accompanying notes to financial statements.

KAYNE ANDERSON ENERGY TOTAL RETURN FUND, INC.

STATEMENT OF CASH FLOWS

FOR THE FISCAL YEAR ENDED NOVEMBER 30, 2008

(amounts in 000’s)

 

 

 

Supplemental disclosure of cash flow information:

 

Non-cash financing activities not included herein consist of reinvestment of distributions of $5,574 pursuant to the Fund’s dividend reinvestment plan.

 

During the fiscal year ended November 30, 2008, state taxes paid were $116 and interest paid was $2,359.

 

See accompanying notes to financial statements.

KAYNE ANDERSON ENERGY TOTAL RETURN FUND, INC.
FINANCIAL HIGHLIGHTS

(amounts in 000’s, except share and per share amounts)

 

 

 

 

See accompanying notes to financial statements.

 

KAYNE ANDERSON ENERGY TOTAL RETURN FUND, INC.
FINANCIAL HIGHLIGHTS — (CONCLUDED)
(amounts in 000’s, except share and per share amounts)

 

 

 

 

 

 

 

See accompanying notes to financial statements.

KAYNE ANDERSON ENERGY TOTAL RETURN FUND, INC.
NOTES TO FINANCIAL STATEMENTS

NOVEMBER 30, 2008

(amounts in 000’s, except option contracts, share and per share amounts)

 

 

Kayne Anderson Energy Total Return Fund, Inc. (the “Fund”) was organized as a Maryland corporation on March 31, 2005 and commenced operations on June 28, 2005. The Fund is registered under the Investment Company Act of 1940, as amended (the “1940 Act”), as a non-diversified closed-end investment company. The Fund’s investment objective is to obtain a high total return with an emphasis on current income. The Fund seeks to achieve this objective by investing primarily in securities of companies engaged in the energy industry, principally including publicly-traded, energy-related master limited partnerships and limited liability companies taxed as partnerships (“MLPs”), MLP affiliates, energy-related U.S. and Canadian royalty trusts and income trusts (collectively, “royalty trusts”) and other companies that derive at least 50% of their revenues from operating assets used in, or providing energy-related services for, the exploration, development, production, gathering, transporting, processing, storing, refining, distributing, mining or marketing of natural gas, natural gas liquids (including propane), crude oil, refined petroleum products or coal (collectively with MLPs, MLP affiliates and royalty trusts, “Energy Companies”). The Fund’s shares of common stock are listed on the New York Stock Exchange, Inc. (“NYSE”) under the symbol “KYE.”

 

 

A. Use of Estimates — The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America (“GAAP”) requires management to make estimates and assumptions that affect the reported amount of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the period. Actual results could differ materially from those estimates.

 

B. Calculation of Net Asset Value — The Fund determines its net asset value as of the close of regular session trading on the NYSE (normally 4:00 p.m. Eastern time) no less frequently than the last business day of each month, and makes its net asset value available for publication monthly. Currently, the Fund calculates its net asset value on a weekly basis and such calculation is made available on its website, www.kaynefunds.com. Net asset value is computed by dividing the value of the Fund’s assets (including accrued interest and dividends), less all of its liabilities (including accrued expenses, dividends payable and any borrowings) by the total number of common shares outstanding.

 

C. Investment Valuation — Readily marketable portfolio securities listed on any exchange other than the NASDAQ Stock Market, Inc. (“NASDAQ”) are valued, except as indicated below, at the last sale price on the business day as of which such value is being determined. If there has been no sale on such day, the securities are valued at the mean of the most recent bid and asked prices on such day. Securities admitted to trade on the NASDAQ are valued at the NASDAQ official closing price. Portfolio securities traded on more than one securities exchange are valued at the last sale price on the business day as of which such value is being determined at the close of the exchange representing the principal market for such securities.

