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, 2021, 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, 2021 ("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 sole remaining portfolio company, as well as on oil and gas markets
generally. 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. Although this authorization has since
expired, we expect to receive a further authorization from our shareholders as 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
renew their authorization to withdraw our BDC election, 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, 2021.
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 has also affected 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. By the first quarter of 2022, most of these restrictions had been lifted,
although the coronavirus and its derivative strains are still causing
significant disruption in global markets. As of March 31, 2022, the number of
worldwide deaths attributable to the coronavirus stood at over 6.0 million.
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.
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Impact of Geopolitical Events and the Coronavirus on the Oil and Gas Sector. The
substantial volatility in world markets has been prominent in the oil and gas
sector, with crude prices falling to 18-year lows in mid-March 2020 as a result
of the coronavirus pandemic, only to increase to multi-year highs in the first
quarter of 2022, largely as a result of high industrial and consumer demand, a
reluctance of U.S. producers and OPEC nations to generate additional supply, and
the conflict in Ukraine. Meanwhile, gas prices had increased in the third
quarter of 2021 to $5.50 per MMBTU, a level not seen since 2014, then decreased
again to $3.82 per MMBTU by the end of 2021. In the first quarter of 2022 and
thereafter, gas prices have increased sharply, largely as a result of increased
demand combined with the effect of the conflict in Ukraine on short term gas
prices globally. The increased prices for oil and gas, including the forward
pricing curves for these commodities, has improved the outlook and prospects for
remaining small oil and gas firms such as Equus Energy that hold development
rights in low-cost production reservoirs such as those underlying the Permian
Basin and the Eagle Ford Shale regions. Notwithstanding present pricing
conditions and forecasts for the remainder of 2022, 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. U.S. GDP unexpectedly declined at an annualized rate of 1.4%
in the quarter ended March 31, 2022, substantially below the 1.5% annualized
growth predicted by the Conference Board for the period. The principal reasons
for the decrease were declines in fixed investment, defense spending and record
trade imbalances. Nevertheless, most economists are not predicting a recession
in the short term. The first quarter's decrease in GDP followed a 5.7% increase
for all of 2021, the highest annual increase since 1984. The GDP gains in 2021
were largely due to increased consumer spending in the first half of the year
which was partially financed from federal stimulus programs, as well as higher
inventory purchases which drove gains during the last half of the year. However,
decreased consumer spending in late 2021 resulting from the expiration of
stimulus payments and the onset of systemic inflation, which continued into the
first quarter of 2022, has led to significantly lower growth forecasts for the
remainder of 2022. The Conference Board is projecting an overall increase of
3.0% for the entire year, down from its 3.5% projection made in late 2021. The
Congressional Budget Office is predicting 3.7% GDP growth for 2022, although
that figure is also expected to be revised downward (Sources: The Conference
Board, CNBC; Congressional Budget Office).
Employment and Housing. As of March 31, 2022, the U.S. unemployment rate stood
at 3.6%, well below the 6.0% rate of March 31, 2021 and substantially below the
high of 14.5% in April 2020 when economic uncertainty associated with Covid-19
was at its peak. Economists are projecting a stable 3.6% to 3.8% range for the
remainder of 2022. Most of the recent employment gains in 2021 and the first
quarter of 2022 were due to gains in nonfarm payrolls, the leisure and
hospitality industry, professional and business services, retail trade,
transportation, and warehousing (Sources: Bureau of Labor Statistics; Trading
Economics).
Consumer Prices. Consumer prices, which had largely been held in check during
the pandemic, began to rise steadily in the second quarter of 2021 and, by the
end of the first quarter of 2022, had reached an annualized rate of 8.5%, the
highest since 1981. Largely as a result of Fed monetary responses and a slowing
of economic growth, a number of commentators are forecasting a decrease in the
rate of inflation throughout the rest of the year, with price increases expected
to be approximately 5.0% to 6.0% by the end of 2022 (Sources: Kiplingers;
Trading Economics).
Interest Rates. Principally as a response to rising prices, the Federal Reserve
increased the short term federal funds rate by one-half percentage point on May
4, 2022 and is further expected to increase short term rates one half percentage
point in each of its next two meetings. The result has been substantially
increased borrowing costs, particularly for homebuyers and small businesses.
Moreover, credit providers have also begun to require higher collateralization
rates, with shorter maturities and higher fees than in the recent past. (Source:
The Wall Street Journal).
