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.
As defined in the Investment Company
Act of 1940, all of our investments are in eligible portfolio companies. We provide significant managerial assistance to portfolio
companies that comprise 100% of the total value of the investments in portfolio securities as of December 31, 2012.
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
DECEMBER 31, 2013, 2012 AND 2011
(1) ORGANIZATION AND BUSINESS PURPOSE
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 the 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 prudent to continue to review alternatives to refine
and further clarify the current strategies.
We elected to be treated as a 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 companies. We reflect
any such income tax expense on our Statements of Operations.
(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-K,
i.e
., the period through December 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 expenditures through the next twelve months.
As of December 31, 2013, we had cash
and cash equivalents of $19.1 million. We had $13.5 million of our net assets of $33.2 million invested in portfolio securities.
We also had $15.2 million of restricted cash and temporary cash investments, including primarily the proceeds of a quarter-end
margin loan that we incurred to maintain the diversification requirements applicable to a RIC to maintain our pass-through tax
treatment. Of this amount, $15.0 million was invested in U.S. Treasury bills and $0.2 million represented a required 1% brokerage
margin deposit. These securities were held by a securities brokerage firm and pledged along with other assets to secure repayment
of the margin loan. The U.S. Treasury bills were sold on January 2, 2014 and we subsequently repaid this margin loan. The margin
interest was paid on January 22, 2014.
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.
As of December 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 and Temporary Cash
Investments
—During 2013 and 2012, we borrowed 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 material to us and our stockholders.
As of December 31, 2013, we borrowed
$15.0 million to make qualifying investments to maintain our RIC status by utilizing a margin account with a securities brokerage
firm. We collateralized such borrowings with restricted cash and temporary cash investments in U.S. Treasury bills of $15.2 million.
The U.S. Treasury bills were sold on January 2, 2014 and the total amount borrowed was repaid at that time. The margin interest
was paid on January 22, 2014.
We had no RIC borrowings or restricted
cash as of December 31, 2012.
Economic Conditions
— Economic
conditions since the second quarter of 2008 and market dislocations have resulted in the availability of debt and equity capital
declining significantly for smaller enterprises. 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 2013
the price of our common stock continued to trade 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 undertook over the past several years
to provide necessary liquidity included monetizations and the utilization of non-cash resources of the Fund to make portfolio investments.
Although there can be no assurances that such initiatives will be sufficient, we believe we have sufficient liquidity to meet our
2014 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 Securities and Exchange Commission (“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). As of December 31,
2013, these securities represented 11.0% of our investments in portfolio securities. 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 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 as deemed 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
as deemed 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 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 or substantially declining operations, we may base a portfolio company’s fair value upon the company’s
estimated liquidation value. Fair valuations are necessarily subjective, and our 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. Certificates of deposit purchased by the Fund generally
will be valued at their face value, plus interest accrued to the date of valuation.
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 $13.3 million and $9.0 million as of December 31, 2013 and 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 December 31,
2013, one of our portfolio investments, consisting of 73,666 ordinary shares of OPG, was publicly listed on the NYSE Euronext
Paris Exchange, along with €1,200,790 in newly-issued 6-year OPG Notes, however, as of December 31, 2013, there had been
no recent trading activity in the OPG Notes.
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
.
Deferred Offering Costs—
Accumulation
of costs related to the offering whereby we will sell additional shares or rights to acquire shares at a market price that may
have been below net asset value. The main components of the costs are legal fees and consultant’s fees specifically related
to the offering.
Offering costs of $0.4 million were
expensed at September 30, 2011, due to the delay in completing an offering to issue new shares.
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 EQS owns more than 25% of the voting securities or maintains greater than 50% of the board representation. 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 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. 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 it recognizes any additional interest
income.
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 recorded 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.
Income Taxes
—We intend
to comply with the requirements of the Internal Revenue Code necessary to qualify as a regulated investment company and, as such,
will not be subject to federal income taxes on otherwise taxable income (including net realized capital gains) which is distributed
to stockholders. Therefore, no provision for federal income taxes is recorded in the 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 the Fund’s
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, $0.01 million and $0.01 million for the years ended December 31, 2013, December 31, 2012 and December
31, 2011, respectively.
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 years ended December 31, 2013, December 31, 2012, and December 31, 2011 respectively.
