The accompanying
notes are an integral part of these financial statements.
Substantially all of our portfolio securities
are restricted from public sale without prior registration under the Securities Act of 1933. We negotiate certain aspects of the
method and timing of the disposition of our investment in each portfolio company, including registration rights and related costs.
We may invest up to 30% of our assets in non-qualifying
portfolio investments, as permitted by the 1940 Act. Specifically, we may invest up to 30% of our assets in entities that are not
considered “eligible portfolio companies” (as defined in the 1940 Act), including companies located outside of the
United States, entities that are operating pursuant to certain exceptions under the 1940 Act, and publicly-traded entities with
a market capitalization exceeding $250 million. As of December 31, 2012, except for our holdings in OPG, all of our investments
are in enterprises that are considered eligible portfolio companies under the 1940 Act, and for which we provide significant managerial
assistance.
Our investments in portfolio securities consist
of the following types of securities as of December 31, 2012 (in thousands):
Interest payments are being received and/or
accrued on notes with a fair value of $1.4 million, while accrued interest has been impaired on notes receivable included in secured
and subordinated debt with a fair value of $0.4 million.
The following is a summary by industry of our
investments in portfolio securities as of December 31, 2012 (in thousands):
The accompanying notes are an integral part
of these financial statements.
NOTES TO FINANCIAL STATEMENTS
March 31, 2013
(Unaudited)
|
(1)
|
Description of Business and Basis of Presentation
|
Description of Business
— Equus
Total Return, Inc. (
“we,” “us,” “our,” “Equus,” the
“Company,” and the “Fund
”), a Delaware corporation, was formed by Equus Investments II, L.P.
(the “Partnership”) on August 16, 1991. On July 1, 1992, the Partnership was reorganized and all of the assets and
liabilities of the Partnership were transferred to the Fund in exchange for shares of common stock of the Fund. Our shares trade
on the New York Stock Exchange under the symbol ‘EQS’. On August 11, 2006, our shareholders approved a change of the
Fund’s investment strategy to a total return investment objective. This new strategy seeks to provide the highest total return,
consisting of capital appreciation and current income. In connection with this strategic investment change, the shareholders also
approved the change of name from Equus II Incorporated to Equus Total Return, Inc.
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.
We seek to achieve capital appreciation by making investments in equity and equity-oriented securities issued
by privately-owned 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 Business Development
Company (“BDC”) under the Investment Company Act of 1940 (“1940 Act”). We currently qualify as a regulated
investment company (“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 certain wholly owned taxable subsidiaries (“Taxable
Subsidiaries”) each of which holds one or more portfolio investments listed on our Schedules of Investments. The purpose
of these Taxable Subsidiaries 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 Subsidiaries, 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 Subsidiaries is taxed to the Taxable Subsidiaries and
does not flow through to us, thereby helping us preserve our RIC status and resultant tax advantages. We do not consolidate the
Taxable Subsidiaries for income tax purposes and they may generate income tax expense because of the Taxable Subsidiaries’
ownership of the portfolio investments. We reflect any such income tax expense on our Statements of Operations.
Basis of Presentation
—In accordance
with Article 6 of Regulation S-X under the Securities Act of 1933 and Securities Exchange Act of 1934, we do not consolidate portfolio
company investments, including those in which we have a controlling interest. Our interim unaudited financial statements were prepared
in accordance with accounting principles generally accepted in the United States of America, or GAAP, for interim financial information
and in accordance with the requirements of reporting on Form 10-Q and Article 10 of Regulation S-X, under the Securities Exchange
Act of 1934, as amended. Accordingly, they are unaudited and exclude some disclosures required for annual financial statements.
Management believes it has made all adjustments, consisting solely of normal recurring accruals, necessary for the fair presentation
of these interim financial statements.
The results of operations for the three months
ended March 31, 2013 are not necessarily indicative of results that ultimately may be achieved for the year. The interim unaudited
financial statements and notes thereto should be read in conjunction with the financial statements and notes thereto included in
the Fund’s Form 10-K for the fiscal year ended December 31, 2012, as filed with the Securities and Exchange Commission
(“SEC”).
|
(2)
|
Liquidity and Financing Arrangements
|
Liquidity
—There are several factors
that may materially affect our liquidity during the reasonably foreseeable future. We view this period as the twelve month period
from the date of the financial statements in this Form 10-Q,
i.e
., the period through March 31, 2014.
