FORM 10-Q

                       SECURITIES AND EXCHANGE COMMISSION

                             Washington, D.C. 20549

(Mark One)

[X]  QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
     ACT OF 1934

For the quarterly period ended September 30, 2002March 31, 2003 or

[ ]  TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
     EXCHANGE ACT OF 1934

For the transition period from _______ to _______

Commission File Number 0-19509

                              EQUUS II INCORPORATED
                       ----------------------------------
             (Exact name of registrant as specified in its charter)

             Delaware                                       76-0345915
  --------------------------------------          ------------------------------
  (State or other jurisdiction of                        (I.R.S. Employer
  incorporation or organization)                        Identification No.)

  2929 Allen Parkway, Suite 2500
           Houston, Texas                                   77019-2120
       -----------------------------------             ------------------------------
         (Address of principal                                (Zip Code)
        executive offices)

Registrant's telephone number, including area code: (713) 529-0900
                                                   ----------------------

Securities registered pursuant to Section 12(b) of the Act:

      Title of each class                     Name of each exchange
                                              on which registered

      Common Stock                           New York Stock Exchange

Securities registered pursuant to Section 12(g) of the Act:  None

Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days. Yes [X] No Approximate aggregate market value of common stock held[ ]

Indicate by non-affiliatescheck mark whether the registrant is an accelerated filer (as
defined in 12b-2 of the registrant: $36,396,442 computed on the basis of $6.65 per share, closing price
of the common stock on the New York Stock Exchange Inc. on November 13, 2002.
For the purpose of calculating this amount only, all directors and executive
officers of the registrant have been treated as affiliates.Act). Yes [X] No [ ]

There were 6,233,021 shares of the registrant's common stock, $.001 par value,
outstanding, as of NovemberMay 13, 2002.2003. The net asset value of a share at September 30, 2002March 31,
2003 was $11.94.

Documents incorporated by reference:  None$12.79.



                              EQUUS II INCORPORATED
                            (A Delaware Corporation)