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 December 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 December 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
|
|
$
|
11,105
|
|
|
$
|
—
|
|
|
$
|
—
|
|
|
$
|
11,105
|
|
Affiliate investments
|
|
|
250
|
|
|
|
—
|
|
|
|
—
|
|
|
|
250
|
|
Non-affiliate investments
|
|
|
2,149
|
|
|
|
169
|
|
|
|
—
|
|
|
|
1,980
|
|
Total investments
|
|
|
13,504
|
|
|
|
169
|
|
|
|
—
|
|
|
|
13,335
|
|
Temporary
cash investments
|
|
|
15,000
|
|
|
|
15,000
|
|
|
|
—
|
|
|
|
—
|
|
Total investments and temporary cash investments
|
|
$
|
28,504
|
|
|
$
|
15,169
|
|
|
$
|
—
|
|
|
$
|
13,335
|
|
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 2013 for all investments for which we determine fair value using significant unobservable (Level 3)
inputs:
|
|
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
|
|
Realized losses
|
|
|
—
|
|
|
|
—
|
|
|
|
(9,795
|
)
|
|
|
(9,795
|
)
|
Change in unrealized depreciation
|
|
|
3,376
|
|
|
|
100
|
|
|
|
9,859
|
|
|
|
13,335
|
|
Purchases of portfolio securities
|
|
|
310
|
|
|
|
—
|
|
|
|
500
|
|
|
|
810
|
|
Proceeds from sales/dispositions
|
|
|
—
|
|
|
|
—
|
|
|
|
(9
|
)
|
|
|
(9
|
)
|
Fair value as of December 31, 2013
|
|
$
|
11,105
|
|
|
$
|
250
|
|
|
$
|
1,980
|
|
|
$
|
13,335
|
|
The following table provides a reconciliation
of fair value changes during 2012 for all investments for which we determine fair value using significant unobservable (Level 3)
inputs:
|
|
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
|
|
Realized losses
|
|
|
(5,187
|
)
|
|
|
—
|
|
|
|
—
|
|
|
|
(5,187
|
)
|
Change in unrealized depreciation
|
|
|
1,996
|
|
|
|
—
|
|
|
|
(282
|
)
|
|
|
1,714
|
|
Purchases of portfolio securities
|
|
|
6,939
|
|
|
|
—
|
|
|
|
301
|
|
|
|
7,240
|
|
Proceeds from sales/dispositions
|
|
|
(9,627
|
)
|
|
|
—
|
|
|
|
—
|
|
|
|
(9,627
|
)
|
Transfers in (out) of Level 3
|
|
|
—
|
|
|
|
—
|
|
|
|
(4,328
|
)
|
|
|
(4,328
|
)
|
Fair value as of December 31, 2012
|
|
$
|
7,419
|
|
|
$
|
150
|
|
|
$
|
1,425
|
|
|
$
|
8,994
|
|
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 non-observable
inputs in the fair value measurements of our level 3 investments by category of investment and valuation technique as of December
31, 2013:
|
|
|
|
|
|
|
|
Range
|
(in thousands)
|
|
Fair Value
|
|
Valuation Techniques
|
|
Unobservable Inputs
|
|
Minimum
|
|
Maximum
|
Secured and subordinated debt
|
|
$
|
4,869
|
|
|
Yield Analysis
|
|
Market interest rate
|
|
|
2.5
|
%
|
|
|
10.5
|
%
|
|
|
|
|
|
|
Yield Analysis
|
|
Discount for lack of marketability
|
|
|
2.5
|
%
|
|
|
12.0
|
%
|
|
|
|
|
|
|
Pending Transaction
|
|
Discount for lack of marketability
|
|
|
7.2
|
%
|
|
|
25
|
%
|
|
|
|
|
|
|
Pending Transaction
|
|
Control Premium
|
|
|
12
|
%
|
|
|
171
|
%
|
|
|
|
|
|
|
New Transation
|
|
Discount
|
|
|
0
|
%
|
|
|
100
|
%
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Common stock
|
|
|
250
|
|
|
Pending Transaction
|
|
Discount
|
|
|
0
|
%
|
|
|
100
|
%
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Asset Approach
|
|
Recovery Rate
|
|
|
0
|
%
|
|
|
100
|
%
|
Limited liability company investments
|
|
|
8,216
|
|
|
Income/Market Approach
|
|
Reserve Adjustment Factors
|
|
|
75
|
%
|
|
|
100
|
%
|
|
|
$
|
13,335
|
|
|
|
|
|
|
|
|
|
|
|
|
|
(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 June, 2010, the Fund ratified and approved the use of
A+ Filings, LLC (“A+ Filings”) to file its reports with the Securities and Exchange Commission. The Fund incurred $7,000
and $14,000 in services rendered by A+ Filings for the years ended December 31, 2012 and 2011, respectively. Mr. Kenneth I. Denos,
Secretary of the Fund, held a majority of the voting shares of A+ Filings; however, Mr. Denos sold his interest in A+ Filings in
March 2013.
On December 20, 2010, our board of directors approved a consulting
agreement ("Consulting Agreement") with John A. Hardy, the Fund's Chief Executive Officer. The Consulting Agreement
provides for base compensation to Mr. Hardy of $200,000 per annum and an annual bonus based upon achievement of certain criteria.
The bonus is subject to an annual payout cap of $150,000, and any bonus earned that exceeds the payout cap will be carried over
into subsequent fiscal years. If the Consulting Agreement is terminated without cause, as defined therein, Mr. Hardy will
be entitled to receive one year's base consulting fee, together with all bonuses earned and unpaid and unpaid up to the date of
termination. Mr. Hardy is not entitled to participate in any employee-related benefits, including health, life and disability
plans, of the Fund. For the years ended December 31, 2012 and 2013, Mr. Hardy’s compensation totaled $350,000 in each
of these years, which included a $150,000 bonus in accordance with this agreement. Mr. Hardy has permanently waived his right
to $873,211 of earned but unpaid bonus under the Consulting Agreement for fiscal 2012 and has further permanently waived his right
to $5,618 of earned but unpaid bonus in connection with activities of the Fund for fiscal 2013.
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. For each of the years ended December 31, 2013 and 2012, payments to Global Energy totaled $75,000.
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. In connection with services rendered by Kenneth I. Denos, Secretary and Chief Compliance Officer
of the Fund, the Fund incurred $344,562 as of December 31, 2013, which is included as compensation expense. In connection
with services rendered by Mr. Denos in 2012, the Fund incurred $249,813 which is included in compensation expense as of December
31, 2012 statement of operations.
(5) FEDERAL INCOME
TAX MATTERS
As a Regulated Investment Company,
our tax liability is dependent upon whether an election is made to distribute taxable investment income and capital gains above
any statutory requirement. As we incurred losses in 2011, 2012 and 2013 no distributions were required or made.
The Internal Revenue Service approved
our request, effective October 31, 1998, to change our year-end for determining capital gains for purposes of Section 4982
of the Internal Revenue Code from December 31 to October 31.
For the year ended December 31, 2013,
we have a net investment loss for book purposes of $3.1 million and $3.1 million for tax purposes. During 2013, we had a net capital
loss for book purposes of $9.8 million and a net capital loss for tax purposes of $9.8 million for tax purposes.