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.
Cash and Cash Equivalents
—As of
March 31, 2013, we had cash and cash equivalents of $22.8 million. We had $8.6 million of our net assets of $31.4 million invested
in portfolio securities.
As of December 31, 2012, we had cash and cash
equivalents of $23.7 million. We had $9.2 million of our net assets of $32.9 million invested in portfolio securities.
Dividends
— We will pay out net
investment income and/or realized capital gains, if any, on an annual basis as required under the 1940 Act.
Investment Commitments
—As of March
31, 2013, we had no outstanding commitments to our portfolio company investments.
Under certain circumstances, we may be called
on to make follow-on investments in certain portfolio companies. If we do not have sufficient funds to make follow-on investments,
the portfolio company in need of the investment may be negatively impacted. Also, our equity interest in the estimated fair value
of the portfolio company could be reduced.
RIC Borrowings, Restricted Cash and Temporary
Cash Investments
—We may periodically borrow sufficient funds to maintain the Fund’s RIC status 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, we may no longer qualify as a RIC. We would then be subject to corporate
income tax on the Fund’s net investment income and realized capital gains, and distributions to stockholders would be subject
to income tax as ordinary dividends. Failure to continue to qualify as a RIC could be materially adverse to us and our stockholders.
We had no RIC borrowings or restricted cash
as of March 31, 2013 and December 31, 2012, respectively.
Certain Risks and Uncertainties
—
Economic conditions since 2008 and resulting market dislocations have resulted in a significant decline in the availability of
debt and equity. Generally, the limited amount of available debt financing has shorter maturities, higher interest rates and fees,
and more restrictive terms than debt facilities available in the past. In addition, during these years and continuing into the
first three months of 2013, the price of our common stock continued to fall well below our net asset value, thereby making it undesirable
to issue additional shares of our common stock. Because of these challenges, our near-term strategies shifted from originating
debt and equity investments to preserving liquidity necessary to meet our operational needs. Key initiatives that we have previously
undertaken to provide necessary liquidity include monetizations, the suspension of dividends and the internalization of management.
Although we cannot assure you that such initiatives will be sufficient, we believe we have sufficient liquidity to meet our 2013
operating requirements.
|
(3)
|
Significant Accounting Policies
|
The following is a summary of significant accounting
policies followed by the Fund in the preparation of its financial statements:
Use of Estimates
—The preparation
of financial statements in accordance with GAAP requires us to make estimates and assumptions that affect the reported amounts
and disclosures in the financial statements. Although we believe the estimates and assumptions used in preparing these financial
statements and related notes are reasonable in light of known facts and circumstances, actual results could differ from those estimates.
Valuation of Investments
—Portfolio
investments are carried at fair value with the net change in unrealized appreciation or depreciation included in the determination
of net assets. Valuations of portfolio securities are performed in accordance with accounting principles generally accepted in
the United States of America and the financial reporting policies of the SEC. The applicable methods prescribed by such principles
and policies are described below:
Publicly-traded portfolio securities
—Investments
in companies whose securities are publicly traded are generally valued at their quoted market price at the close of business on
the valuation date.
Privately-held portfolio securities
—The
fair value of investments for which no market exists is determined on the basis of procedures established in good faith by our
Board of Directors. As a general principle, the current “fair value” of an investment would be the amount we might
reasonably expect to receive for it upon its current sale, in an orderly manner. Appraisal valuations are necessarily subjective
and the estimated values arrived at by the Fund may differ materially from amounts actually received upon the disposition of portfolio
securities.
Thinly Traded and Over-the-Counter Securities
—Generally,
we value securities that are traded in the over-the-counter market or on a stock exchange at the average of the prevailing bid
and ask prices on the date of the relevant period end. However, we may apply a discount to the market value of restricted or thinly
traded public securities to reflect the impact that these restrictions have on the value of these securities. We review factors,
including the trading volume, total securities outstanding and our percentage ownership of securities to determine whether the
trading levels are active (Level 1) or inactive (Level 2) or unobservable (Level 3). These types of securities represented 16.0%
and 15.4% of our investments in portfolio securities as of March 31, 2013 and December 31, 2012, respectively. We utilized independent
pricing services with certain of our fair value estimates. To corroborate “bid/ask” quotes from independent pricing
services, we perform a market-yield approach to validate prices obtained or obtain other evidence.
