Equus Total Return, Inc. ("we," "us," "our," "Equus," and the "Fund"), a
Delaware corporation, was formed on August 16, 1991. Our shares trade on the New
York Stock Exchange under the symbol 'EQS'. Our investment strategy seeks to
provide the highest total return, consisting of capital appreciation and current
income.
The information contained in this section should be read in conjunction with our
financial statements and notes thereto appearing elsewhere in this Quarterly
Report and in conjunction with the financial statements and notes thereto in the
Fund's Form 10-K for the year ended December 31, 2020, as filed with the SEC. In
addition, some of the statements in this report constitute forward-looking
statements. The matters discussed in this Quarterly Report, as well as in future
oral and written statements by management of Equus, that are forward-looking
statements are based on current management expectations that involve substantial
risks and uncertainties which could cause actual results to differ materially
from the results expressed in, or implied by, these forward-looking statements.
Forward-looking statements relate to future events or our future financial
performance. We generally identify forward-looking statements by terminology
such as "may," "will," "should," "expects," "plans," "anticipates," "could,"
"intends," "target," "projects," "believes," "estimates," "predicts,"
"potential" or "continue" or the negative of these terms or other similar words.
Important assumptions include our ability to originate new investments, achieve
certain margins and levels of profitability, and the availability of additional
capital. In light of these and other uncertainties, the inclusion of a
forward-looking statement in this Quarterly Report should not be regarded as a
representation by us that our plans or objectives will be achieved. The forward-
looking statements contained in this Quarterly Report include statements as to:
• our future operating results;
• our business prospects and the prospects of our existing and
prospective portfolio companies;
• the return or impact of current and future investments;
• our contractual arrangements and other relationships with third
parties;
• the dependence of our future success on the general economy and its
impact on the industries in which we invest;
• the financial condition and ability of our existing and prospective
portfolio companies to achieve their objectives;
• our expected financings and investments;
• our regulatory structure and tax treatment;
• our ability to qualify and operate as a BDC and a RIC, including the
impact of changes in laws or regulations governing our operations, or
the operations of our portfolio companies;
• the adequacy of our cash resources and working capital;
• the timing of cash flows, if any, from the operations of our
portfolio companies;
• the impact of fluctuations in interest rates on our business;
• the valuation of our investments in portfolio companies, particularly
those having no liquid trading market;
• our ability to recover unrealized losses;
• market conditions and our ability to access additional capital, if
deemed necessary;
• developments in the global economy as well as the public health
crisis related to the COVID-19 virus and resulting demand and supply
for oil and natural gas;
• natural or man-made disasters and other external events that may
disrupt our operations; and
• continued volatility of oil and natural gas prices.
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There are a number of important risks and uncertainties that could cause our
actual results to differ materially from those indicated by such forward-looking
statements. For a discussion of factors that could cause our actual results to
differ from forward-looking statements contained in this Quarterly Report,
please see the discussion in Part II, "Item 1A. Risk Factors", and in Part I,
"Item 1A. Risk Factors" in our Annual Report on Form 10-K for the fiscal year
ended December 31, 2020 ("10-K"). In particular, you should carefully consider
the risks we have described in the 10-K and elsewhere in this Quarterly Report
concerning our efforts to transform Equus into an operating company, as well as
the coronavirus pandemic and the economic impact of the coronavirus on the Fund
and our portfolio companies and oil and gas markets. You should not place undue
reliance on these forward-looking statements. The forward-looking statements
made in this Quarterly Report relate only to events as of the date on which the
statements are made. We undertake no obligation to update any forward-looking
statement to reflect events or circumstances occurring after the date this
Quarterly Report is filed with the SEC.
We attempt to maximize the return to stockholders in the form of current
investment income and long-term capital gains by investing in the debt and
equity securities of companies with a total enterprise value of between $5.0
million and $75.0 million, although we may engage in transactions with smaller
or larger investee companies from time to time. We seek to invest primarily in
companies pursuing growth either through acquisition or organically, leveraged
buyouts, management buyouts and recapitalizations of existing businesses or
special situations. Our income-producing investments consist principally of debt
securities including subordinate debt, debt convertible into common or preferred
stock, or debt combined with warrants and common and preferred stock. Debt and
preferred equity financing may also be used to create long- term capital
appreciation through the exercise and sale of warrants received in connection
with the financing. To the extent that we remain a BDC, we will seek to achieve
capital appreciation by making investments in equity and equity-oriented
securities issued by privately-owned companies (and smaller public companies) in
transactions negotiated directly with such companies. Given market conditions
over the past several years and the performance of our portfolio, our management
and Board of Directors believe it is prudent to continue to review alternatives
to refine and further clarify the current strategies.