                                      INDEX

                                                                            
PART I. FINANCIAL INFORMATION PAGE ---- Item 1. Financial Statements Balance Sheets - September 30, 2002 and December 31, 2001 ............................... 1 Statements of Operations - For the three months ended September 30, 2002 and 2001 ................. 2 - For the nine months ended September 30, 2002 and 2001 .................. 3 Statements of Changes in Net Assets - For the nine months ended September 30, 2002 and 2001 .................. 4 Statements of Cash Flows - For the nine months ended September 30, 2002 and 2001 .................. 5 Selected Per Share Data and Ratios - For the nine months ended September, 2002 and 2001 ..................... 7 Schedule of Portfolio Securities - September 30, 2002 ..................................................... 8 Notes to Financial Statements ............................................ 14 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations ...................................... 21 Item 3. Quantitative and Qualitative Disclosure about Market Risk ................ 27 PART II. OTHER INFORMATION Item 4. Controls and Procedures .................................................. 28 Item 6. Exhibits and Reports on Form 8-K ......................................... 29 SIGNATURE ............................................................................... 29
PAGE ---- PART I. FINANCIAL INFORMATION Item 1. Financial Statements Balance Sheets - March 31, 2003 and December 31, 2002............................1 Statements of Operations - For the three months ended March 31, 2003 and 2002..............2 Statements of Changes in Net Assets - For the three months ended March 31, 2003 and 2002..............3 Statements of Cash Flows - For the three months ended March 31, 2003 and 2002..............4 Selected Per Share Data and Ratios - For the three months ended March 31, 2003 and 2002 .............6 Schedule of Portfolio Securities - March 31, 2003..................................................7 Notes to Financial Statements....................................13 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations..............................20 Item 3. Quantitative and Qualitative Disclosure about Market Risk........25 PART II. OTHER INFORMATION Item 4. Controls and Procedures..........................................25 Item 6. Exhibits and Reports on Form 8-K.................................26 SIGNATURE.....................................................................27 ii Part I. Financial Information Item 1. Financial Statements EQUUS II INCORPORATED BALANCE SHEETS SEPTEMBER 30, 2002MARCH 31, 2003 AND DECEMBER 31, 20012002 (Unaudited)
2003 2002 2001 ---- ---- Assets------------ ------------ Assets Investments in portfolio securities at fair value (cost $90,337,517$82,088,042 and $90,371,825,$92,611,224, respectively) $ 82,035,08487,382,558 $ 85,878,83187,194,210 Restricted cash & temporary investments, at cost which approximates fair value 55,432,419 58,000,000 Cash 4,852 442 Temporary cash investments, at cost which approximates fair value 56,026,144 62,010,212 Cash 508 23,465526,011 516,236 Accounts receivable 15,318 15,06115,367 15,330 Accrued interest receivable 3,200,098 2,891,1073,037,650 2,610,639 ------------ ------------ Total assets 141,277,152 150,818,676146,398,857 148,336,857 ------------ ------------ Liabilities and net assets Liabilities: Accounts payable 94,028 267,011116,881 200,882 Due to management company 372,179 384,834 Notes payable to bank 66,375,000 73,200,000783,450 384,880 Revolving line of credit 10,825,000 12,775,000 Brokerage margin account obligation 54,959,521 -- Line of credit promissory note -- 58,000,000 ------------ ------------ Total liabilities 66,841,207 73,851,84566,684,852 71,360,762 ------------ ------------ Commitments and contingencies Net assets: Preferred stock, $.001 par value, 5,000,000 shares authorized, no shares outstanding - --- -- Common stock, $.001 par value, 25,000,000 shares authorized, 6,233,021 shares outstanding 6,233 6,233 Additional paid-in capital 84,849,332 84,863,76682,496,540 82,496,540 Undistributed net investment income 893,686 -losses (296,815) (423,919) Undistributed net capital losses (3,010,873) (3,410,174)gains (losses) (7,786,469) 314,255 Unrealized depreciationappreciation (depreciation) of portfolio securities, net (8,302,433) (4,492,994)5,294,516 (5,417,014) ------------ ------------ Total net assets $ 74,435,94579,714,005 $ 76,966,831 ------------ ------------76,976,095 ============ ============ Net assets per share $ 11.9412.79 $ 12.35 ============ ============
