EQUUS TOTAL RETURN, INC. Overview
Equus is a BDC that provides financing solutions for privately held middle
market and small capitalization companies. We began operations in 1983 and have
been a publicly traded closed-end fund since 1991. Our investment objective is
to seek the highest total return, consisting of capital appreciation and current
income. Consistent with our announced intention to transform Equus into an
operating company or a permanent capital vehicle, on
As a BDC, we are required to comply with certain regulatory requirements. For
instance, we generally have to invest at least 70% of the Fund's total assets in
"qualifying assets," including securities of private
Investment Income. We generate investment income from interest payable on the debt securities that the Fund holds, dividends received on equity interests in our portfolio companies and capital gains, if any, realized upon sales of equity and, to a lesser extent, debt securities in the investment portfolio. Our equity investments may include shares of common and preferred stock, membership interests in limited liability companies and warrants to purchase additional equity interests. These equity securities may or may not pay dividends, and the exercise prices of warrants that we acquire in connection with debt investments, if any, vary by investment. Our debt investments in portfolio companies may be in the form of senior or subordinated loans and may be unsecured or have a first or second lien on some or all of the assets of the borrower. Our loans typically have a term of three to seven years and bear interest at fixed or floating rates. Interest on these debt securities is generally payable either quarterly or semiannually. Some promissory notes held by the Fund provide that a portfolio company may elect to pay interest in cash or provide that discount interest may accrete in the form of original issue discount or payment-in-kind (PIK) over the life of the notes by adding unpaid interest amounts to the principal balance. Amortization of principal on our debt investments is generally deferred for several years from the date of initial investment. The principal amount of these debt securities and any accrued but unpaid interest generally will become due at maturity. We also earn interest income at market rates on investments in short-term marketable securities. From time to time, we generate income in the form of commitment, origination, structuring, and extension fees in connection with our investments. We recognize all such fees when earned.
Expenses. Currently, our primary operating expenses include director fees and expenses, professional fees, compensation expense, and general and administrative fees. During 2021, 2020 and 2019, we did not incur any non-recurring expenses.
Non-Operating Subsidiary. We have established
Operating Activities. We use cash to make new investments and follow-on
investments in our existing portfolio companies. We record these investments at
cost on the applicable trade date. Realized gains or losses are computed using
the specific identification method. On an ongoing basis, we carry our
investments in our financial statements at fair value, as determined by our
board of directors. See "Critical Accounting Policies - Valuation of
Investments" below. As of
26 Table of Contents
Commitments. Under certain circumstances, we make follow-on investments in some
of our portfolio companies. As of
Financing Activities. From time to time, we use leverage to finance a portion of
our investments. We then repay such debt from the sale of portfolio securities.
Under the 1940 Act, we have the ability to borrow funds and issue debt
securities or preferred stock that are referred to as senior securities, subject
to certain restrictions, including an overall limitation on the amount of
outstanding debt, or leverage, relative to equity of 1.5:1. Because of the
nature and size of our portfolio investments, we periodically borrow funds to
make qualifying investments in order to maintain our qualification as a RIC.
During 2021 and 2020, we borrowed such funds by accessing a margin account with
a securities brokerage firm. We invest the proceeds of these margin loans in
high-quality securities such as
Distributions. So long as we remain a BDC, save for minor exceptions we will continue to pay out net investment income and/or realized capital gains, if any, on an annual basis as required under the 1940 Act.
Possible Share Repurchase. As a closed-end BDC, our shares of common stock are not redeemable at the option of stockholders, and our shares currently trade at a discount to their net asset value. Our Board has determined that it would be in the best interests of our stockholders to reduce or eliminate this market value discount. Accordingly, we have been authorized to, and may from time to time, repurchase shares of our outstanding common stock (including by means of tender offers or privately negotiated transactions) in an effort to reduce or eliminate this market discount or to increase the net asset value of our shares. We are not required to undertake, and we have not previously undertaken, any such share repurchases, nor do we further anticipate taking any such action in 2022.