During the first twelve months after an investment
is made, the original investment value is utilized 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). After the twelve month period, or if material events have occurred within the twelve month period,
we consider a two-step process when appraising investments of privately held companies. The first step involves determining the
enterprise value of the portfolio company. During this step, we consider three different valuation approaches: a market approach,
an income approach, and an asset approach. The particular facts and circumstances of each portfolio company determine which approach,
or combination of approaches, will be utilized. The second step when appraising equity investments of privately held companies
involves allocating value to the various debt and equity securities of the company. We allocate value to these securities based
on their relative priorities. For equity securities such as warrants, we may also incorporate alternative methodologies including
the Black-Scholes Option Pricing Model.
Market approach
—The market approach
typically employed by our management calculates the enterprise value of a company as a multiple of earnings before interest,
taxes, depreciation and amortization (“EBITDA”) generated by the company for the trailing twelve month period.
Adjustments to the company’s EBITDA, including those for non-recurring items, may be considered. Multiples are estimated
based on current market conditions and past experience in the private company marketplace and are subjective in nature. We will
apply liquidity and other discounts it deems appropriate to equity valuations where applicable. We may also use, when available,
third-party transactions in a portfolio company’s securities as the basis of valuation (the “private market method”).
The private market method will be used only with respect to completed transactions or firm offers made by sophisticated, independent
investors.
Income approach
—The income approach
typically utilized by our management calculates the enterprise value of a company utilizing a discounted cash flow model incorporating
projected future cash flows of the company. Projected future cash flows consider the historical performance of the company
as well as current and projected market participant performance. Discount rates are estimated based on current market conditions
and past experience in the private company marketplace and are subjective in nature. We will apply liquidity and other discounts
we deem appropriate to equity valuations where applicable.
Asset approach
—We consider the
asset approach to determine the fair value of significantly deteriorated investments demonstrating circumstances indicative of
a liquidation analysis. This situation may arise when a portfolio company: 1) cannot generate adequate cash flow to meet the principal
and interest payments on its indebtedness; 2) is not successful in refinancing its debt upon maturity; 3) we believe the credit
quality of a loan has deteriorated due to changes in the business and underlying asset or market conditions which may result in
the company’s inability to meet future obligations; or 4) the portfolio company’s reorganization or bankruptcy. Consideration
is also given as to whether a liquidation event would be orderly or forced.
We base adjustments upon such factors as the
portfolio company’s earnings, cash flow and net worth, the market prices for similar securities of comparable companies,
an assessment of the company’s current and future financial prospects and various other factors and assumptions. In the case
of unsuccessful operations, we may base a portfolio company’s fair value upon the company’s estimated liquidation value.
Fair valuations are necessarily subjective, and management’s estimate of fair value may differ materially from amounts actually
received upon the disposition of its portfolio securities. 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 to determine if a debt security has been impaired.
The Audit Committee of the Board of Directors
may engage independent, third-party valuation firms to conduct independent appraisals and review management’s preliminary
valuations of each privately-held investment in order to make their own independent assessment. Any third-party valuation data
would be considered as one of many factors in a fair value determination. The Audit Committee then would recommend the fair values
for all privately-held securities based on all relevant factors to the Board of Directors for final approval.
Because of the inherent uncertainty of the
valuation of portfolio securities which do not have readily ascertainable market values, amounting to $8.4 million and $9.0 million
as of March 31, 2013 and December 31, 2012, respectively, our fair value determinations may materially differ from the values that
would have been used had a ready market existed for the securities. As of March 31, 2013 and December 31, 2012 respectively, one
of the Fund’s portfolio investments, the 73,666 ordinary shares of Orco Property Group, S.A. (“OPG”), was publicly
listed on the NYSE Euronext Paris Exchange.
On a daily basis, 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 reports those amounts to Lipper Analytical Services,
Inc. Weekly and daily net asset values appear in various publications, including
Barron’s
and
The Wall Street Journal
.
Foreign Exchange
—We record temporary
changes in foreign exchange rates of portfolio securities denominated in foreign currencies as changes in fair value. These changes
are therefore reflected as unrealized gains or losses until realized.