The accompanying notes are an integral part of these financial statements 1 EQUUS II INCORPORATED STATEMENTS OF OPERATIONS FOR THE THREE MONTHS ENDED SEPTEMBER 30,MARCH 31, 2003 AND 2002 AND 2001 (Unaudited)
2003 2002 2001 ---- ---------------- ----------- Investment income: IncomeInterest income from portfolio securities $ 784,799803,598 $ 480,866490,281 Dividend income from portfolio securities 43,000 756,703 Interest from temporary cash investments 2,107 14,482 Other income 190,000 -2,408 10,067 ----------- ----------- Total investment income 976,906 495,348849,366 1,257,051 ----------- ----------- Expenses: Management fees 372,179 391,485 Non-cash compensation expense - (180,037)398,570 393,151 Director fees and expenses 61,344 56,92954,555 61,556 Professional fees 43,637 12,09367,125 40,953 Administrative fees 12,500 12,500 Mailing, printing and other expenses 19,611 (5,336)6,448 9,774 Interest expense 123,936 136,991183,064 154,314 Non-cash compensation expense -- 41,859 Franchise taxes - 7,040-- 36,860 ----------- ----------- Total expenses 633,207 431,665722,262 750,967 ----------- ----------- Net investment income 343,699 63,683127,104 506,084 ----------- ----------- Realized loss on sales of portfolio securities, net - (283,022)(8,100,724) (666,922) ----------- ----------- Unrealized depreciationappreciation (depreciation) of portfolio securities, net: End of period (8,302,433) (6,633,747)5,294,516 (2,710,696) Beginning of period (6,006,467) (3,610,715)(5,417,014) (4,492,995) ----------- ----------- Increase in unrealized depreciation,appreciation (depreciation), net (2,295,966) (3,023,032)10,711,530 1,782,299 ----------- ----------- Total decreaseincrease in net assets from operations $(1,952,267) $(3,242,371)$ 2,737,910 $ 1,621,461 =========== ===========
The accompanying notes are an integral part of these financial statements 2 EQUUS II INCORPORATED STATEMENTS OF OPERATIONSCHANGES IN NET ASSETS FOR THE NINETHREE MONTHS ENDED SEPTEMBER 30,MARCH 31, 2003 AND 2002 AND 2001 (Unaudited)
2003 2002 2001 ---- --------------- ----------- Investment income: Income from portfolio securities $ 2,652,139 $ 2,008,731 Interest from temporary cash investments 18,894 55,570 Other income 240,000 55,000 ----------- ----------- Total investment income 2,911,033 2,119,301 ----------- ----------- Expenses: Management fees 1,147,271 1,233,950 Non-cash compensation expense (14,434) (1,536,856) Director fees and expenses 183,513 192,976 Professional fees 143,204 271,260 Administrative fees 37,500 37,500 Mailing, printing and other expenses 47,889 56,759 Interest expense 384,608 295,191 Excise tax 36,832 - Franchise taxes 50,964 83,990 ----------- ----------- Total expenses 2,017,347 634,770 ----------- -----------Operations: Net investment income 893,686 1,484,531 ----------- -----------$ 127,104 $ 506,084 Realized gain (loss)loss on sales of portfolio securities, net 399,301 (4,040,983) ----------- ----------- Unrealized(8,100,724) (666,922) Decrease in unrealized depreciation of portfolio securities, net: End of period (8,302,433) (6,633,747) Beginning of period (4,492,994) (818,963)net 10,711,530 1,782,299 ----------- ----------- Increase in unrealized depreciation, net (3,809,439) (5,814,784) ----------- ----------- Total decrease in net assets from operations $(2,516,452) $(8,371,236)2,737,910 1,621,461 ----------- ----------- Capital Transactions: Non-cash compensation expense -- 41,859 ----------- ----------- Increase in net assets from capital transactions -- 41,859 ----------- ----------- Increase in net assets 2,737,910 1,663,320 Net assets at beginning of period 76,976,095 76,966,831 ----------- ----------- Net assets at end of period $79,714,005 $78,630,151 =========== ===========
The accompanying notes are an integral part of these financial statements 3 EQUUS II INCORPORATED STATEMENTS OF CHANGES IN NET ASSETSCASH FLOWS FOR THE NINETHREE MONTHS ENDED SEPTEMBER 30,MARCH 31, 2003 AND 2002 AND 2001 (Unaudited)