We elected to be treated as a BDC under the 1940 Act. We currently qualify as a
RIC for federal income tax purposes and, therefore, are not required to pay
corporate income taxes on any income or gains that we distribute to our
stockholders. We have a wholly-owned Taxable Subsidiary which holds one of our
portfolio investments listed on our Schedules of Investments. The purpose of
this Taxable Subsidiary is to permit us to hold certain income-producing
investments or portfolio companies organized as limited liability companies, or
LLCs, (or other forms of pass-through entities) and still satisfy the RIC tax
requirement that at least 90% of our gross revenue for income tax purposes must
consist of investment income. Absent the Taxable Subsidiary, a portion of the
gross income of these income- producing investments or of any LLC (or other
pass-through entity) portfolio investment, as the case may be, would flow
through directly to us for the 90% test. To the extent that such income did not
consist of investment income, it could jeopardize our ability to qualify as a
RIC and, therefore, cause us to incur significant federal income taxes. The
income of the LLCs (or other pass-through entities) owned by Taxable Subsidiary
is taxed to the Taxable Subsidiary and does not flow through to us, thereby
helping us preserve our RIC status and resultant tax advantages. We do not
consolidate the Taxable Subsidiary for income tax purposes and they may generate
income tax expense because of the Taxable Subsidiary's ownership of the
portfolio investment. We reflect any such income tax expense on our Statements
of Operations.
Conversion to an Operating Company
Authorization to Withdraw BDC Election. On August 17, 2021, holders of a
majority of the outstanding common stock of the Fund approved our cessation as a
BDC under the 1940 Act and authorized our Board to cause the Fund's withdrawal
of its election to be classified as a BDC, effective as of a date designated by
the Board and our Chief Executive Officer, but no later than January 31, 2022.
This authorization and others which preceded it are a consequence of our
expressed intent to transform Equus into an operating company or a permanent
capital vehicle. Notwithstanding any such authorization to withdraw our BDC
election, we will not submit any such withdrawal unless and until Equus has
entered into a definitive agreement to effect a transformative transaction.
Further, even if we are again authorized to withdraw our election as a BDC, we
will require a subsequent affirmative vote from holders of a majority of our
outstanding voting shares to enter into any such definitive agreement or change
the nature of our business. While we are presently evaluating various
opportunities that could enable us to accomplish this transformation, we cannot
assure you that we will be able to do so within any particular time period or at
all, and, although we expect our shareholders will extend our current
authorization, we do not expect to cause the Fund to withdraw its election to be
classified as a BDC by January 31, 2022. Moreover, we cannot assure you that the
terms of any such transformative transaction would be acceptable to us.
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Increase in Authorized Shares. On January 20, 2021, holders of a majority of the
outstanding common stock of the Fund approved the restatement of our Certificate
of Incorporation to increase the number of our authorized shares of common stock
from 50,000,000 to 100,000,000, and the number of our authorized shares of
preferred stock from 5,000,000 to 10,000,000. The increase is intended to help
facilitate the transformation of Equus into an operating company and provide
sufficient authorized shares to evaluate larger business concerns as possible
acquisition or merger candidates.
Reduction in Asset Coverage Ratio
On November 14, 2019, our shareholders approved a reduction in our asset
coverage ratio from 200% to 150%. Prior to the reduction, we were restricted in
the amount that we could borrow to the value of our net assets. The reduction in
our asset coverage from 200% to 150% means that we may now borrow up to twice
the value of our net assets. Except for a margin loan that we have previously
procured each quarter to acquire U.S. Treasury bills as part of the maintenance
of our RIC status, we have not incurred any additional borrowings as a
consequence of this authorization.