 

Equity securities traded in the over-the-counter market, but excluding securities admitted to trading on the NASDAQ, are valued at the closing bid prices. Fixed income securities that are considered corporate bonds are valued by using the mean of the bid and ask prices provided by an independent pricing service. For fixed income securities that are considered corporate bank loans, the fair market value is determined by the mean of the bid and ask prices provided by the syndicate bank or principal market maker. When price quotes are not available, fair market value will be based on prices of comparable securities. In certain cases, the Fund may not be able to purchase or sell fixed income securities at the quoted prices due to the lack of liquidity for these securities.

 

The Fund holds securities that are privately issued or otherwise restricted as to resale. For these securities, as well as any other portfolio security held by the Fund for which reliable market quotations are not readily available,

 

KAYNE ANDERSON ENERGY TOTAL RETURN FUND, INC.
NOTES TO FINANCIAL STATEMENTS — (CONTINUED)

(amounts in 000’s, except option contracts, share and per share amounts)

 

valuations are determined in a manner that most fairly reflects fair value of the security on the valuation date. Unless otherwise determined by the Board of Directors, the following valuation process is used for such securities:

 

 

Unless otherwise determined by the Board of Directors, securities that are convertible into or otherwise will become publicly traded (e.g., through subsequent registration or expiration of a restriction on trading) are valued through the process described above, using a valuation based on the market value of the publicly traded security less a discount. The discount is initially equal in amount to the discount negotiated at the time the purchase price is agreed to. To the extent that such securities are convertible or otherwise become publicly traded within a time frame that may be reasonably determined, KAFA may determine an applicable discount in accordance with a method- ology approved by the Valuation Committee.

 

Exchange-traded options and futures contracts are valued at the last sales price at the close of trading in the market where such contracts are principally traded or, if there was no sale on the applicable exchange on such day, at the mean between the quoted bid and ask price as of the close of such exchange.

 

At November 30, 2008, the Fund held 0.3% of its net assets applicable to common stockholders (0.2% of total assets) in securities valued at fair value as determined pursuant to procedures adopted by the Board of Directors, with an aggregate fair value of $1,125. (See Note 6 — Restricted Securities).

 

On March 19, 2008, the FASB released SFAS No. 161, “Disclosures about Derivative Instruments and Hedging Activities.” SFAS No. 161 requires qualitative disclosures about objectives and strategies for using derivatives, quantitative disclosures about fair value amounts of and gains and losses on derivative instruments, and disclosures about credit-risk-related contingent features in derivative agreements. The application of SFAS No. 161 is required for fiscal years beginning after November 15, 2008 and interim periods within those fiscal years. At this time, management is evaluating the implications of SFAS No. 161 and its impact on the financial statements has not yet been determined.

 

D. Repurchase Agreements — The Fund has agreed to purchase securities from financial institutions subject to the seller’s agreement to repurchase them at an agreed-upon time and price (“repurchase agreements”). The financial institutions with which the Fund enters into repurchase agreements are banks and broker/dealers which

 

KAYNE ANDERSON ENERGY TOTAL RETURN FUND, INC.
NOTES TO FINANCIAL STATEMENTS — (CONTINUED)

(amounts in 000’s, except option contracts, share and per share amounts)

 

KAFA considers creditworthy. The seller under a repurchase agreement is required to maintain the value of the securities as collateral, subject to the agreement, at not less than the repurchase price plus accrued interest. KAFA monitors daily the mark-to-market of the value of the collateral, and, if necessary, requires the seller to maintain additional securities, so that the value of the collateral is not less than the repurchase price. Default by or bankruptcy of the seller would, however, expose the Fund to possible loss because of adverse market action or delays in connection with the disposition of the underlying securities.

 

E. Short Sales — A short sale is a transaction in which the Fund sells securities it does not own (but has borrowed) in anticipation of or to hedge against a decline in the market price of the securities. To complete a short sale, the Fund may arrange through a broker to borrow the securities to be delivered to the buyer. The proceeds received by the Fund for the short sale are retained by the broker until the Fund replaces the borrowed securities. In borrowing the securities to be delivered to the buyer, the Fund becomes obligated to replace the securities borrowed at their market price at the time of replacement, whatever the price may be.