2003 2002 2001 ---- ---------------- ------------ Operations:Cash flows from operating activities: Interest and dividends received $ 95,411 $ 591,796 Cash paid to management company, directors, bank and suppliers (407,692) (753,777) ------------ ------------ Net investment income $ 893,686 $ 1,484,531 Realized gain (loss) oncash used by operating activities (312,281) (161,981) ------------ ------------ Cash flows from investing activities: Purchase of portfolio securities (375,000) (3,114,329) Proceeds from sales of portfolio securities net 399,301 (4,040,983) Increase in unrealized depreciation of1,159,854 4,844,558 Principal payments from portfolio securities 1,964,547 -- Sales (purchases) of restricted cash & temporary investments, net (3,809,439) (5,814,784) ----------- ----------- Decrease2,567,581 (1,000,000) Advances to portfolio companies (37) (109) ------------ ------------ Net cash provided by investing activities 5,316,945 730,120 ------------ ------------ Cash flows from financing activities: Borrowings under brokerage margin account 54,959,521 -- Advances from bank 375,000 64,900,000 Repayments to bank (60,325,000) (64,575,000) ------------ ------------ Net cash provided (used) by financing activities (4,990,479) 325,000 ------------ ------------ Net increase in net assets from operations (2,516,452) (8,371,236) ----------- ----------- Capital Transactions: Non-cash compensation expense (14,434) (1,536,856) Increase from officer notes, net - (536,780) Repurchase shares of common stock - (2,182,988) ----------- ----------- Decrease in net assets from capital transactions (14,434) (4,256,624) ----------- ----------- Decrease in net assets (2,530,886) (12,627,860) Net assetscash and cash equivalents 14,185 893,139 Cash and cash equivalents at beginning of period 76,966,831 90,924,765 ----------- ----------- Net assets516,678 33,677 ------------ ------------ Cash and cash equivalents at end of period $74,435,945 $78,296,905 =========== ===========$ 530,863 $ 926,816 ============ ============
The accompanying notes are an integral part of these financial statements 4 EQUUS II INCORPORATED STATEMENTS OF CASH FLOWS FOR THE NINETHREE MONTHS ENDED SEPTEMBER 30,MARCH 31, 2003 AND 2002 AND 2001 (Unaudited) (Continued)
2003 2002 2001------------ ----------- Cash flowsReconciliation of increase in net assets from operations to net cash used by operating activities: InterestIncrease in net assets from operations $ 2,737,910 $ 1,621,461 Adjustments to reconcile increase in net assets from operations to net cash used by operating activities: Realized loss on sales of portfolio securities, net 8,100,724 666,922 Decrease in unrealized depreciation, net (10,711,530) (1,782,299) Accrued interest and dividends received $ 1,116,877 $ 363,515 Cash paidexchanged for portfolio securities (326,943) (415,371) Increase in accrued interest receivable (427,011) (249,883) Non-cash compensation expense -- 41,859 Decrease in accounts payable (84,001) (52,987) Increase in due to management company directors, bank and suppliers (2,217,419) (2,409,447) -----------398,570 8,317 ------------ ----------- Net cash used by operating activities (1,100,542) (2,045,932) ----------- ----------- Cash flows from investing activities: Purchase of portfolio securities (5,365,973) (7,140,284) Proceeds from sales of portfolio securities 6,541,225 10,071,403 Principal payments from portfolio securities 743,522 - Advances to portfolio companies (257) (13,579) ----------- ----------- Net cash provided by investing activities 1,918,517 2,917,540 ----------- ----------- Cash flows from financing activities: Advances from bank 185,810,000 205,400,000 Repayments to bank (192,635,000) (216,050,000) Repurchase of common stock - (2,182,988) Payments received on officer notes - 92,531 Dividend payments - (1,442) ----------- ----------- Net cash used by financing activities (6,825,000) (12,741,899) ----------- ----------- Net decrease in cash and cash equivalents (6,007,025) (11,870,291) Cash and cash equivalents at beginning of period 62,033,677 77,043,532 ----------- ----------- Cash and cash equivalents at end of period $56,026,652 $65,173,241 ===========$ (312,281) $ (161,981) ============ ===========
The accompanying notes are an integral part of these financial statements 5 EQUUS II INCORPORATED STATEMENTS OF CASH FLOWSSUPPLEMENTAL INFORMATION - SELECTED PER SHARE DATA AND RATIOS FOR THE NINETHREE MONTHS ENDED SEPTEMBER 30,MARCH 31, 2003 AND 2002 AND 2001 (Unaudited) (Continued)