Investment Transactions
—Investment
transactions are recorded on the accrual method. Realized gains and losses on investments sold are computed on a specific identification
basis.
We classify our investments in accordance with
the requirements of the 1940 Act. Under the 1940 Act, “Control Investments” are defined as investments in companies
in which we own more than 25% of the voting securities or maintain greater than 50% representation on the portfolio company’s
governing board. Under the 1940 Act, “Affiliate Investments” are defined as those non-control investments in companies
in which we own between 5% and 25% of the voting securities. Under the 1940 Act, “Non-affiliate Investments” are defined
as investments that are neither Control Investments nor Affiliate Investments.
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.
Payment in Kind Interest (PIK)
—We
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 record it as interest income. To maintain our status as a RIC,
we must pay out to 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.
Cash Flows
—For purposes of the
Statements of Cash Flows, we consider all highly liquid temporary cash investments purchased with an original maturity of three
months or less to be cash equivalents. We include our investing activities within cash flows from operations. We exclude “Restricted
Cash & Temporary Cash Investments” used for purposes of complying with RIC requirements from cash equivalents. See
Note 2 for further discussion of the Fund’s RIC borrowings.
Income Taxes
—We intend to comply
with the requirements of the Internal Revenue 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. Therefore, we did not record a provision for federal income taxes in our financial statements.
We borrow money from time to time to maintain our tax status under the Internal Revenue Code as a RIC. See Note 2 for further
discussion of our RIC borrowings.
All corporations incorporated in the
State of Delaware are required to file an Annual Report and to pay a franchise tax. As a result, we paid Delaware Franchise tax
in the amount of $0.01 million, for the year ended December 31, 2012.
Texas margin tax applies to legal entities
conducting business in Texas. The margin tax is based on our Texas sourced taxable margin. The tax is calculated by applying a
tax rate to a base that considers both revenue and expenses and therefore has the characteristics of an income tax. As a result,
we did not owe state income tax for the year ended December 31, 2012.
Fair Value Measurement
—Fair value
is defined as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between
market participants at the measurement date. We have categorized all investments recorded at fair value based upon the level of
judgment associated with the inputs used to measure their fair value. Hierarchical levels, directly related to the amount of subjectivity
associated with the inputs to fair valuation of these assets and liabilities, are as follows:
Level 1—Inputs are unadjusted, quoted
prices in active markets for identical assets at the measurement date. The types of assets carried at Level 1 fair value generally
are equities listed in active markets.
Level 2—Inputs (other than quoted prices
included in Level 1) are either directly or indirectly observable for the asset in connection with market data at the measurement
date and for the extent of the instrument’s anticipated life. Fair valued assets that are generally included in this category
are warrants held in a public company.
Level 3—Inputs reflect our best estimate
of what market participants would use in pricing the asset at the measurement date. It includes prices or valuations that require
inputs that are both significant to the fair value measurement and unobservable. Generally, assets carried at fair value and included
in this category are debt, warrants and/or other equity investments held in a private company. As previously described, we consider
a two step process when appraising investments of privately held companies. The first step involves determining the enterprise
value of the portfolio company. During this step, we consider three different valuation approaches: a market approach, an income
approach, and a cost approach. The particular facts and circumstances of each portfolio company determine which approach, or combination
of approaches, will be utilized. The second step when appraising equity investments of privately held companies involves allocating
value to the various debt and equity securities of the company. We allocate value to these securities based on their relative priorities.
For equity securities such as warrants, we may also incorporate alternative methodologies including the Black-Scholes Option Pricing
Model. Yield analysis is also employed to determine if a debt security has been impaired.
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.