 

All short sales are fully collateralized. The Fund maintains assets consisting of cash or liquid securities equal in amount to the liability created by the short sale. These assets are adjusted daily to reflect changes in the value of the securities sold short. The Fund is liable for any dividends or distributions paid on securities sold short.

 

The Fund may also sell short “against the box” (i.e., the Fund enters into a short sale as described above while holding an offsetting long position in the security which it sold short). If the Fund enters into a short sale “against the box,” the Fund segregates an equivalent amount of securities owned as collateral while the short sale is outstanding. At November 30, 2008, the Fund had no open short sales.

 

F. Option Writing — When the Fund writes an option, an amount equal to the premium received by the Fund is recorded as a liability and is subsequently adjusted to the current fair value of the option written. Premiums received from writing options that expire unexercised are treated by the Fund on the expiration date as realized gains from investments. The difference between the premium and the amount paid on effecting a closing purchase transaction, including brokerage commissions, is also treated as a realized gain, or if the premium is less than the amount paid for the closing purchase transaction, as a realized loss. If a call option is exercised, the premium is added to the proceeds from the sale of the underlying security in determining whether the Fund has realized a gain or loss. If a put option is exercised, the premium reduces the cost basis of the securities purchased by the Fund. The Fund, as the writer of an option, bears the market risk of an unfavorable change in the price of the security underlying the written option (See Note 7 — Option Contracts for more detail on option contracts written and purchased).

 

G. Security Transactions — Security transactions are accounted for on the date these securities are purchased or sold (trade date). Realized gains and losses are reported on an identified cost basis.

 

H. Return of Capital Estimates — Distributions received from the Fund’s investments in MLPs and royalty trusts generally are comprised of income and return of capital. The Fund records investment income and return of capital based on estimates made at the time such distributions are received. Such estimates are based on historical information available from each MLP and royalty trust and other industry sources. These estimates may subse- quently be revised based on information received from MLPs and royalty trusts after their tax reporting periods are concluded.

 

For the fiscal year ended November 30, 2008, the Fund estimated that 90% of the MLP distributions received and 2% of Canadian Royalty Trust distributions received would be treated as a return of capital. The Fund recorded as return of capital the amount of $28,875 of dividends and distributions received from its investments. Included in this amount is a decrease of $367 attributed to distributions received in fiscal 2007 based on tax reporting information received by the Fund in fiscal 2008. This resulted in an equivalent reduction in the cost basis of the associated investments. Net Realized Losses and Net Change in Unrealized Losses in the accompanying Statement

 

KAYNE ANDERSON ENERGY TOTAL RETURN FUND, INC.
NOTES TO FINANCIAL STATEMENTS — (CONTINUED)

(amounts in 000’s, except option contracts, share and per share amounts)

 

of Operations were decreased by $16,040 and $12,835, respectively, attributable to the recording of such dividends and distributions as reduction in the cost basis of investments.

 

I. Investment Income — The Fund records dividends and distributions on the ex-dividend date. Interest income is recognized on the accrual basis, including amortization of premiums and accretion of discounts. In accordance with Statement of Position (“SOP”) 93-1, Financial Accounting and Reporting for High-Yield Debt Securities by Investment Companies, to the extent that interest income to be received is not expected to be realized, a reserve against income is established.

 

As of November 30, 2008, the Fund has $0.5 million of past due interest accrued on its investment in CDX Funding LLC, which is currently in payment default. The Fund has not established a reserve against this income because it believes this interest will be collected.