The aggregate book cost of
investments as of December 31, 2013 was $17.5 million. These investments had unrealized appreciation of approximately
$1.8 million and unrealized depreciation of $5.8 million for book purposes, resulting in unrealized depreciation of
approximately $4.0 million. The Fund had unrealized appreciation of approximately $1.9 million and unrealized depreciation of
approximately $2.9 million for tax purposes, resulting in net unrealized depreciation of approximately $1 million as of
December 31, 2013. As of December 31, 2013, we had approximately $ 32.5 million in Capital losses of which $15.6 million
will begin expiring after 2017, and the remaining $16.9 million can be carried over indefinitely.
The Return of Capital Statement of Position,
for the three years ended December 31, 2013, includes a reclassification for permanent book to tax differences of less than $1,000
in each year. These differences were primarily due to the tax exempt interest income received. The adjustments resulted in a net
decrease in accumulated earnings. The reclassification has no effect on net assets.
For the year ended December 31, 2012,
we have a net investment loss for book purposes of $2.7 million and $3.2 million for tax purposes. During 2012, we had a net capital
loss for book purposes of $2.8 million and a net capital loss for tax purposes of $6.3 million for tax purposes. The aggregate
book cost of investments as of December 31, 2012 was $23.3 million. Such investments had unrealized appreciation of approximately
$0 .8 million and unrealized depreciation of $18.0 million for book purposes, resulting in net unrealized depreciation of approximately
$17.2 million. The Fund had unrealized appreciation of approximately $1.0 million and unrealized depreciation of approximately
$15.2 million for tax purposes, resulting in net unrealized depreciation of approximately $14.2 million as of December 31,
2012. As of December 31, 2012, we had approximately $22.7 million in Capital losses of which $15.6 million will begin expiring
after 2017, and the remaining $7.1 million can be carried over indefinitely.
For the year ended December 31, 2011,
we have a net investment loss for book purposes of $3.5 million and $4.9 million for tax purposes. During 2011, we had a net capital
loss for book purposes of $10.9 million and a net capital loss for tax purposes of $0.8 million for tax purposes. The aggregate
book cost of investments as of December 31, 2011 was $33.6 million. Such investments had unrealized appreciation of approximately
$ 2.7 million and unrealized depreciation of $20.1 million for book purposes, resulting in net unrealized depreciation of approximately
$17.4 million. The Fund had unrealized appreciation of approximately $2.8 million and unrealized depreciation of approximately
$17.1 million for tax purposes, resulting in net unrealized depreciation of approximately $14.3 million as of December 31,
2011. As of December 31, 2011, we had approximately $16.4 million in Capital losses of which $15.6 million will expire after 2017,
and the remaining $0.8 million can be carried over indefinitely.
We believe that any aggregate exposure
for uncertain tax positions should not have a material impact on our financial statements as of December 31, 2013 or December 31,
2012. An uncertain tax position is measured as the largest amount of tax return benefits that does not have a greater than 50%
likelihood of being realized upon ultimate settlement. We have not recorded an adjustment to our financial statements related to
any uncertain tax positions. We will continue to evaluate our tax positions and recognize any future impact of uncertain tax positions
as a charge to income in the applicable period in accordance with promulgated standards.
The Fund’s accounting policy related
to income tax penalties and interest assessments is to accrue for these costs and record a charge to expenses during the period
that the Fund records a benefit for an uncertain tax position until resolution is achieved with the taxing authorities or the expiration
of the applicable statute of limitations.
The Fund’s accounting policy
related to income tax penalties and interest assessments is to accrue for these costs and record a charge to expenses during the period that the Fund takes an uncertain tax position through resolution with the taxing authorities or
expiration of the applicable statute of limitations.
All of the Fund’s
federal and state income tax returns for 2009 through 2012 remain open to examination. We believe that there are no tax
positions taken or expected to be taken that would significantly increase or decrease unrecognized tax benefits within 12
months of the reporting date.
(6) CONTRACTUAL OBLIGATIONS
We have operating leases for office
space and office equipment. The lease for office space expires in 2014. The lease also contains a provision for certain annual
rental escalations. Rent expense inclusive of common area maintenance costs was $85,000,
$84,000, and $81,000 for each of the years ended December 31, 2013, 2012 and 2011, respectively. Future minimum lease payments
under the operating lease as of December 31, 2013 for the year ended December 31, 2014 is $42,000.
As of December 31, 2013, we had no outstanding
commitments to our portfolio company investments.
(7) DIVIDENDS
On March 24, 2009, we announced that
we suspended our managed distribution policy and payment of quarterly distributions for an indefinite period. We will continue
to 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.
(8) PORTFOLIO SECURITIES
2013 Portfolio Activity
During the year ended December 31, 2013,
we had investment activity of $0.8 million in two portfolio companies. We capitalized consulting expenses of $0.3 million relating
to Spectrum Management. We made a short-term working capital loan of $0.5 million to Security Monitor Holdings, LLC (“SMH”).
SMH is a company which specializes in managing and improving operations of distressed companies.
The following table includes significant investment activity
during the year ended December 31, 2013 (in thousands):
|
|
Investment Activity
|
|
|
|
|
New Investments
|
|
Existing Investments
|
|
|
Portfolio Company
|
|
Cash
|
|
Non-Cash
|
|
Follow-On
|
|
PIK
|
|
Total
|
|
|
|
|
|
|
|
|
|
|
|
Security Monitor Holdings, Inc.
|
|
$
|
500
|
|
|
$
|
—
|
|
|
$
|
—
|
|
|
$
|
—
|
|
|
$
|
500
|
|
Spectrum Management, LLC
|
|
|
—
|
|
|
|
—
|
|
|
|
310
|
|
|
|
—
|
|
|
|
310
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
$
|
500
|
|
|
$
|
—
|
|
|
$
|
310
|
|
|
$
|
—
|
|
|
$
|
810
|
|
During 2013, we realized net capital
losses of $9.8 million, including the following significant transactions:
Portfolio Company
|
|
Industry
|
|
Type
|
|
Transaction Type
|
|
Realized Gain (Loss)
|
The Bradshaw Group
|
|
Business products and services
|
|
Non-affiliate
|
|
|
Disposition
|
|
$
|
(1,795
|
)
|
Infinia Corporation
|
|
Alternative Energy
|
|
Non-affiliate
|
|
|
Disposition
|
|
|
(8,000
|
)
|
|
|
|
|
|
|
|
|
|
|
$
|
(9,795
|
)
|
During 2013, we recorded a net
change in unrealized depreciation of $13.3 million, to a net unrealized depreciation of $3.9 million at December 31, 2013.