As of March 31, 2013, investments measured
at fair value on a recurring basis are categorized in the tables below based on the lowest level of significant input to the valuations:
|
|
|
|
Fair Value Measurements as of March 31, 2013
|
(in thousands)
|
|
Total
|
|
Quoted Prices in
Active Markets for
Identical Assets
(Level 1)
|
|
Significant
Other
Observable Inputs
(Level 2)
|
|
Significant
Unobservable
Inputs
(Level 3)
|
Assets
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Investments:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Control investments
|
|
$
|
6,893
|
|
|
$
|
—
|
|
|
$
|
—
|
|
|
$
|
6,893
|
|
Affiliate investments
|
|
|
150
|
|
|
|
—
|
|
|
|
—
|
|
|
|
150
|
|
Non-affiliate investments
|
|
|
1,582
|
|
|
|
202
|
|
|
|
—
|
|
|
|
1,380
|
|
Total investments
|
|
$
|
8,625
|
|
|
$
|
202
|
|
|
$
|
—
|
|
|
$
|
8,423
|
|
As of December 31, 2012, investments measured
at fair value on a recurring basis are categorized in the tables below based on the lowest level of significant input to the valuations:
|
|
|
|
Fair
Value Measurements As of December 31, 2012
|
(in
thousands)
|
|
Total
|
|
Quoted
Prices in
Active Markets for
Identical Assets
(Level 1)
|
|
Significant
Other
Observable Inputs
(Level 2)
|
|
Significant
Unobservable
Inputs
(Level 3)
|
Assets
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Investments:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Control investments
|
|
$
|
7,419
|
|
|
$
|
—
|
|
|
$
|
—
|
|
|
$
|
7,419
|
|
Affiliate investments
|
|
|
150
|
|
|
|
—
|
|
|
|
—
|
|
|
|
150
|
|
Non-affiliate investments
|
|
|
1,663
|
|
|
|
238
|
|
|
|
—
|
|
|
|
1,425
|
|
Total investments
|
|
$
|
9,232
|
|
|
$
|
238
|
|
|
$
|
—
|
|
|
$
|
8,994
|
|
The following table provides a reconciliation
of fair value changes during the three months ended March 31, 2013 for all investments for which we determine fair value using
unobservable (Level 3) factors:
|
|
Fair value measurements using significant unobservable inputs (Level 3)
|
(in thousands)
|
|
Control Investments
|
|
Affiliate Investments
|
|
Non-affiliate Investments
|
|
Total
|
Fair value as of December 31, 2012
|
|
$
|
7,419
|
|
|
$
|
150
|
|
|
$
|
1,425
|
|
|
$
|
8,994
|
|
Change in unrealized appreciation (depreciation)
|
|
|
(616
|
)
|
|
|
—
|
|
|
|
(36
|
)
|
|
|
(652
|
)
|
Purchases of portfolio securities
|
|
|
90
|
|
|
|
—
|
|
|
|
—
|
|
|
|
90
|
|
Proceeds from sales/dispositions
|
|
|
—
|
|
|
|
—
|
|
|
|
(9
|
)
|
|
|
(9
|
)
|
Fair value as of March 31, 2013
|
|
$
|
6,893
|
|
|
$
|
150
|
|
|
$
|
1,380
|
|
|
$
|
8,423
|
|
The following table provides a reconciliation
of fair value changes during the three months ended March 31, 2012 for all investments for which we determine fair value using
unobservable (Level 3) factors:
|
|
Fair value measurements using significant unobservable inputs (Level 3)
|
(in thousands)
|
|
Control Investments
|
|
Affiliate Investments
|
|
Non-affiliate Investments
|
|
Total
|
Fair value as of December 31, 2011
|
|
$
|
13,298
|
|
|
$
|
150
|
|
|
$
|
5,734
|
|
|
$
|
19,182
|
|
Change in unrealized appreciation (depreciation)
|
|
|
(13
|
)
|
|
|
—
|
|
|
|
14
|
|
|
|
1
|
|
Proceeds from sales/dispositions
|
|
|
(70
|
)
|
|
|
—
|
|
|
|
—
|
|
|
|
(70
|
)
|
Fair value as of March 31, 2012
|
|
$
|
13,215
|
|
|
$
|
150
|
|
|
$
|
5,748
|
|
|
$
|
19,113
|
|
Significant Unobservable Inputs
—
Our investment portfolio is not composed of homogeneous debt and equity securities that can be valued with a small number of inputs.
Instead, the majority of our investment portfolio is composed of complex debt and equity securities with distinct contract terms
and conditions. As such, our valuation of each investment in our portfolio is unique and complex, often factoring in numerous different
inputs, including historical and forecasted financial and operational performance of the portfolio company, project cash flows,
market multiples comparable market transactions, the priority of our securities compared with those of other investors, credit
risk, interest rates, independent valuations and reviews and other inputs.