 

J. Dividends and Distributions to Stockholders — Dividends and distributions to common stockholders are recorded on the ex-dividend date. The character of dividends/distributions made during the year may differ from their ultimate characterization for federal income tax purposes. Dividend and distributions to stockholders of each series of the Fund’s Auction Rate Preferred Stock (the “Preferred Stock”) were accrued on a daily basis and are determined as described in Note 10 — Senior Unsecured Notes and Preferred Stock. The Fund’s dividends and distributions may be comprised of return of capital and ordinary income, which is based on the earnings and profits of the Fund. The Fund is unable to make final determinations as to the tax character of the dividend/distributions until the January after the end of the current fiscal year. The Fund informs its common stockholders of the tax character of dividends and distributions made during that fiscal year in January following such fiscal year.

 

K. Partnership Accounting Policy — The Fund records its pro-rata share of the income/(loss) and capital gains/(losses), to the extent of dividends it has received, allocated from the underlying partnerships and adjusts the cost of the underlying partnerships accordingly. These amounts are included in the Fund’s Statement of Operations.

 

L. Taxes — It is the Fund’s intention to continue to be treated as and to qualify each year for special tax treatment afforded a Regulated Investment Company under Subchapter M of the Internal Revenue Code. As long as the Fund meets certain requirements that govern its source of income, diversification of assets and timely distribution of earnings to stockholders, the Fund will not be subject to U.S. federal income tax.

 

Income and capital gain distributions made by Regulated Investment Companies often differ from the aggregate GAAP basis net investment income and net realized gains. For the Fund, the principal reason for these differences is the return of capital treatment of dividends and distributions from MLPs, royalty trusts and certain other of its investments. As of November 30, 2008, accumulated dividends and distributions to preferred and common stockholders exceeded accumulated net investment income and net realized gains for GAAP purposes by $103,556. Net investment income and net realized gains for GAAP purposes may differ from taxable income for federal income tax purposes due to wash sales, disallowed partnership losses from MLPs and foreign currency transactions. As of November 30, 2008, the principal temporary differences were (a) realized losses that were recognized for book purposes, but disallowed for tax purposes due to wash sale rules; (b) disallowed partnership losses related to the Fund’s MLP investments and (c) other basis adjustments in the Fund’s MLPs and other investments. For purposes of characterizing the nature of the dividend/distributions to investors, the amounts in excess of the Fund’s earnings and profits for federal income tax purposes is treated as a return of capital. Earnings and profits differ from the taxable income due principally to adjustments related to the Fund’s investments in MLPs. During the fiscal year ended November 30, 2008, the Fund reclassified $8,387 to accumulated net investment income from paid-in capital primarily due to distributions in excess of taxable net investment income. The Fund also reclassified $7,562 of accumulated capital losses to accumulated net investment income due to permanent differences between GAAP and tax treatment of certain net realized losses.

 

The tax basis of the components of distributable earnings can differ from the amounts reflected in the Statement of Assets and Liabilities due to temporary differences between the carrying amounts of assets and

 

KAYNE ANDERSON ENERGY TOTAL RETURN FUND, INC.
NOTES TO FINANCIAL STATEMENTS — (CONTINUED)

(amounts in 000’s, except option contracts, share and per share amounts)

 

liabilities for financial reporting purposes and the amounts used for income tax purposes. At November 30, 2008, there were no distributable earnings on a tax basis for the Fund.

 

 

At November 30, 2008, the Fund had a capital loss carryforward for U.S. federal income tax purposes of $28,220 expiring in 2016.

 

For the fiscal year ended November 30, 2008, the tax character of the total $66,186 dividends and distributions paid to common stockholders was $12,116 (ordinary income) and $54,070 (return of capital). For the fiscal year ended November 30, 2008, the tax character of the $10,773 cash distribution paid to preferred stockholders was entirely ordinary income.

 

For the fiscal year ended November 30, 2007, the tax character of the total $58,842 dividends and distributions paid to common stockholders was $43,513 (ordinary income) and $15,329 (capital gains). For the fiscal year ended November 30, 2007, the tax character of the $16,101 cash distribution paid to preferred stockholders was $11,907 (ordinary income) and $4,194 (capital gains).