Such change in depreciation resulted primarily from the following changes:
(i)
|
|
Transfer of unrealized depreciation to realized loss of our holdings in Bradshaw of $1.8 million in connection with Bradshaw’s sale of all of its assets;
|
(ii)
|
|
Transfer of unrealized depreciation to realized loss of our holdings in Infinia of $8.0 million as a result of the liquidation of Infinia due to bankruptcy proceedings initiated by the company;
|
(iii)
|
|
Increase in the fair value of Equus Energy of $1.1 million due improved operational results and an increase in proved developed producing reserves;
|
(iv)
|
|
Increase in the fair value of our holdings in Spectrum of $2.5 million due to continued stability in operations resulting in the utilization of a market approach in determining fair value, in lieu of an asset approach applying a liquidation analysis used in prior quarters; and
|
(v)
|
|
Increase in the fair value of our holdings in PalletOne of $0.1 million due to improved operations.
|
2012 Portfolio Activity
During the year ended December 31, 2012,
we received $6.4 million from the disposal of the Fund’s 55% fully-diluted equity interest in Sovereign, together with the
Fund’s promissory note and all interest as accrued interest. We also received $5.3 million from the disposal of the Fund’s
34.2% equity interest in ConGlobal, together with the Fund’s promissory note and all interest as accrued interest.
On May 7, 2012, holders of 72.5% of
all OG bondholders approved a joint restructuring of certain bond debt of OG and its parent company, OPG. Pursuant to such restructuring,
approximately 84.5% of the Orco Germany bonds held by each bondholder were converted into
Obligations Convertibles en Actions
(“OCA”) on May 9, 2012. The OCA were converted into an aggregate of 26,209,613 OPG shares which were delivered
in two tranches. The first tranche, consisting of 18,361,540 OPG shares, was delivered in May 2012, of which the Fund received
1,102,455 OPG shares. The second tranche, consisting of 7,848,073 OPG shares, was received in October 2012. Also in October, the
remaining 15.5% of the Orco Germany bonds held by each bondholder was converted into new 6-year OPG Notes with a face value of
€20.0 million bearing cash and PIK interest each at 5% per annum, which interest percentages may be reduced over time upon
timely repayments of principal tranches during a four-year period commencing in 2015. Of the total amount of OPG Notes issued,
Equus received OPG Notes in the face amount of €1,200,790. On October 15, 2012, we announced the sale of 1,500,000 of our
1,573,666 OPG shares, where we received net cash proceeds of €3.8 million [$4.9 million]. As of December 31, 2012, we held
73,666 OPG shares, and €1,200,790 OPG Notes.
During the year ended December 31, 2012,
we had investment activity of $7.2 million in two portfolio companies. We made a follow-on investment of $6.8 million in Equus
Energy, LLC. The restructuring of the Orco Germany bonds noted above resulted in the capitalization of $0.3 million accrued interest
received in the form of additional portfolio securities (PIK). We capitalized legal and consulting expenses of $0.1 million relating
to Spectrum.
The following table includes significant investment activity
during the year ended December 31, 2012 (in thousands):
|
|
Investment Activity
|
|
|
|
|
New Investments
|
|
Existing Investments
|
|
|
Portfolio Company
|
|
Cash
|
|
Non-Cash
|
|
Follow-On
|
|
PIK
|
|
Total
|
Equus Energy, LLC
|
|
$
|
—
|
|
|
$
|
—
|
|
|
$
|
6,800
|
|
|
$
|
—
|
|
|
$
|
6,800
|
|
Orco Property Group S.A.
|
|
|
—
|
|
|
|
—
|
|
|
|
—
|
|
|
|
301
|
|
|
|
301
|
|
Spectrum Management, LLC
|
|
|
—
|
|
|
|
—
|
|
|
|
139
|
|
|
|
—
|
|
|
|
139
|
|
|
|
$
|
—
|
|
|
$
|
—
|
|
|
$
|
6,939
|
|
|
$
|
301
|
|
|
$
|
7,240
|
|
During 2012, we realized net capital
losses of $2.8 million, including the following significant transactions:
Portfolio Company
|
|
Industry
|
|
Type
|
|
Transaction Type
|
|
Realized Gain (Loss)
|
ConGlobal Industries Holding, Inc.
|
|
Shipping products and services
|
|
Control
|
|
|
Disposition
|
|
$
|
(4,114
|
)
|
Sovereign Business Forms, Inc.
|
|
Business products and services
|
|
Control
|
|
|
Disposition
|
|
|
(1,073
|
)
|
Orco Property Group
|
|
Real Estate
|
|
Non-affiliate
|
|
|
Disposition
|
|
|
2,318
|
|
Various others
|
|
|
|
|
|
|
Disposition
|
|
|
72
|
|
|
|
|
|
|
|
|
|
|
|
$
|
(2,797
|
)
|
During 2012, we recorded a net
change in unrealized depreciation of $0.2 million, to a net unrealized depreciation of $17.2 million at December 31, 2012.