The following table summarizes the significant
observable inputs in the fair value measurements of our level 3 investments by category of investment and valuation technique as
of March 31, 2013:
|
|
|
|
|
|
|
|
Range
|
(in thousands)
|
|
Fair Value
|
|
Valuation Techniques
|
|
Unobservable Inputs
|
|
Minimum
|
|
Maximum
|
Secured and subordinated debt
|
|
$
|
1,504
|
|
|
Yield Analysis
|
|
Market interest rate
|
|
|
5.4
|
%
|
|
|
12.4
|
%
|
|
|
|
|
|
|
Pending Transaction
|
|
Discount for lack of marketability
|
|
|
5
|
%
|
|
|
15
|
%
|
|
|
|
|
|
|
Asset Approach
|
|
Recovery rate
|
|
|
0
|
%
|
|
|
100
|
%
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Common stock
|
|
|
150
|
|
|
Pending Transaction
|
|
Discount
|
|
|
0
|
%
|
|
|
100
|
%
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Limited liability company investments
|
|
|
6,769
|
|
|
Asset Approach
|
|
Recovery rate
|
|
|
0
|
%
|
|
|
100
|
%
|
|
|
$
|
8,423
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
(4)
|
Related Party Transactions and Agreements
|
Except as noted below, as compensation for
services to the Fund, each Independent Director receives an annual fee of $20,000 paid quarterly in arrears, a fee of $2,000 for
each meeting of the Board of Directors attended in person, a fee of $1,000 for participation in each telephonic meeting of the
Board and a fee of $1,000 for each committee meeting attended, and reimbursement of all out-of-pocket expenses relating to attendance
at such meetings. A quarterly fee of $15,000 is paid to the Chairman of the Audit Committee and a quarterly fee of $3,750 is paid
to the Chairman of the Independent Directors. We may also pay other one-time or recurring fees to members of our Board of Directors
in special circumstances. None of our interested directors receive annual fees for their service on the Board of Directors.
In November, 2011, Equus Energy, LLC, a wholly-owned
subsidiary of the Fund, entered into a consulting agreement with Global Energy Associates, LLC (“Global Energy”) to
provide consulting services for energy related investments. Henry W. Hankinson, Director, is a managing partner and co-founder
of Global Energy. Payments to Global Energy totaled $18,750 for each of the three months ended March 31, 2013 and 2012.
In respect of services provided to the Fund
by members of the Board not in connection with their roles and duties as directors, the Fund pays a rate of $250 per hour for services
rendered.
We will pay out net investment income and/or
realized capital gains, if any, on an annual basis as required under the 1940 Act.
During the three months ended March 31,
2013, we capitalized legal and consulting expenses of $0.1 million relating to Spectrum Management. We also received a
semi-annual interest payment of $0.03 million and a 5.75% partial principal repayment of $9,000 in respect of our €1.2
million [$1.5 million] in OPG notes.
During the three months ended March 31, 2013,
we did not realize any significant gains or losses on sales of portfolio securities.
Net unrealized depreciation on investments
increased $0.7 million during the three months ended March 31, 2013, to a net unrealized depreciation of $17.9 million. Such
decrease in unrealized depreciation is largely due to the following changes:
|
(i)
|
Decrease in fair value of Equus Energy LLC of $0.2 million due to operating expenses
.
|
|
(ii)
|
Decrease in fair value of OPG of $0.1 million due to a decline in stock price and
foreign exchange translation.
|
|
(iii)
|
Decrease in fair value of Spectrum Management, Inc. (“Spectrum”) of
$0.4 million due to adecline in operating performance.
|
During the three months ended March 31, 2012,
we made no follow-on investments, nor realized any significant gains or losses on sales of portfolio securities.
Net unrealized depreciation on investments
remained relatively unchanged during the three months ended March 31, 2012, at a net unrealized depreciation of $17.4 million.
Such decrease in depreciation is largely due to the following changes:
|
(i)
|
Increase in fair market value of ConGlobal Industries Holding, Inc. (“ConGlobal”)
of $0.3 million due to improved productivity.
|
|
(ii)
|
Decrease in the fair market value of Spectrum of $0.2 million due to the continued decline in
operating performance and liquidity issues.
|
Equus Energy, LLC (“Equus
Energy”) was formed in November 2011 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 December 2011, we contributed
$250,000 to the capital of Equus Energy.