 

At November 30, 2008, the identified cost of investments for federal income tax purposes was $906,595, and the net cash received on option contracts written was $50. At November 30, 2008, gross unrealized appreciation and depreciation of investments and options for federal income tax purposes were as follows:

 

 

Dividend income received by the Fund from sources within Canada is subject to a 15% foreign withholding tax.

 

Interest income on Canadian corporate obligations may be subject to a 10% withholding tax unless an exemption is met. The most common exemption available is for corporate bonds that have a tenure of at least 5 years, provided that not more than 25% of the principal is repayable in the first five years and provided that the borrower and lender are not “associated.” Further, interest is exempt if derived from debt obligations guaranteed by the Canadian government.

 

As of December 1, 2007, the Fund adopted FASB Interpretation 48 (“FIN 48”), “Accounting for Uncertainty in Income Taxes.” This standard defines the threshold for recognizing the benefits of tax-return positions in the financial statements as “more-likely-than-not” to be sustained by the taxing authority and requires measurement of a tax position meeting the more-likely-than-not criterion, based on the largest benefit that is more than 50 percent likely to be realized. At adoption, companies must adjust their financial statements to reflect only those tax positions that are more-likely-than-not to be sustained as of the adoption date.

 

The adoption of the interpretation did not have a material effect on the Fund’s net asset value. The Fund’s policy is to classify interest and penalties associated with underpayment of federal and state income taxes, if any, as income tax expense on its Statement of Operations. As of November 30, 2008, the Fund does not have any interest or

 

KAYNE ANDERSON ENERGY TOTAL RETURN FUND, INC.
NOTES TO FINANCIAL STATEMENTS — (CONTINUED)

(amounts in 000’s, except option contracts, share and per share amounts)

 

penalties associated with the underpayment of any income taxes. All tax years since inception remain open and subject to examination by tax jurisdictions.

 

M. Foreign Currency Translations — The books and records of the Fund are maintained in U.S. dollars. Foreign currency amounts are translated into U.S. dollars on the following basis: (i) market value of investment securities, assets and liabilities at the rate of exchange as of the valuation date; and (ii) purchases and sales of investment securities, income and expenses at the relevant rates of exchange prevailing on the respective dates of such transactions.

 

The Fund does not isolate that portion of gains and losses on investments in equity and debt securities which is due to changes in the foreign exchange rates from that which is due to changes in market prices of equity securities. Accordingly, realized and unrealized foreign currency gains and losses with respect to such securities are included in the reported net realized and unrealized gains and losses on investment transactions balances.

 

Net realized foreign exchange gains or losses represent gains and losses from transactions in foreign currencies and foreign currency contracts, foreign exchange gains or losses realized between the trade date and settlement date on security transactions, and the difference between the amounts of interest and dividends recorded on the Fund’s books and the U.S. dollar equivalent of such amounts on the payment date.

 

Net unrealized foreign exchange gains or losses represent the difference between the cost of assets and liabilities (other than investments) recorded on the Fund’s books from the value of the assets and liabilities (other than investments) on the valuation date.

 

N. Derivative Financial Instruments — The Fund uses derivative financial instruments (principally interest rate swap contracts) to manage interest rate risk. The Fund has established policies and procedures for risk assessment and the approval, reporting and monitoring of derivative financial instrument activities. The Fund does not hold or issue derivative financial instruments for speculative purposes. All derivative financial instruments are recorded at fair value with changes in value during the reporting period are included as unrealized gains or losses in the Statement of Operations. The Fund generally values its interest rate swap contracts based on dealer quotations, if available, or by discounting the future cash flows from the stated terms of the interest rate swap agreement by using interest rates currently available in the market. As of November 30, 2008, the Fund did not have any interest rate swap contracts outstanding.

 

O. Indemnifications — Under the Fund’s organizational documents, its officers and directors are indemnified against certain liabilities arising out of the performance of their duties to the Fund. In addition, in the normal course of business, the Fund enters into contracts that provide general indemnification to other parties. The Fund’s maximum exposure under these arrangements is unknown, as this would involve future claims that may be made against the Fund that have not yet occurred, and may not occur. However, the Fund has not had prior claims or losses pursuant to these contracts and expects the risk of loss to be remote.