2003 2002 2001 ---- ---------- ------ Reconciliation of decrease in net assets from operations to net cash used by operating activities: Decrease in net assets from operations $(2,516,452) $(8,371,236) Adjustments to reconcile decrease in net assets from operations to net cash used by operating activities:Investment income $ 0.13 $ 0.20 Expenses 0.11 0.12 ------ ------ Net investment income 0.02 0.08 Realized (gain) loss on sale of portfolio securities, net (399,301) 4,040,983 Increase(1.30) (0.11) Decrease in unrealized depreciation net 3,809,439 5,814,784 Accrued interest and dividends exchanged forof portfolio securities, (1,485,165) (1,950,830)net 1.72 0.29 ------ ------ Increase in net assets from operations 0.44 0.26 ------ ------ Capital Transactions: Non-cash compensation expense related to officers' stock options (14,434) (1,536,856)-- 0.01 ------ ------ Increase in accounts receivable - (600) (Increase) decreasenet assets from capital transactions -- 0.01 ------ ------ Net increase in accrued interest receivable (308,991) 195,643 Decreasenet assets 0.44 0.27 Net assets at beginning of period 12.35 12.35 ------ ------ Net assets at end of period $12.79 $12.62 ====== ====== Weighted average number of shares outstanding during year, in accounts payable (172,983) (174,681) Decreasethousands 6,233 6,233 Market value $ 6.91 $ 7.82 Ratio of expenses to average net assets 0.92% 0.97% Ratio of net investment income to average net assets 0.16% 0.65% Ratio of increase in duenet assets from operations to management company (12,655) (63,139) ----------- ----------- Net cash used by operating activities $(1,100,542) $(2,045,932) =========== ===========average net assets 3.49% 2.08% Total return on market price 4.07% 0.39%
The accompanying notes are an integral part of these financial statements 6 EQUUS II INCORPORATED SUPPLEMENTAL INFORMATION - SELECTED PER SHARE DATA AND RATIOS FOR THE NINE MONTHS ENDED SEPTEMBER 30, 2002 AND 2001SCHEDULE OF PORTFOLIO SECURITIES MARCH 31, 2003 (Unaudited) (Continued)
2002 2001 ---- ----Date of Portfolio Company Initial Investment Cost Fair Value ----------------- ------------------ --------- ---------- Investment income Alenco Window Holdings II, LLC January 2002 Manufacturer & distributor of alumimnum and vinyl windows -24% membership interest $ 0.47 $ 0.33 Expenses 0.33 0.10 ------ ------ Net investment income 0.14 0.23 Realized gain (loss) on sale227 $3,200,000 American Trenchless Technology, LLC February 2001 Boring, tunneling and directional drilling -100,000 shares of portfolio securities, net 0.06 (0.63) Increase in unrealized depreciation of portfolio securities, net (0.61) (0.91) ------ ------ Decrease in net assets from operations (0.41) (1.31) ------ ------ Capital Transactions: Decrease related to officers' notes - (0.09) Non-cash compensation expense - (0.25) Effectpreferred stock 1,208,144 -- -1,934,532 shares of common stock repurchase - 0.21 ------ ------ Decrease116,550 -- -50% membership interest in net assets from capital transactions - (0.13) ------ ------ Net decreaseGlendale, LLC 300,000 300,000 The Bradshaw Group May 2000 Sells and services midrange and high-speed printing equipment -Prime + 2% promissory note with a face amount -- -- of $398,383 /(2)/ -15% promissory note /(2)/ 459,545 -- -1,335,000 shares of preferred stock 1,335,000 -- -Warrant to buy 2,229,450 shares of common stock for $0.01 through May 2008 1 -- Champion Window Holdings, Inc. March 1999 Manufacturer & distributor of residential windows -1,400,000 shares of common stock 1,400,000 18,800,000 CMC Investments, LLC December 2001 Manufacturer of oil and gas drilling rigs -21% membership interest 781,805 232,358 -4,432 shares of Weatherford International common stock 256,806 167,397 Container Acquisition, Inc. February 1997 Shipping container repair & storage -78,318 shares of preferred stock 7,831,800 1,500,000 -Conditional warrant to buy up to 370,588 shares of common stock at $0.01 through February 2007 1,000 -- -1,370,000 shares of common stock 1,370,000 -- -85% membership interest in net assets (0.41) (1.44) Net assets at beginning of period 12.35 14.00 ------ ------ Net assets at end of period $11.94 $12.56 ------ ------ Weighted average number of shares outstanding during year, in thousands 6,233 6,407 Market value per share $ 6.44 $ 7.71 Ratio of expenses to average net assets 2.66% 0.75% Ratio of expenses before interest and non-cash compensation expense to average net assets 2.17% 2.22% Ratio of net investment income to average net assets 1.18% 1.75% Ratio of net investment income to average net assets, exclusive of non-cash compensation expense 1.16% (0.06)% Ratio of decrease in net assets from operations to average net assets (3.32)% (9.89)% Ratio of decrease in net assets from operations to average net assets, exclusive of non-cash compensation expense (3.34)% (11.71)% Total return on market price (17.33)% (3.75)%CCI-ANI Finance, LLC 1,571,000 2,000,000