2016 Equity Incentive Plan
On
27 Table of Contents
Critical Accounting Policies and Estimates
We follow the accounting and reporting guidance in FASB Accounting Standards Codification Topic 946 "Financial Services - Investment Companies." Our financial statements are based on the selection and application of significant accounting policies, which require management to make significant estimates and assumptions. We believe that the following are some of the more critical judgment areas in the application of our accounting policies that currently affect our financial condition and results of operations.
Valuation of Investments
For most of our investments, market quotations are not available. With respect to investments for which market quotations are not readily available or when such market quotations are deemed not to represent fair value, our Board has approved a multi-step valuation process each quarter, as described below:
1. Each portfolio company or investment is reviewed by our investment
professionals;
2. With respect to investments with a fair value exceeding $2.5 million
that have been held for more than one year, we engage independent
valuation firms to assist our investment professionals. These
independent valuation firms conduct independent valuations and make
their own independent assessments;
3. Our Management produces a report that summarizes each of our portfolio
investments and recommends a fair value of each such investment as of
the date of the report;
4. The Audit Committee of our Board reviews and discusses the preliminary
valuation of our portfolio investments as recommended by Management in
their report and any reports or recommendations of the independent
valuation firms, and then approves and recommends the fair values of
our investments so determined to our Board for final approval; and
5. The Board discusses valuations and determines the fair value of each
portfolio investment in good faith based on the input of our
Management, the respective independent valuation firm, as applicable,
and the Audit Committee.
During the first twelve months after an investment is made, we rely on the original investment amount to determine the fair value unless significant developments have occurred during this twelve-month period which would indicate a material effect on the portfolio company (such as results of operations or changes in general market conditions).
Investments are valued utilizing a yield analysis, enterprise value ("EV") analysis, net asset value analysis, liquidation analysis, discounted cash flow analysis, or a combination of methods, as appropriate. The yield analysis uses loan spreads and other relevant information implied by market data involving identical or comparable assets or liabilities. Under the EV analysis, the EV of a portfolio company is first determined and allocated over the portfolio company's securities in order of their preference relative to one another (i.e., "waterfall" allocation). To determine the EV, we typically use a market multiples approach that considers relevant and applicable market trading data of guideline public companies, transaction metrics from precedent M&A transactions and/or a discounted cash flow analysis. The net asset value analysis is used to derive a value of an underlying investment (such as real estate property) by dividing a relevant earnings stream by an appropriate capitalization rate.
For this purpose, we consider capitalization rates for similar enterprises as may be obtained from guideline public companies and/or relevant transactions. The liquidation analysis is intended to approximate the net recovery value of an investment based on, among other things, assumptions regarding liquidation proceeds based on a hypothetical liquidation of a portfolio company's assets. The discounted cash flow analysis uses valuation techniques to convert future cash flows or earnings to a range of fair values from which a single estimate may be derived utilizing an appropriate discount rate. The measurement is based on the net present value indicated by current market expectations about those future amounts.
28 Table of Contents
In applying these methodologies, additional factors that we consider in fair value pricing our investments may include, as we deem relevant: security covenants, call protection provisions, and information rights; the nature and realizable value of any collateral; the portfolio company's ability to make payments; the principal markets in which the portfolio company does business; publicly available financial ratios of peer companies; the principal market; and enterprise values, among other factors. Also, any failure by a portfolio company to achieve its business plan or obtain and maintain its financing arrangements could result in increased volatility and result in a significant and rapid change in its value.
Our general intent is to hold our loans to maturity when appraising our privately held debt investments. As such, we believe that the fair value will not exceed the cost of the investment. However, in addition to the previously described analysis involving allocation of value to the debt instrument, we perform a yield analysis assuming a hypothetical current sale of the security to determine if a debt security has been impaired. The yield analysis considers changes in interest rates and changes in leverage levels of the portfolio company as compared to the market interest rates and leverage levels. Assuming the credit quality of the portfolio company remains stable, the Fund will use the value determined by the yield analysis as the fair value for that security if less than the cost of the investment.