Such change in depreciation resulted primarily from the following changes:
(i)
|
|
Transfer of unrealized depreciation to realized loss of our holdings in ConGlobal of $1.6 million upon the divestiture of the investment;
|
(ii)
|
|
Transfer of unrealized depreciation to realized loss of our holdings in Sovereign of $0.6 million upon the divestiture of the investment;
|
(iii)
|
|
The restructuring of the 8,890 Orco Germany bonds resulted in the Fund holding 1,573,666 ordinary shares of OPG and €1,200,790 newly-issued 6-year OPG notes. The capitalization of $0.3 million accrued interest and the subsequent sale of 1.5 million shares of OPG shares in October 2012 resulted in a decrease in fair value our holdings in of OPG of $1.8 million; and
|
(iv)
|
|
Decrease in the fair value of Equus Energy, LLC of $0.2 million due to working capital expenditures.
|
2011 Portfolio Activity
During the year ended December 31, 2011,
we received $0.4 million from Sovereign in the form of principal payments and a distribution from Equus Media Development Company,
LLC in the amount of $1.0 million. We sold our promissory notes in 1848 Capital Partners, LLC , Big Apple Entertainment Partners,
LLC, and London Bridge and certain assets of Riptide in which we hold a 64.67% membership interest. All of these assets were sold
to Capital Markets Acquisition Partners, LLC for a combined price of $10 million, with $9.8 million allocated to the promissory
notes held by the Fund and $0.2 million to Riptide. We allocated the proceeds to the promissory notes resulting in a realized loss
of approximately $0.9 million at London Bridge. In addition, the monies provided to Riptide were sufficient to satisfy its outstanding
liabilities, resulting in a value of $0. We also received $0.8 million in connection with the sale and redemption of our membership
interest in RP&C International Investments LLC.
During the year ended December 31, 2011,
we had investment activity of $3.7 million in three portfolio companies. We made a follow-on investment of $0.3 million in Spectrum.
On April 27, 2011, we announced that we had entered into two separate transactions involving the purchase of an aggregate of 11,408
4% bonds due May 2012 (“Bonds”) issued by Orco Germany S.A., a commercial and multi-family residential real estate
holding company and developer based in Berlin. The consideration provided to the selling bondholders consisted of an aggregate
of 1,700,000 newly issued shares of common stock of the Fund. These shares are unregistered under the Securities Act of 1933.
We received 8,890 of the Bonds on April 27, 2011. On May 9, 2011, one of these agreements was amended and restated to provide
for an additional 45 days to deliver 2,518 of the Bonds in exchange for providing to the Fund approximately $1.6 million in cash
as security for such delivery. As the remaining bonds were not delivered by the specified date, the cash collateral became free
and clear property of the Fund on June 23, 2011. On September 30, 2011, 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 December 2011, we contributed $250,000 to the capital of Equus Energy.
The following table includes significant
investment activity during the year ended December 31, 2011 (in thousands):
|
|
Investment Activity
|
|
|
|
|
New Investments
|
|
Existing Investments
|
|
|
Portfolio Company
|
|
Cash
|
|
Non-Cash
|
|
Follow-On
|
|
PIK
|
|
Total
|
Orco Germany S.A
|
|
$
|
67
|
|
|
$
|
3,016
|
|
|
$
|
—
|
|
|
$
|
—
|
|
|
$
|
3,083
|
|
Spectrum Management, LLC
|
|
|
—
|
|
|
|
—
|
|
|
|
325
|
|
|
|
—
|
|
|
|
325
|
|
Equus Energy, LLC
|
|
|
250
|
|
|
|
—
|
|
|
|
—
|
|
|
|
—
|
|
|
|
250
|
|
|
|
$
|
317
|
|
|
$
|
3,016
|
|
|
$
|
325
|
|
|
$
|
—
|
|
|
$
|
3,658
|
|
During 2011, we realized net capital
losses of $10.9 million, including the following significant transactions (in thousands):
Portfolio Company
|
|
Industry
|
|
Type
|
|
Transaction Type
|
|
Realized Gain (Loss)
|
Riptide Entertainment, LLC
|
|
Entertainment and leisure
|
|
Control
|
|
|
Disposition
|
|
$
|
(10,074
|
)
|
London Bridge Entertainment Partners Ltd
|
|
Entertainment and leisure
|
|
Non-affiliate
|
|
|
Disposition
|
|
|
(992
|
)
|
RP&C International Investments LLC
|
|
Healthcare
|
|
Affiliate
|
|
|
Disposition
|
|
|
138
|
|
Various others
|
|
|
|
|
|
|
Disposition
|
|
|
(2
|
)
|
|
|
|
|
|
|
|
|
|
|
$
|
(10,930
|
)
|
During 2011, we recorded a net
change in unrealized depreciation of $9.9 million, to a net unrealized depreciation of $17.4 million at December 31, 2011.
Such change in unrealized depreciation resulted primarily from the following changes:
(i)
|
|
Decline in fair market value of our holdings in ConGlobal $2.6 million due to the decline in operating performance;
|
(ii)
|
|
Transfer of unrealized depreciation to realized depreciation of our holdings in London Bridge Entertainment Partners, Ltd. of $0.8 million due to the sale of the promissory note;
|
(iii)
|
|
Increase in the fair market value of our holding in Orco Germany S.A. bonds of $2.7 million due to the difference in the market price of Equus shares used as consideration for the bonds on the date of acquisition offset by the change in Euro-USD exchange rate;
|
(iv)
|
|
Increase in the fair market value of our holding in PalletOne of $0.1 million due to steady improvement in operating performance and indications of value from independent third parties;
|
(v)
|
|
Transfer of unrealized depreciation to realized depreciation for our holding in Riptide of $10.1 million due to the sale of the promissory notes and the winding up of the entity;
|
(vi)
|
|
Transfer of unrealized appreciation to realized appreciation for our holding in RP&C of $0.1 million due to the maturity of the investment;
|
(vii)
|
|
Increase in fair market value of our holding in Sovereign of $0.6 million as Sovereign has seen an upward trend in operating results and has continued to reduce its debt which has resulted in a corresponding increase its equity value;
|
(viii)
|
|
Decrease in fair market value of our holdings in Spectrum of $1.4 million due to the decline in operating performance and the maturity of its funded debts which remain in default; and
|
(ix)
|
|
Decrease in the fair market value of our holdings in Trulite, Inc. of $0.1 due to the lack of progress and inability to achieve sufficient funding with regards to its product development program.
|
(9) 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 129 producing and non-producing oil and gas wells. The working interests include
associated development rights of approximately 23,000 acres situated on 13 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 Chevron USA, Inc., 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, is working with Chevron in a recompletion program of existing Conger Field wells to the Wolfcamp formation,
a zone containing oil as well as gas and natural gas liquids. Two recompletions in the Conger Field have been effected since the
closing date of the acquisition of the working interests and a third recompletion is planned during the second quarter of 2014,
with additional recompletions anticipated for the remainder of 2014 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 located in the area known
as the “Eagle Ford Shale” play.