2016 Equity Incentive Plan
On June 13, 2016, our shareholders approved the adoption of our 2016 Equity
Incentive Plan ("Incentive Plan"). On January 10, 2017, the SEC issued an order
approving the Incentive Plan and certain awards intended to be made thereunder.
The Incentive Plan is intended to promote the interests of the Fund by
encouraging officers, employees, and directors of the Fund and its affiliates to
acquire or increase their equity interest in the Fund and to provide a means
whereby they may develop a proprietary interest in the development and financial
success of the Fund, to encourage them to remain with and devote their best
efforts to the business of the Fund, thereby advancing the interests of the Fund
and its stockholders. The Incentive Plan is also intended to enhance the ability
of the Fund and its affiliates to attract and retain the services of individuals
who are essential for the growth and profitability of the Fund. The Incentive
Plan permits the award of restricted stock as well as common stock purchase
options. The maximum number of shares of common stock that are subject to awards
granted under the Incentive Plan is 2,434,728 shares. The term of the Incentive
Plan will expire on June 13, 2026. On March 17, 2017, we granted awards of
restricted stock under the Plan to certain of our directors and executive
officers in the aggregate amount of 844,500 shares. The awards were each subject
to a vesting requirement over a 3-year period unless the recipient thereof was
terminated or removed from their position as a director or executive officer
without "cause", or as a result of constructive termination, as such terms are
defined in the respective award agreements entered into by each of the
recipients and the Fund. As of March 31, 2020, all awards granted under the
Incentive Plan were fully vested. We account for share-based compensation using
the fair value method, as prescribed by ASC 718. Accordingly, for restricted
stock awards, we measure the grant date fair value based upon the market price
of our common stock on the date of the grant and amortize the fair value of the
awards as share-based compensation expense over the requisite service period,
which is generally the vesting term. We recorded compensation expense of $0.08
million for the three months ended March 31, 2020 in connection with these
awards.
Critical Accounting Policies
See the Fund's Critical Accounting Policies from the disclosure set forth in the
Fund's Annual Report on Form 10-K for the year ended December 31, 2020.
Current Market Conditions
Impact of the Coronavirus Generally. The introduction of the coronavirus has had
a substantial detrimental impact on markets and economic forecasts for
governments and businesses worldwide, and could have a materially adverse impact
upon our operations and that of our sole remaining portfolio company, although
the extent of the impact cannot be determined at the present time. Beginning in
the first quarter of 2020, all U.S. states and many foreign countries
implemented significant travel, movement, and assembly restrictions, as well as
restrictions on the movement of goods. Beginning in September 2020, a number of
U.S. states began to relax certain restrictions on commercial and social
activity, including permitting some primary, secondary, and university students
to return to in-person classes.
Largely as a consequence of this type of increased social interaction, the U.S.
experienced a resurgence in COVID-19 infections and concomitant deaths that
continued through the first two quarters of 2021. In addition, beginning in late
2020, a number of new and more highly contagious strains of the virus began to
appear, most notably of which was the Delta variant, which was first encountered
in the United States in March 2021. The resurgence in infections and the
introduction of these new strains resulted in the return of proscriptions on
certain social gatherings, some of which continued through the end of the third
quarter of 2021.
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As of October 28, 2021, the number of U.S. deaths attributable to the
coronavirus stood at over 742,000. Beginning in late 2020, however, a number of
global pharmaceutical companies introduced one and two-dose COVID-19 vaccines to
the market, and in the third quarter of 2021, also introduced a third 'booster'
shot to address new variants to the virus. On October 28, 2021, the U.S. Centers
for Disease Control ("CDC") reported that 78.0% of the U.S. population above the
age of 12 had received at least one dose of these vaccines. With lowering
infection and death rates, a number of states had begun again to relax
restrictions on social and commercial activity, and most of these states had
also relaxed requirements regarding the wearing of a protective face mask.
However, the CDC has reported that persons infected with the Delta variant can
carry up to 1,000 times more virus in their nasal passages than compared to the
original coronavirus strain, making it one of the most highly contagious
respiratory diseases encountered in many years. The virulence of this and other
strains has led some states and foreign countries to delay or even reverse an
easing of certain social activity proscriptions.