 

 

SFAS No. 157.  In September 2006, the FASB issued SFAS No. 157, “Fair Value Measurements.” This standard establishes a single authoritative definition of fair value, sets out a framework for measuring fair value and requires additional disclosure about fair value measurements. SFAS No. 157 applies to fair value measurements already required or permitted by existing standards. SFAS No. 157 is effective for financial statements issued for fiscal years beginning after November 15, 2007, and interim periods within those fiscal years. The changes to current generally accepted accounting principles from the application of this Statement relate to the definition of fair value, the methods used to measure fair value, and the expanded disclosures about fair value measurements.

 

As of December 1, 2007, the Fund adopted SFAS No. 157. The Fund has performed an analysis of all existing investments and derivative instruments to determine the significance and character of all inputs to their fair value determination. Based on this assessment, the adoption of this standard did not have any material effect on the Fund’s

 

KAYNE ANDERSON ENERGY TOTAL RETURN FUND, INC.
NOTES TO FINANCIAL STATEMENTS — (CONTINUED)

(amounts in 000’s, except option contracts, share and per share amounts)

 

net asset value. However, the adoption of the standard does require the Fund to provide additional disclosures about the inputs used to develop the measurements and the effect of certain measurements on changes in net assets for the reportable periods as contained in the Fund’s periodic filings.

 

SFAS No. 157 establishes a fair value hierarchy that prioritizes the inputs to valuation techniques used to measure fair value into the following three broad categories.

 

 

The following table presents our assets and liabilities measured at fair value on a recurring basis at November 30, 2008.

 

 

 

The following table presents the Fund’s assets measured at fair value on a recurring basis using significant unobservable inputs (Level 3) at November 30, 2007 and at November 30, 2008.

 

 

The $1,875 of unrealized losses, net, presented in the table above relate to investments that are still held at November 30, 2008, and the Fund presents these unrealized losses in the Statement of Operations — Net Change in Unrealized Gains (Losses).

 

The Fund did not have any liabilities that were measured at fair value on a recurring basis using significant unobservable inputs (Level 3) at November 30, 2007 and at November 30, 2008.

 

KAYNE ANDERSON ENERGY TOTAL RETURN FUND, INC.
NOTES TO FINANCIAL STATEMENTS — (CONTINUED)

(amounts in 000’s, except option contracts, share and per share amounts)

 

 

The Fund’s investment objective is to obtain a high level of total return with an emphasis on current income paid to its stockholders. Under normal circumstances, the Fund intends to invest at least 80% of the aggregate of its net assets and borrowings (“total assets”) in securities of Energy Companies. The Fund invests in equity securities such as common stocks, preferred stocks, convertible securities, warrants, depository receipts, and equity interests in MLPs, MLP affiliates, royalty trusts and other Energy Companies. Additionally, the Fund may invest up to 30% of its total assets in debt securities of Energy Companies. It may directly invest up to 25% (or such higher amount as permitted by any applicable tax diversification rules) of its total assets in equity or debt securities of MLPs. The Fund may invest up to 50% of its total assets in unregistered or otherwise restricted securities of Energy Companies. It will not invest more than 15% of its total assets in any single issuer. The Fund may, for defensive purposes, temporarily invest all or a significant portion of its assets in investment grade securities, short-term debt securities and cash or cash equivalents. To the extent the Fund uses this strategy, it may not achieve its investment objectives.

 

 

A.  Investment Management Agreement — The Fund has entered into an investment management agreement with KAFA under which the Adviser, subject to the overall supervision of the Fund’s Board of Directors, manages the day-to-day operations of, and provides investment advisory services to, the Fund. For providing these services, the Adviser receives a management fee from the Fund.