Mergers and Acquisitions. Global merger and acquisition activity in 2021
exceeded $5.0 trillion, an all-time record and $1.4 trillion greater than 2020,
an increase of 38.9%. U.S.-based corporate acquirors, sitting on over $2.0
trillion in cash from higher earnings and funds raised from bond and equity
offerings, were the principal drivers of the acquisition boom, accounting for
over 50.0% of worldwide activity, while private equity firms comprised 27.0% of
this total. Technology and healthcare were the sectors that experienced the most
significant dealmaking activity during the year. Data for the first quarter of
2022 has not yet been released, but many analysts are expecting a slight cooling
of acquisition activity in 2022 resulting from higher interest rates and
heightened geopolitical tensions. (Sources: Reuters; WoltersKluwer).
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Private Equity. Private equity firms experienced a record year in 2021,
concluding 8,548 transactions worth $2.1 trillion, which was more than double
the industry's total for 2020 ($1.0 trillion). Buyouts comprised the largest
component of PE activity, amounting to $1.5 trillion of the total. Technology,
media, and telecommunications were the industries most represented in private
equity transactions in 2021, recording $784.2 billion during the year, almost
double the $404.0 billion for 2020. The number of transactions sharply increased
as well, with 3,268 deals consummated in 2021 versus 1,845 in 2020. At the end
of 2021, private equity firms were in possession of $2.3 trillion in cash
reserves, suggesting that robust dealmaking activity is likely to continue well
into 2022, notwithstanding inflationary pressures and other economic
uncertainties. Data for the first quarter of 2022 is not yet available. However,
the invasion of Ukraine by Russian armed forces in February 2022, combined with
systematic increases in short-term rates by the Federal Reserve that are
expected to continue into the intermediate term is expected to temper private
equity activity in the first quarter of 2022 and perhaps beyond. Transactions by
special purpose acquisition companies (SPACs) had experienced considerable
investor interest and dealmaking activity in 2020 and the beginning of 2021,
with 298 SPAC IPOs in the first quarter of 2021. SPAC IPOs slowed dramatically
during the second and third quarters of 2021 as a result of poor
post-acquisition (de-SPAC) performance and increased regulatory scrutiny.
Although the fourth quarter of 2021 saw a rebound with 166 SPAC IPOs, 60% of the
cash in previously existing SPACs had been returned to investors, and more than
500 SPACs had yet to find a suitable acquisition target. (Sources: The Wall
Street Journal; SPACInsider)
During the three months ended March 31, 2022, our net asset value increased from
$2.69 per share to $2.77 per share, an increase of 2.97%. As of March 31, 2022,
our common stock is trading at a 7.2% discount to our net asset value as
compared to 13.0% as of December 31, 2021.
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.
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.
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Results of Operations
Investment Income and Expense
Net investment loss was $0.9 million for the three months ended March 31, 2022
and $1.0 million March 31, 2021, respectively.
Compensation expense was $0.3 million for the three months ended March 31, 2022
and $0.5 million for the three months ended March 31, 2021, as a result of
bonuses earned in connection with dispositions of certain of the Fund's
portfolio investments in 2021.
Professional liability expenses increased to $0.4 million for the three months
ended March 31, 2022 from $0.3 million for the three months ended March 31,
2021, primarily due to overall increases in liability premiums.
General and administrative expenses were comparable for the three months ended
March 31, 2022 and 2021, and were $0.12 million and $0.08 million respectively.
Realized Gains and Losses on Sales of Portfolio Securities
During the three months ended March 31, 2021, we realized a loss of $0.2 million
from the adjustment of the escrow receivable from the sale of PalletOne, Inc.
Changes in Unrealized Appreciation/Depreciation of Portfolio Securities
During the three months ended March 31, 2022, with respect to our holding in
Equus Energy, LLC, we recorded an increase in the fair value of $2.0 million,
resulting in a net change in unrealized appreciation of $7.0 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 three months ended March 31, 2021, we recorded a net change in
unrealized appreciation of $1.5 million, to a net unrealized appreciation of
$0.9 million. Such change in unrealized appreciation, principally due to
increases in mineral acreage prices and a substantial increase in the short-and
long-term prices for crude oil.
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.
Subsequent Events
Management performed an evaluation of the Fund's activity through the date the
financial statements were issued, noting the following subsequent event:
On April 7, 2022, our holding in $3.0 million in U.S. Treasury Bills matured and
we repaid our margin loan..
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