Revenue and Income.
For
the year ended December 31, 2013. Equus energy’s revenue, operating income, and net loss were $2,555,475, $1,314,864, and
$230,306, respectively.
Capital Expenditures
.
Since the effective date of the acquisition of the working interests described above (Sept. 1, 2012), Equus Energy has
invested approximately $832,811 in respect of the following four projects on two properties, collectively resulting in an
estimated 29,000 additional BOE to Equus Energy’s proved developed producing reserves based on a reserve report
provided to Equus Energy by Lee Keeling & Associates, Inc., an independent petroleum engineering firm.
Conger Field (Chevron USA)
-
Recompletion of the Mahaffey #1 Well ($363,589)
.
The recompletion of the Mahaffey #1 gas well to the Wolfcamp shale oil formation was committed by WAOC prior to the date of acquisition
and came on-line in January 2013. For the year ended December 31, 2013, the Mahaffey well generated, net to Equus Energy, approximately
$132,373 and $92,186 in gross revenue and operating income, respectively.
-
Recompletion of the EB Cope #6 Well ($327,253)
.
In August 2013, Chevron commenced recompletion of the EB Cope #6 gas well to the Wolfcamp shale oil formation. During the period
since recompletion to December 31, 2013, this well generated, net to Equus Energy, an estimated $242,962 and $208,162 in gross
revenue and operating income, respectively.
Needville Field (Sue Ann Operating)
-
Drilling of the Hurta #4 Oil Well ($140,420)
.
The Hurta #4 well was drilled in February 2013 and came on-line in March 2013. During the year ended December 31, 2013, this well
generated, net to Equus Energy, $294,296 and $262,177 in gross revenue and operating income, respectively. In the future, the well
may be recompleted to an additional zone.
-
Recompletion of the Hurta #3 Oil Well ($8,360)
. The
Hurta #3 well was recompleted in late July 2013. For the period since recompletion to December 31, 2013, this well generated, net
to Equus Energy, $149,371 and $114,912 in gross revenue and operating income, respectively. In the future, the well may be recompleted
to an additional zone.
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 in part on the net values of the underlying assets held by Equus Energy, a
discounted cash flow analysis based on a reserve report prepared for Equus Energy by Lee Keeling & Associates, Inc.,
an independent petroleum engineering firm, the transactions and values of comparable companies in this sector, and the
estimated value of leasehold mineral interests associated with the acreage held by Equus Energy.
A valuation of Equus
Energy was performed by a third-party valuation firm, who recommended a value range of Equus Energy consistent with the fair
value we ascribed in our Schedule of Investments on page 39.
Below
is summarized consolidated financial information for Equus Energy as of December 31, 2013 and December 31, 2012 and for the year
ended December 31, 2013 (in thousands):
EQUUS ENERGY, LLC.
Consolidated Balance Sheets
|
|
December 31,
2013
|
|
December 31,
2012
|
|
|
(Unaudited)
|
|
(Unaudited)
|
|
|
|
|
|
Assets
|
|
|
|
|
|
|
|
|
CURRENT ASSETS:
|
|
|
|
|
|
|
|
|
Cash
|
|
$
|
486
|
|
|
$
|
175
|
|
Accounts receivable
|
|
|
288
|
|
|
|
453
|
|
Total current assets
|
|
|
774
|
|
|
|
628
|
|
|
|
|
|
|
|
|
|
|
Oil and gas properties
|
|
|
7,700
|
|
|
|
6,899
|
|
Less: accumulated depletion, depreciation and amortization
|
|
|
(983
|
)
|
|
|
—
|
|
Net oil and gas properties
|
|
|
6,717
|
|
|
|
6,899
|
|
|
|
|
|
|
|
|
|
|
Total assets
|
|
$
|
7,491
|
|
|
$
|
7,527
|
|
|
|
|
|
|
|
|
|
|
Liabilities and members' capital
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
CURRENT LIABILITIES:
|
|
|
|
|
|
|
|
|
Accounts payable and other
|
|
$
|
324
|
|
|
$
|
489
|
|
Due to affiliate
|
|
|
364
|
|
|
|
10
|
|
Total current liabilities
|
|
|
688
|
|
|
$
|
499
|
|
|
|
|
|
|
|
|
|
|
Asset retirement obligations
|
|
|
178
|
|
|
|
173
|
|
Total non-current liabilities
|
|
|
178
|
|
|
|
173
|
|
|
|
|
|
|
|
|
|
|
Total liabilities
|
|
|
866
|
|
|
|
672
|
|
|
|
|
|
|
|
|
|
|
Members' capital
|
|
|
|
|
|
|
|
|
Total members' capital
|
|
|
6,625
|
|
|
|
6,855
|
|
|
|
|
|
|
|
|
|
|
Total liabilities and members capital
|
|
$
|
7,491
|
|
|
$
|
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,
depletion, depreciation 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 revenue 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.
EQUUS ENERGY, LLC.