On December 27, 2012 we invested an additional $6.8
million in Equus Energy for the purpose of additional working capital and to fund the purchase of $6.6 million in working
interests in 150 producing and non-producing oil and gas wells. The working interests include associated development rights of approximately 23,000 acres situated on 15
separate properties in Texas and Oklahoma. The working interests range from a
de minimus
amount to 50% of the
leasehold that includes these wells.
The wells are operated by a number of experienced
operators, including a major multinational oil and gas conglomerate which has operating responsibility for all of Equus Energy’s
40 producing well interests located in the Conger Field, a productive oil and gas field on the edge of the Permian Basin that
has experienced successful gas and hydrocarbon extraction in multiple formations. Equus Energy, which holds a 50% working interest
in each of these Conger Field wells, has partnered with the operator in an aggressive recompletion program of existing Conger
Field wells to the Wolfcamp formation, a zone containing oil as well as gas and natural gas liquids. One recompletion has been
effected since the closing date of the acquisition, with additional recompletions scheduled for the remainder of 2013 and beyond.
Part of Equus Energy’s acreage rights described above also includes a 50% working interest in possible new drilling to the
base of the Canyon formation (appx. 8,500 feet) on 2,400 acres in the Conger Field. Also included in the interests acquired by
Equus Energy are working interests of 7.5% and 2.5% in the Burnell and North Pettus Units, respectively, which collectively comprise
approximately 13,000 acres are located in the area known as the “Eagle Ford Shale” play.
We do
not consolidate Equus Energy or its wholly owned subsidiaries and accordingly only the value of our investment in Equus
Energy is included on our statement of assets and liabilities. Our investment in Equus Energy is valued in accordance with
our normal valuation procedures and is based on the values of the underlying assets held by EQS Energy Holdings, Inc. a
wholly-owned subsidiary of Equus Energy, net of associated liabilities.
Below is summarized consolidated
financial information for Equus Energy as of March 31, 2013 and December 31, 2012 and for the three months ended March 31,
2013 (in thousands).
|
|
As of
|
|
|
March 31, 2013
|
|
December 31, 2012
|
|
|
(unaudited)
|
|
(unaudited)
|
|
|
|
|
|
ASSETS
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Current assets
|
|
$
|
1,011
|
|
|
$
|
628
|
|
|
|
|
|
|
|
|
|
|
Oil and gas properties, net
|
|
|
6,930
|
|
|
|
6,899
|
|
|
|
|
|
|
|
|
|
|
TOTAL ASSETS
|
|
$
|
7,941
|
|
|
$
|
7,527
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
LIABILITIES AND MEMBERS' CAPITAL
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Current liabilities
|
|
$
|
1,144
|
|
|
$
|
499
|
|
|
|
|
|
|
|
|
|
|
Asset retirement obligations
|
|
|
174
|
|
|
|
173
|
|
TOTAL LIABILITIES
|
|
|
1,318
|
|
|
|
672
|
|
|
|
|
|
|
|
|
|
|
MEMBERS' CAPITAL
|
|
$
|
6,623
|
|
|
$
|
6,855
|
|
|
|
|
|
|
|
|
|
|
|
TOTAL LIABILITIES AND MEMBERS' CAPITAL
|
|
$
|
7,941
|
|
|
$
|
7,527
|
|
|
Revenue and direct operating expenses
for the various oil and gas assets included in the accompanying statements represent the net
collective working and revenue interests acquired by Equus Energy. The revenue and direct operating
expenses presented herein relate only to the interests in the producing oil and natural gas properties and do not represent all of the oil and natural gas operations of all of these properties.
Direct operating expenses include lease operating expenses and production and other related taxes. General and
administrative expenses, depreciation, depletion and amortization (“DD&A”) of oil and gas
properties and federal and state taxes have been excluded from direct operating expenses in the accompanying
statements of revenues and direct operating expenses because the allocation of certain expenses would be
arbitrary and would not be indicative of what such costs would have been had Equus Energy been operated as
a stand alone entity.