Impact of the Coronavirus on Our Operations. The highly contagious nature of the
coronavirus and its various strains has caused numerous private and public
organizations to substantially alter the way in which they operate. In some
cases, these workplace and operational alterations have become permanent. Many
such organizations have, to the extent possible, required employees to work
remotely to reduce opportunities for contagion. We have also taken steps to
minimize the exposure of our employees and service providers by allowing all
such persons to work from a remote location. We utilize a cloud-based storage
and retrieval system for our records and can communicate electronically or by
telephone with third parties such as our financial institutions, legal and
accounting advisors, and our portfolio companies. Our day-to-day operations and
management has not, therefore, been materially affected by the coronavirus
pandemic. However, government directives on social distancing and other
restrictions and conditions have impaired our ability to travel to attend board
meetings, negotiations, and other functions which are endemic to the
interpersonal nature of private equity investing. As a consequence, our ability
to source new investment prospects, facilitate dispositions of existing
portfolio holdings, or consummate a substantial transaction has been constrained
by these limitations. Should these disruptions and restrictions continue as a
result of the coronavirus, we cannot, therefore, assure you that our operations
as a BDC or our efforts to effect a transformative transaction involving Equus
will not be materially adversely affected thereby.
Impact of Geopolitical Events and the Coronavirus on the Oil and Gas Sector.
2020 witnessed unprecedented systemic events that had a material effect on oil
prices globally and continued through the first three quarters of the year.
Commencing in the fourth quarter of 2020, crude and natural gas prices began to
experience a sustained increase and, as of the date of this filing on Form 10-Q,
have recovered to, or have exceeded, pre-pandemic levels. Notwithstanding
present pricing conditions and forecasts for the remainder of 2021, operators of
the leasehold interests held by Equus Energy have not yet undertaken significant
capital expenditures, which could have a material adverse effect upon the
operations and long-term financial condition of Equus Energy. To conserve
existing cash resources or create additional cash resources during the next
year, Equus Energy intends to either: (i) attempt to secure equity or debt
financing from one or more institutional sources, which sources may include the
Fund, a commercial lender, or other investors, (ii) request that its operators
shut-in additional wells, (iii) sell certain of its oil and gas holdings, or
(iv) undertake a combination of the foregoing. However, we cannot assure you
that Equus Energy will be able to implement these plans successfully, or that
such plans will generate sufficient liquidity to fund the operating expenses of
Equus Energy over the next twelve-months.
The U.S. Economy. Largely resulting from the economic disruption caused by the
coronavirus, the U.S. economy was highly volatile during 2020, but finished the
year on a strong upward trend. With the decrease in infection rates and deaths,
together with increased vaccination rates and a substantial fiscal stimulus, the
U.S. economy began to stabilize, posting annualized increases of 6.4% and 6.7%,
respectively, in GDP growth during the first and second quarters of 2021. The
rise of the Delta variant and the phasing out of stimulus payments contributed
to slowing growth in the third quarter of 2021, which posted an annualized
increase of 2.0%, significantly below the Conference Board Economic Forecast of
3.5%. The Conference Board expects U.S. GDP to increase overall by 5.7% for all
of 2021, 3.8% for 2022, and 3.0% for 2023. The sector that contributed most
significantly to the GDP increase during the first nine months of 2021 was
consumer spending, principally driven by additional stimulus checks being
delivered in the first and second quarters. (Sources: U.S. Dept. of Commerce
Bureau of Economic Analysis, Conference Board Leading Economic Index, CNBC)
Employment and Housing. Prior to the onset of the coronavirus pandemic, the U.S.
unemployment rate stood at 3.5%, a historic low. The rate peaked at 14.7% in
April 2020 and finished the year at 6.7%. The first nine months of 2021 saw this
number further reduced to 4.8% as of September 30, 2021. Commensurate with
expected strong GDP growth overall in 2021, Goldman Sachs predicts the
unemployment rate to be 4.1% by the end of 2021. In keeping with this trend,
with the exception of a few months during the height of the pandemic, the U.S.
housing market saw robust growth throughout 2020 and into the first nine months
of 2021. At the end of the third quarter of 2021, the median home value was
$400,000 for the first time in history, and the average sale price during the
third quarter of 2021 also set a record at $453,000. Given the escalation in
property values, a number of industry analysts have begun to consider if a
significant price correction will occur later in 2021 or in 2022. (Sources: U.S.