Consolidated Statement of Operations
|
|
Year ended
|
|
|
December 31, 2013
|
|
|
(Unaudited)
|
|
|
|
Operating revenue
|
|
$
|
2,556
|
|
|
|
|
|
|
|
|
|
|
|
Operating expenses
|
|
|
|
|
Direct operating expenses
|
|
|
1,241
|
|
Depletion, depreciation, amortization and accretion
|
|
|
989
|
|
General and administrative
|
|
|
535
|
|
Total operating expenses
|
|
|
2,765
|
|
|
|
|
|
|
Operating loss before income tax expense
|
|
|
(209
|
)
|
|
|
|
|
|
Income tax
|
|
|
21
|
|
|
|
|
|
|
Net loss
|
|
$
|
(230
|
)
|
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 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, depreciation and amortization
expense for the Company’s oil and gas properties totaled $0.8 million for the year ended December 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 December 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 its oil and gas properties for the year ended December 31, 2013 and 2012, respectively.
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 impairment or reduction
in value. If a reduction in value has occurred, costs being amortized are increased accordingly.
Revenue Recognition
-
Revenue
recognized for oil and natural gas sales under the sales method of accounting. Under this method, revenue 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 leasehold interest. These differences result from production imbalances, which are not significant, and
are reflected as adjustments to proven 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 in calculating depletion of its proved oil and gas properties,
wherein 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.
(10) RECENT ACCOUNTING PRONOUNCEMENTS
In June 2013, the Financial Accounting
Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) 2013-08, Financial Services—Investment
Companies. ASU 2013-08 provides clarifying guidance to determine if an entity qualifies as an investment company. ASU 2013-08 also
requires an investment company to measure non-controlling interests in other investment companies at fair value. The following
disclosures will also be required upon adoption of ASU 2013-08: (i) whether an entity is an investment company and is applying
the accounting and reporting guidance for investment companies; (ii) information about changes, if any, in an entity’s status
as an investment company; and (iii) information about financial support provided or contractually required to be provided by an
investment company to any of its investees. The requirements of ASU 2013-08 are effective for the Company beginning in the first
quarter of 2014. The Company is currently evaluating the impact, if any, that these updates will have on its financial condition
or results of operations.
(11) SUBSEQUENT EVENT
Our Management performed an evaluation
of the Fund’s activity through the date the financial statements were issued, noting the following subsequent event:
On January 2, 2014, the Fund sold
U.S. Treasury Bills for $15.0 million and repaid its year-end margin loan.
(12) SELECTED QUARTERLY DATA
(in thousands, except per share amounts)
|
|
Year Ended December 31, 2013
|
|
|
Quarter Ended
|
|
Quarter Ended
|
|
Quarter Ended
|
|
Quarter Ended
|
|
|
|
|
March 31,
|
|
June 30,
|
|
September 30,
|
|
December 31,
|
|
|
|
|
2013
|
|
2013
|
|
2013
|
|
2013
|
|
Total
|
|
|
|
|
|
|
|
|
|
|
|
Total investment income (loss)
|
|
$
|
(95
|
)
|
|
$
|
14
|
|
|
$
|
35
|
|
|
$
|
53
|
|
|
$
|
7
|
|
Net investment loss
|
|
$
|
(771
|
)
|
|
$
|
(1,365
|
)
|
|
$
|
(588
|
)
|
|
$
|
(407
|
)
|
|
$
|
(3,131
|
)
|
Increase (decrease) in net assets resulting
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
from operations
|
|
$
|
(1,460
|
)
|
|
$
|
(1,249
|
)
|
|
$
|
(794
|
)
|
|
$
|
3,845
|
|
|
|
342
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Basic and diluted earnings per share
(1)
|
|
$
|
(0.14
|
)
|
|
$
|
(0.12
|
)
|
|
$
|
(0.08
|
)
|
|
$
|
0.36
|
|
|
$
|
0.02
|
|
(in
thousands, except per share amounts)
|
|
Year Ended December 31, 2012
|
|
|
Quarter
Ended
|
|
Quarter
Ended
|
|
Quarter
Ended
|
|
Quarter
Ended
|
|
|
|
|
March
31,
|
|
June
30,
|
|
September
30,
|
|
December
31,
|
|
|
|
|
2012
|
|
2012
|
|
2012
|
|
2012
|
|
Total
|
Total
investment income (loss)
|
|
$
|
227
|
|
|
$
|
212
|
|
|
$
|
(100
|
)
|
|
$
|
177
|
|
|
$
|
516
|
|
Net
investment loss
|
|
$
|
(498
|
)
|
|
$
|
(777
|
)
|
|
$
|
(685
|
)
|
|
$
|
(694
|
)
|
|
$
|
(2,654
|
)
|
Increase
(decrease) in net assets resulting
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
from
operations
|
|
$
|
(498
|
)
|
|
$
|
(4,232
|
)
|
|
$
|
(1,754
|
)
|
|
$
|
1,211
|
|
|
|
(5,273
|
)
|
Basic
and diluted earnings per share
(1)
|
|
$
|
(0.05
|
)
|
|
$
|
(0.40
|
)
|
|
$
|
(0.17
|
)
|
|
$
|
0.12
|
|
|
$
|
(0.50
|
)
|
(
1)
The sum of quarterly per
share amount may not equal per share amounts reported for year-to-date periods due to changes in the number of weighted average
shares outstanding and the effects of rounding.
(13) LEGAL PROCEEDINGS
Champion Window Arbitration Claim
—In
January 2006, we sold our 31.5% ownership interest in Champion Window, Inc. (“Champion”), a portfolio company of the
Fund, to Atrium Companies Inc. (“Atrium”) pursuant to a Stock Purchase Agreement (“SPA”) dated December
22, 2005. The SPA contained certain limited rights of indemnification for Atrium in connection with its purchase of such ownership
interest.
More than five years after the closing
of the sale of our Champion interest, Atrium filed suit in the District Court of Harris County, Texas against two former officers
of Atrium’s subsidiary, Champion, alleging, amongst other matters, that the former officers breached their fiduciary duties
to Champion by hiring undocumented workers. This action was commenced primarily as a result of an investigation by the U.S. Immigration
and Customs Enforcement agency (“ICE”) into Atrium’s hiring practices. On March 12, 2012, to protect its interests,
we filed a Petition in Intervention in the State Court Action seeking a declaration from the Court that Equus did not owe any obligation
to indemnify Atrium or Champion for any penalties, costs or fees associated with the investigation by ICE.