 

For the fiscal year ended November 30, 2008, the Fund paid and accrued management fees at an annual rate of 1.25% of average monthly total assets of the Fund.

 

For purposes of calculating the management fee, the “average total assets” for each monthly period are determined by averaging the total assets at the last business day of that month with the total assets at the last business day of the prior month (or as of the commencement of operations for the initial period if a partial month). The total assets of the Fund shall be equal to its average monthly gross asset value (which includes assets attributable to or proceeds from the Fund’s use of preferred stock, commercial paper or notes issuances and other borrowings), minus the sum of the Fund’s accrued and unpaid dividends/distributions on any outstanding common stock and accrued and unpaid dividends/distributions on any outstanding preferred stock and accrued liabilities (other than liabilities associated with borrowing or leverage by the Fund). Liabilities associated with borrowing or leverage include the principal amount of any borrowings, commercial paper or notes that issued by the Fund, the liquidation preference of any outstanding preferred stock, and other liabilities from other forms of borrowing or leverage such as short positions and put or call options held or written by the Fund.

 

B.  Portfolio Companies — From time to time, the Fund may “control” or may be an “affiliate” of one or more portfolio companies, each as defined in the 1940 Act. In general, under the 1940 Act, the Fund would “control” a portfolio company if the Fund owned 25% or more of its outstanding voting securities and would be an “affiliate” of a portfolio company if the Fund owned 5% or more of its outstanding voting securities. The 1940 Act contains prohibitions and restrictions relating to transactions between investment companies and their affiliates (including the Fund’s investment adviser), principal underwriters and affiliates of those affiliates or underwriters.

 

The Fund believes that there is significant ambiguity in the application of existing Securities and Exchange Commission (“SEC”) staff interpretations of the term “voting security” to complex structures such as limited partnership interests of the kind in which the Fund invests. As a result, it is possible that the SEC staff may consider that certain securities investments in limited partnerships are voting securities under the staff’s prevailing interpretations of this term. If such determination is made, the Fund may be regarded as a person affiliated with and controlling the issuer(s) of those securities for purposes of Section 17 of the 1940 Act.

 

In light of the ambiguity of the definition of voting securities, the Fund does not intend to treat any class of limited partnership interests that it holds as “voting securities” unless the security holders of such class currently

 

KAYNE ANDERSON ENERGY TOTAL RETURN FUND, INC.
NOTES TO FINANCIAL STATEMENTS — (CONTINUED)

(amounts in 000’s, except option contracts, share and per share amounts)

 

have the ability, under the partnership agreement, to remove the general partner (assuming a sufficient vote of such securities, other than securities held by the general partner, in favor of such removal) or the Fund has an economic interest of sufficient size that otherwise gives it the de facto power to exercise a controlling influence over the partnership. The Fund believes this treatment is appropriate given that the general partner controls the partnership, and without the ability to remove the general partner or the power to otherwise exercise a controlling influence over the partnership due to the size of an economic interest, the security holders have no control over the partnership.

 

Plains All American, L.P. — Robert V. Sinnott is a senior executive of Kayne Anderson Capital Advisors, L.P. (“KACALP”), the managing member of KAFA. Mr. Sinnott also serves as a director on the board of Plains All American GP LLC, the general partner of Plains All American Pipeline, L.P. Members of senior management and various advisory clients of KACALP and KAFA own units of Plains All American GP LLC. Various advisory clients of KACALP and KAFA, including the Fund, own units in Plains All American Pipeline, L.P. The Fund believes that it is an affiliate of Plains All American, L.P. under the 1940 Act.

 

 

From time to time, certain of the Fund’s investments may be restricted as to resale. For instance, private investments that are not registered under the Securities Act of 1933, as amended, and cannot, as a result, be offered for public sale in a non-exempt transaction without first being registered. In other cases, certain of the Fund’s investments have restrictions such as lock-up agreements that preclude the Fund from offering these securities for public sale.

 

At November 30, 2008, the Fund held the following restricted securities.