Dept. of Commerce, St. Louis Federal Reserve; Bureau of Labor Statistics, CNBC;
Reuters).
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Merger, Acquisition, and Private Equity Activity. Merger and acquisition
activity in the first nine months of 2021 totaled $4.3 trillion, a record for a
nine month period. KPMG is predicting that total merger and acquisition values
for all of 2021 will be $6.0 trillion, which amount would surpass 2019 as the
highest ever. A combination of low interest rates and high equity values
contributed to this trend, which is expected to continue for the remainder of
2021 and into 2022. (Sources: Bloomberg, Financial Times; Reuters).
Private equity firms, special purpose acquisition companies (SPACs) and
operating companies accumulated more than $7.6 trillion in cash during 2020 in
anticipation of economic fallout from COVID-19. Due to such accumulation,
companies were more likely to use their own securities rather than cash as
currency in M&A transactions than in prior years. Of particular note is the
increased use of SPACs as acquisition vehicles during 2020, which activity hit
an all-time high of 317 SPAC transactions during the first quarter of 2021. This
number then slowed to 106 and 111 transactions during the second and third
quarters, respectively, of 2021, principally due to enhanced SEC scrutiny, but
is again expected to gain momentum in the fourth quarter of the year. Private
equity firms invested more in underperforming companies than during the 2008-09
market downturn, principally as a result of low capital costs and the
anticipated short-term effect of the negative economic fallout from the
coronavirus. Private debt and equity funds continued to increase in size, with
U.S. debt funds now averaging more than $1.0 billion. The first half of 2021
witnessed a record $580 billion in private equity transactions, with some
industry analysts predicting the year 2021 to surpass $1.0 trillion in total
private equity deals. Despite this increasing activity, low interest rates and
large amounts of undeployed capital from previous have continued to put upward
pressure on asset prices and have constrained expected investment yields.
(Sources: Pitchbook, Forbes).
During the three months ended September 30, 2021, our net asset value increased
from $2.57 per share to $2.68 per share, an increase of 4.3%. As of September
30, 2021, our common stock is trading at a 15.5% discount to our net asset value
as compared to 36.0% as of December 31, 2020.
Over the past several years, we have executed certain initiatives to enhance
liquidity, achieve a lower operational cost structure, provide more assistance
to portfolio companies and realize certain of our portfolio investments.
Specifically, we changed the composition of our Board of Directors and
Management, terminated certain of our follow-on investments, internalized the
management of the Fund, suspended our managed distribution policy, modified our
investment strategy to pursue shorter term liquidation opportunities, pursued
non-cash investment opportunities, and sold certain of our legacy and
underperforming investment holdings. We believe these actions continue to be
necessary to protect capital and liquidity in order to preserve and enhance
shareholder value. Because our Management is internalized, certain of our
expenses should not increase commensurate with an increase in the size of the
Fund and, therefore, to the extent we remain a BDC, we expect to achieve
efficiencies in our cost structure if we are able to grow the Fund.
Liquidity and Capital Resources
We generate cash primarily from maturities, sales of securities and borrowings,
as well as capital gains realized upon the sale of portfolio investments. We use
cash primarily to make additional investments, either in new companies or as
follow-on investments in the existing portfolio companies and to pay the
dividends to our stockholders.
Because of the nature and size of the portfolio investments, we may periodically
borrow funds to make qualifying investments to maintain our tax status as a RIC.
We often borrow such funds by utilizing a margin account with a securities
brokerage firm. There is no assurance that such arrangement will be available in
the future. If we are unable to borrow funds to make qualifying investments,
Equus may no longer qualify as a RIC. The Fund would then be subject to
corporate income tax on its net investment income and realized capital gains,
and distributions to stockholders would be subject to income tax as ordinary
dividends.
The Fund has the ability to borrow funds and issue forms of senior securities
representing indebtedness or stock, such as preferred stock, subject to certain
restrictions. Net taxable investment income and net taxable realized gains from
the sales of portfolio investments are intended to be distributed at least
annually, to the extent such amounts are not reserved for payment of expenses
and contingencies or to make follow-on or new investments.