We will record unrealized depreciation on investments when we determine that the fair value of a security is less than its cost basis and will record unrealized appreciation when we determine that the fair value is greater than its cost basis.
Because of the inherent uncertainty of the valuation of portfolio securities
which do not have readily ascertainable market values, amounting to
We adjust our net asset value for the changes in the value of our publicly held
securities, if applicable, and material changes in the value of private
securities, generally determined on a quarterly basis or as announced in a press
release, and report those amounts to
Federal Income Taxes
So long as we maintain our status as a BDC, we intend to comply with the
requirements of the Code necessary for us to qualify as a RIC. So long as we
comply with these requirements, we generally will not be subject to
corporate-level federal income taxes on otherwise taxable income (including net
realized capital gains) distributed to stockholders. As of
Interest Income Recognition
We record interest income, adjusted for amortization of premium and accretion of discount, on an accrual basis to the extent that we expect to collect such amounts. We stop accruing interest on investments when we determine that interest is no longer collectible. We may also impair the accrued interest when we determine that all or a portion of the current accrual is uncollectible. If we receive any cash after determining that interest is no longer collectible, we treat such cash as payment on the principal balance until the entire principal balance has been repaid, before we recognize any additional interest income. We accrete or amortize discounts and premiums on securities purchased over the life of the respective security using the effective yield method. The amortized cost of investments represents the original cost adjusted for the accretion of discount and/or amortization of premium on debt securities.
29 Table of Contents Payment in Kind Interest
We may have loans in our portfolio that may pay PIK interest. We add PIK interest, if any, computed at the contractual rate specified in each loan agreement, to the principal balance of the loan and recorded as interest income. To maintain our status as a RIC, we must pay out to our stockholders this non-cash source of income in the form of dividends even if we have not yet collected any cash in respect of such investments.
Recent Accounting Pronouncements
See the Fund's Accounting Standards Recently Adopted and Accounting Standards Not Yet Adopted from the disclosure set forth in Footnote 9 in the notes to the Financial Statements.
Current Market Conditions
As of
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 third quarter of
2021, had reached an annualized rate of 5.4%. Although a number of commentators
suggested that the price rises would be temporary due to supply and logistical
constraints, the fourth quarter of 2021 saw further increases, with a non-core
annualized rate of inflation of 7.0% by the end of 2021.
Global merger and acquisition activity in 2021 exceeded
Private equity firms experienced a record year in 2021, concluding 8,548
transactions worth
30 Table of Contents
During 2021, our net asset value increased from
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, if 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 the Fund is unable to borrow funds to make qualifying investments, it 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.
The Fund reserves 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 have followed valuation techniques in a consistent manner; however, we are cognizant of current market conditions that might affect future valuations of portfolio securities. 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. If we effect a Consolidation of the Fund as described under "Significant Developments - Authorization to Withdraw BDC Election" above, we may utilize some or a substantial portion of our current liquidity in connection with a contemplated transaction as payment of the purchase price and to pay associated legal, due diligence, accounting, and other fees. Further, we may borrow funds from financial institutions or other providers of debt capital to provide and pay for a part of the consideration and expenses necessary to effect a conversion of Equus into an operating company.