The statements of revenues and direct operating expenses
presented are not indicative of the financial condition or results of operations of Equus Energy on a
go forward basis due to changes in the business and the omission of various operating expenses.
|
|
Three months ended
|
|
|
March 31, 2013
|
|
|
(unaudited)
|
|
|
|
OPERATING REVENUES:
|
|
|
|
|
Total operating revenue
|
|
$
|
605
|
|
|
|
|
|
|
OPERATING EXPENSES:
|
|
|
|
|
Direct operating expenses
|
|
|
328
|
|
OPERATING PROFIT
|
|
|
277
|
|
|
|
|
|
|
Depletion, depreciation and amortization
|
|
|
322
|
|
General and administrative
|
|
|
187
|
|
|
|
|
|
|
NET INCOME (LOSS)
|
|
$
|
(232
|
)
|
Critical
Accounting Policies for Equus Energy
—Equus Energy and its wholly-owned subsidiary EQS Energy Holdings, Inc.
(collectively “the Company”) follow the
Full Cost Method of Accounting
for oil and gas properties. Under
the full cost method, all costs associated with property acquisition, exploration, and development activities are
capitalized. Capitalized costs include lease acquisitions, geological and geophysical work, delay rentals, costs of drilling,
completing and equipping successful and unsuccessful oil and gas wells and directly related costs. Gains or losses are
normally not recognized on the sale or other disposition of oil and gas properties. Gains or losses are normally reflected
as an adjustment to the full cost pool.
The
capitalized costs of oil and gas properties, plus estimated future development costs relating to proved reserves and
estimated cost of dismantlement and abandonment, net of salvage value, are amortized on a unit-of-production method over the
estimated productive life of the proved oil and gas reserves. Unevaluated oil and gas properties are excluded from this
calculation. Depletion and depreciation expense for the Company’s oil and gas properties totaled $0.3 million for
the quarter ending March 31, 2013.
Capitalized
oil and gas property costs are limited to an amount (the ceiling limitation) equal to the sum of the following:
(a)
As of March 31, 2013 the present value of estimated future net revenue from the projected production of proved oil and gas reserves,
calculated at the simple arithmetic average, first-day-of-the-month prices during the twelve-month period before the balance sheet
date (with consideration of price changes only to the extent provided by contractual arrangements) and a discount factor
of 10%;
(b)
The cost of investments in unproved and unevaluated properties excluded from the costs being amortized; and
(c)
The lower of cost or estimated fair value of unproved properties included in the costs being amortized.
When
it is determined that oil and gas property costs exceed the ceiling limitation, an impairment charge is recorded to reduce its
carrying value to the ceiling limitation. The Company did not recognize an impairment loss on their oil and gas properties
during 2012 or during the three months ended March 31, 2013.
The costs
of certain unevaluated leasehold acreage and certain wells being drilled are not amortized. The Company excludes all costs until
proved reserves are found or until it is determined that the costs are impaired. Costs not amortized are periodically assessed
for possible impairments or reductions in value. If a reduction in value has occurred, costs being amortized are increased.
Revenue Recognition—
Revenues
are recognized for oil and natural gas sales under the sales method of accounting. Under this method, revenues are recognized
on production as it is taken and delivered to its purchasers. The volumes sold may be more or less than the volumes entitled to,
based on the owner’s net interest in the Assets. These differences result from production imbalances, which are not significant,
and are reflected as adjustments to prove reserves and future cash flows in the unaudited supplementary oil and gas information
included herein.
Accounting Policy on
Depletion—
The Company employs the Units of Production method whereby depletion of proved oil and gas properties is
computed on the units-of-production method, where capitalized costs, as adjusted for future development costs and asset
retirement obligations, are amortized over the total estimated proved reserves.
Asset Retirement Obligations—
The
fair value of asset retirement obligations are recorded in the period in which they are incurred if a reasonable estimate of fair
value can be made, and the corresponding cost is capitalized as part of the carrying amount of the related long-lived asset.
The fair value of the asset retirement obligation is measured using expected future cash outflows discounted at the Company’s
credit-adjusted risk-free interest rate. Fair value, to the extent possible, should include a market risk premium for unforeseeable
circumstances. No market risk premium was included in the Company’s asset retirement obligation fair value estimate
since a reasonable estimate could not be made. The liability is accreted to its then present value each period, and the
capitalized cost is depleted or amortized over the estimated recoverable reserves using the units-of-production method.
Management performed an evaluation of the Fund’s
activity through the date the financial statements were issued, noting no subsequent events.