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We reserve the right to retain net long-term capital gains in excess of net
short-term capital losses for reinvestment or to pay contingencies and expenses.
Such retained amounts, if any, will be taxable to the Fund as long-term capital
gains and stockholders will be able to claim their proportionate share of the
federal income taxes paid on such gains as a credit against their own federal
income tax liabilities. Stockholders will also be entitled to increase the
adjusted tax basis of their Fund shares by the difference between their
undistributed capital gains and their tax credit.
We are evaluating the impact of current market conditions on our portfolio
company valuations and their ability to provide current income. We believe we
have followed valuation techniques in a reasonably consistent manner; however,
we are cognizant of current market conditions that might affect future
valuations of portfolio securities. In view of our present status as a BDC and
our anticipated transformation into an operating company, we believe that our
operating cash flow and cash on hand will be sufficient to meet operating
requirements and to finance routine capital expenditures through the next twelve
months.
Results of Operations
Investment Income and Expense
Net investment loss was $0.8 million for the three months ended September 30,
2021 and $0.7 million September 30, 2020, respectively. Net investment loss was
$2.5 million and $2.3 million for the nine months ended September 30, 2021, and
September 30, 2020, respectively
Investment income declined to $0.0 million for the three and nine months ended
September 30, 2021, respectively from $0.1 million and $0.3 million for the
three and nine ended September 30, 2020, respectively due to the sale of
interest/dividend bearing investments. Total expense was relatively unchanged at
$0.8 million for the three months ended September 30, 2021 and 2020,
respectively and $2.5 million for the nine months ended September 30, 2021 and
$2.6 million for the nine months ended September 30, 2020, respectively.
Realized Gains and Losses on Sales of Portfolio Securities
During the nine months ended September 30, 2021, we realized a gain of $0.5
million from the adjustment of the escrow receivable from the sale of PalletOne,
Inc.
During the nine months ended September 30, 2020, we realized a gain of $8.0
thousand from the sale of temporary cash investments.
Changes in Unrealized Appreciation/Depreciation of Portfolio Securities
During the nine months ended September 30, 2021, with respect to our holding in
Equus Energy, LLC, we recorded an increase in the fair value of $5.0 million and
an increase in our cost basis of $0.35 million, resulting in a net change in
unrealized appreciation of $4.65 million. Such change in fair value was
principally due to increases in mineral acreage prices and a substantial
increase in short-and long-term prices for crude oil and natural gas.
During the nine months ended September 30, 2020, in connection with our
shareholding in MVC Capital, Inc. ("MVC"), we received dividends in the form of
additional MVC shares valued at $0.2 million, together with $134,585 in cash.
During the nine months ended September 30, 2020, we recorded a net change in
unrealized appreciation of $6.3 million, to a net unrealized appreciation of
$19.0 million. Such change in unrealized appreciation resulted primarily from
the following changes:
(i) Decrease in the fair value of our shareholding in MVC of $0.8 million due
to a decrease in the share price of MVC which was partially offset by the
receipt of dividend payments in the form of additional shares of MVC during
the period;
(ii) Decrease in the fair value of our holdings in Equus Energy, LLC of $3.0
million, principally due to decreases in mineral acreage prices and a
substantial decrease in the short- and long-term prices for crude oil,
which fell from $61.06 per barrel at December 31, 2019 to $20.48 at March
31, 2020, before recovering moderately to $40.22 at September 30, 2020; and
(iii) Decrease in the fair value of our shareholding in PalletOne, Inc. of $2.5
million due to a less favorable outlook for the Company in 2021 and the
remainder of 2020.
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Dividends
We will pay out net investment income and/or realized capital gains, if any, on
an annual basis as required under the Investment Company Act of 1940.
Portfolio Securities
During the nine months ended September 30, 2021, we made a follow-on investment
of $0.35 million in Equus Energy, LLC.
During the nine months ended September 30, 2020, we converted into equity $0.6
million in advances we made to Equus Energy, LLC, our wholly-owned subsidiary.
Subsequent Events
Management performed an evaluation of the Fund's activity through the date the
financial statements were issued, noting the following subsequent event:
In October 2021, we received $1.2 million for the cash escrow receivable related
to the sale of PalletOne.
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