31 Table of Contents
Year Ended
As of
As of
Operating Activities. We provided
Financing Activities. We used
Year EndedDecember 31, 2020
As of
As of
Operating Activities. We provided
Financing Activities. We used
32 Table of Contents Year EndedDecember 31, 2019
As of
As of
Operating Activities. We used
Financing Activities. We provided
Results of Operations Investment Income and Expense
Year Ended
Total income from portfolio securities was
Compensation expense in 2020 was
Professional fees decreased to
General and administrative expenses were comparable from 2020 to 2021, and were
As a result of the factors described above, net investment loss after expenses
was
33 Table of Contents
Year Ended
Total income from portfolio securities was comparable from 2019 to 2020, and
were
Compensation expense in 2019 was
Professional fees increased to
General and administrative expenses were comparable from 2019 to 2020, and were
As a result of the factors described above, net investment loss after expenses
was
Year Ended
Total income from portfolio securities decreased
Compensation expense was comparable from 2018 to 2019, and was
As a result of the factors described above, net investment loss after expenses
was
Summary of Portfolio Investment Activity
Year EndedDecember 31, 2021
During 2021, we made a
The following table includes summarizes investment activity during the year
ended
Investment Activity
New Investments Existing Investments
Equus Energy, LLC $ - $ - $ 350 $ -$ 350 $ - $ - $ 350 $ -$ 350 34 Table of Contents
Year Ended
During 2020, we received 19,164 shares of MVC in the form of stock dividend payments.
During 2020, we made a
The following table includes summarizes investment activity during the year
ended
Investment Activity
New Investments Existing Investments
Portfolio Company Cash Non-Cash Follow-On Non-cash PIK Total
MVC Capital, Inc. $ - $ - $ - $ 156 $ 156
Equus Energy, LLC - - 561 - 561
$ - $ - $ 561 $ 156 $ 717
Year Ended December 31, 2019 During 2019, we received 36,757 shares of MVC in the form of stock dividend payments.
The following table includes summarizes investment activity during the year
ended
Investment Activity
New Investments Existing Investments
Portfolio Company Cash Non-Cash Follow-On PIK Total
MVC Capital, Inc. $ - $ - $ - $ 333 $ 333
$ - $ - $ - $ 333 $ 333
35
Table of Contents
Realized Gains and Losses
Year Ended December 31, 2021 During 2021, we received a combination of escrowed and contingent payments of
Year Ended
During 2020, we liquidated our investment in 5th
Year EndedDecember 31, 2019
During 2019, we dissolved
Changes in Unrealized Appreciation of
Year EndedDecember 31, 2021
During 2021, we recorded an increase of
Year EndedDecember 31, 2020
During 2020, we recorded a decrease of
(i) Transfer of unrealized depreciation to realized loss of our holdings
in MVC of $1.7 million in connection with the sale of our shares of
MVC;
(ii) Transfer of unrealized appreciation to realized gain of our holdings
in PalletOne, Inc. of $26.1 million in connection with the sale of
our common shares of PalletOne, Inc. ; and
(iii) Decrease in the fair value of our holdings in Equus Energy, LLC of
$1.6 million , principally due to decreases in gas prices and
decreases in the short- and long-term forward pricing curve for
oil.
Year Ended December 31, 2019 During 2019, we recorded an increase of
(i) Net increase in the fair value of our shareholding in MVC of $0.5
million due to an increase in the share price of MVC and the receipt
of dividend payments in the form of additional shares of MVC during
the year;
(ii) Increase in fair value of our shareholding in PalletOne, Inc. of
$6.0 million due to improved operating performance;
(iii) Transfer of unrealized depreciation to realized loss of our
holdings in EMDC of $2.8 million in connection with the dissolution
of EMDC and the transfer of its assets to the Fund; and
(iv) Decrease in the fair value of our holdings in Equus Energy, LLC of
$1.0 million , principally due to decreases in gas prices and
decreases in the short- and long-term forward pricing curve for oil.
36
Table of Contents
Portfolio Securities As of
Equus Energy, LLC
We formed Equus Energy, as a wholly-owned subsidiary of the Fund, to make
investments in companies in the energy sector, with particular emphasis on
income-producing oil& gas properties. In
Off Balance Sheet Arrangements
We had an operating lease for office space that expired in
Contractual Obligations
As of
Dividends
So long as we remain a BDC, we will continue to pay out net investment income and/or realized capital gains, if any, on an annual basis as required under the 1940 Act.
Subsequent Events
Our Management performed an evaluation of the Fund's activity through the date the financial statements were issued, noting the following subsequent events:
On
© Edgar Online, source