On March 16, 2012, Atrium and Champion
filed a claim with the American Arbitration Association in Dallas, Texas, against Equus and a number of the other sellers under
the SPA. In September 2013, all of Atrium and Champion’s claims including claims against its former officers described above,
were also consolidated in the Arbitration Action.
In the Arbitration Action, Atrium and
Champion seek damages arising from Equus’ and the other sellers’ indemnity obligations set forth in the SPA. Atrium
claims it is entitled to indemnification under the SPA for costs it has incurred in responding to an ongoing investigation by ICE.
Atrium entered into a Non-Prosecution Agreement with ICE. It appears that one condition of the Non-Prosecution Agreement required
Atrium to pay ICE $2,000,000. Atrium and Champion asserted two counts of breach of contract against Equus, both arising out of
the alleged obligation to indemnify Atrium and Champion pursuant to certain provisions of the SPA. Atrium and Champion also asserted
claims for fraudulent inducement against two former officers and directors of Champion. Through the arbitration, Atrium and Champion
seek to recover an unspecified amount in the form of alleged “losses, damages, assessments, penalties, interest, reasonable
attorneys’ and accountants’ fees, settlement costs, and other costs and expenses arising directly or indirectly out
of or incident to,” the alleged breach of the indemnity provisions in the SPA. As a consequence of their fraudulent inducement
claim against the two former officers and directors, Atrium and Champion alternatively seek equitable rescission of the SPA and
exemplary damages from the two former officers and directors.
Atrium and Champion have yet to specify
the amount of damages they seek from Equus or the other sellers pursuant to the alleged indemnity obligations under the SPA. Atrium
and Champion have disclosed the payment of $2 million to ICE to resolve the investigation and avoid prosecution for their hiring
practices.
We filed an answer to Atrium and Champion’s
claims on December 6, 2013. In our answer, we denied that we owed any indemnity obligations to Atrium or Champion and further denied
that the Fund is in any way liable to Atrium or Champion. To the extent Atrium and Champion are able to establish a right to an
indemnity, we will further contest the amount of the claimed indemnity, inasmuch as we believe (among other defenses) that the
indemnity obligation can only exist, if at all, with respect to damages arising as a direct and proximate result of employees who
were hired prior to the closing date of the 2006 sale of Champion and remained in continuous employment after the 2006 sale, and
not to any employee who may have been hired in the six years after the sale.
While we believe the Atrium claim is
without merit and we intend to continue to vigorously dispute the claim, there is a reasonable possibility of an adverse ruling
which may require the Fund to indemnify Atrium. If Equus is required to indemnify Atrium and Champion, we estimate that such indemnity
obligation could vary from $2.0 million to $3.0 million. Pursuant to the
SPA, the indemnification obligation of Equus and the other
sellers is several and not joint, and any such indemnity, however uncertain, would likely be reduced proportionately to our percentage
ownership in Champion at the time of sale, which was 31.5% of Champion’s shares outstanding.
Indemnification Settlement
—Effective
June 13, 2013, the Fund entered into a settlement agreement with Sam Douglass, a former director and executive officer of the Fund,
in respect of a claim for indemnification pursuant to the General Corporation Law of Delaware and an indemnification agreement
entered into by the Fund with Mr. Douglass on May 3, 2001. The settlement agreement provides for the reimbursement to Mr. Douglass
of actual expenses incurred, excluding any fines or penalties, in connection with an enforcement action initiated by the Securities
and Exchange Commission against Mr. Douglass in 2009. The settlement payment of $125,000 was made on June 24, 2013.
Lawsuit Settlement
—On August
12, 2012, Paula Douglass filed a lawsuit against the Fund and members of the Board of Directors in the District Court of Harris
County, Texas. Ms. Douglass’ complaint alleged various causes of action, including minority shareholder oppression, dilution,
and breach of fiduciary duty, and sought unspecified damages and attorney’s fees. Effective June 13, 2013, the Fund entered
into a settlement agreement with Ms. Douglass, Sam Douglass, as well as certain trusts controlled by them. Pursuant to the settlement
agreement and in view of the estimated costs of protracted litigation and the associated disruption to the operations of the Fund,
the Board of Directors approved a payment of $402,254, in complete settlement of the lawsuit, as being in the best interests of
the Fund and its shareholders. The settlement payment was made on July 30, 2013. Ms. Douglass filed a motion to dismiss the lawsuit
with prejudice on August 8, 2013.
Lawsuit
Settlement—
On June 9, 2011, RNR Production, Land and Cattle Company, Inc. (“RNR”) filed a lawsuit
against the Fund and members of the Board of directors in the district Court of Harris County, Texas, seeking
various monetary and equitable remedies, including a motion for a temporary restraining order against the Fund from holding
its annual meeting of shareholders. The Fund prevailed against the motion but agreed to a nuisance settlement with RNR in
exchange for a one-time payment of $200,000 which was paid on September 2, 2011,
Lawsuit
Settlement—
On March 10, 2010, American General Life Insurance Company (“American General”) filed a
complaint against the Fund in the District Court of Harris County, Texas in connection with an office lease entered into
by our former administrator with American General. The complaint by American General sought to hold the Fund liable for
unpaid rent, improvements, and attorneys’ fees totaling approximately $450,000. We agreed to a settlement with American
General in exchange for a one-time payment of $120,000, which was paid on June 7, 2011.
From time to time, the Fund is also
a party to certain proceedings incidental to the normal course of our business including the enforcement of our rights under contracts
with our portfolio companies. While the outcome of these legal proceedings cannot at this time be predicted with certainty, we
do not expect that these proceedings will have a material effect upon the Fund’s financial condition or results of operations.