The accompanying notes are an integral part of these financial statements 7 EQUUS II INCORPORATED SCHEDULE OF PORTFOLIO SECURITIES SEPTEMBER 30, 2002 (Unaudited)
Date of Portfolio Company Initial Investment Cost Fair Value ----------------- ------------------ ---- ---------- Alenco Window Holdings II, LLC January 2002 Manufacturer of residential windows -24% membership interest $ 227 $2,500,000 American Trenchless Technology, LLC February 2001 Boring, tunneling and directional drilling -100,000 shares of preferred stock 1,208,144 - -1,934,532 shares of common stock 116,550 - The Bradshaw Group May 2000 Sells and services midrange and high-speed printing equipment -Prime + 2% promissory note * - - -15% promissory note * 459,545 - -1,335,000 shares of preferred stock 1,335,000 - -Warrant to buy 2,229,450 shares of common stock for $0.01 through May 2008 1 - Champion Window, Inc. March 1999 Manufacturer & distributor of residential windows -1,400,000 shares of common stock 1,400,000 11,500,000 CMC Investments, LLC December 2001 Manufacturer of oil and gas drilling rigs -21% membership interest 1,038,611 925,000 Container Acquisition, Inc. February 1997 Shipping container repair & storage -78,318 shares of preferred stock 7,831,800 5,500,000 -Conditional warrant to buy up to 370,588 shares of common stock at $0.01 through February 2007 1,000 - -1,370,000 shares of common stock 1,370,000 - -Member interest in CCI-ANI Finance, LLC 1,571,000 1,970,000
The accompanying notes are an integral part of these financial statements 8 EQUUS II INCORPORATED SCHEDULE OF PORTFOLIO SECURITIES SEPTEMBER 30, 2002MARCH 31, 2003 (Unaudited) (Continued)
Date of Portfolio Company Initial Investment Cost Fair Value ----------------- ------------------ -------------- ---------- Doane PetCare Enterprises, Inc. October 1995 (formerly Summit/DPC Partners, L.P.) Manufacturer of private label pet food -15% promissory note with a face amount of $1,805,556, including amortized discount $1,689,435 $1,689,435 -1,943,598 shares of common stock 3,936,643 5,000,000$3,936,643 $5,000,000 The Drilltec Corporation August 1998 Provides protection & packaging for pipe & tubing -Prime + 9.75% promissory note */(2)/ 1,000,000 --- ENGlobal, Inc. (AMEX:(AMEX; ENG) December 2001 (formerly Industrial Data Systems Corporation) Engineering and consulting services -9.5% promissory note 2,890,000 2,890,000/(1)/ 2,670,000 2,670,000 -2,588,000 shares of convertible preferred stock /(1)(3)/ 2,588,000 2,588,000 -1,225,758 shares of common stock 716,461 837,6691,637,398 -Options to acquire 200,000 shares of common stock -- -- Equicom, Inc. July 1997 Radio stations -10% promissory note * 1,638,500 1,638,500 -10% promissory note 1,429,250 1,429,250notes 3,191,730 3,191,730 -657,611 shares of preferred stock 6,576,110 500,000-- -452,000 shares of common stock 141,250 --- Equipment Support Services, Inc. December 1999 Equipment rental -8% promissory note */(2)/ 1,138,000 --- -35,000 shares of preferred stock 1,929,000 --- -35,000 shares of common stock 101,500 - FS Strategies, Inc. June 2000 Temporary staffing and web-based human resources services -1,667 shares of preferred stock 1,667,000 1,500,000 -110,000 shares of common stock 7,591,667 --- GCS RE, Inc. February 1989 Investment in real estate -1,000- 1,000 shares of common stock 320,924 600,000
The accompanying notes are an integral part of these financial statements 98 EQUUS II INCORPORATED SCHEDULE OF PORTFOLIO SECURITIES SEPTEMBER 30, 2002MARCH 31, 2003 (Unaudited) (Continued)
Date of Portfolio Company Initial Investment Cost Fair Value ----------------- ------------------ -------------- ---------- Jones Industrial Services, Inc. July 1998 (formerly United Industrial Services, Inc.) Field service for petrochemical & power generation industries -35,000 shares of preferred stock $3,500,000 $2,500,000 -Warrant to buy 63,637 shares of common stock at $0.01 through June 2008 100 - Milam Enterprises, LLC December 1986 (formerly Travis International, Inc.) Specialty distribution -Member interest 1,912 500,000-- NCI Building Systems, Inc. (NYSE: NCS) April 1989 Design & manufacture metal buildings -200,000 shares of common stock 159,784 3,760,0003,102,000 PalletOne, Inc. October 2001 Wooden pallet manufacturer -3,150,000-3,465,000 shares of preferred stock 3,150,000 3,150,000/(1)(3)/ 3,465,000 3,500,000 -350,000 shares of common stock 350,000 350,000-- Reliant Window Holdings, LLC February 2001 Manufacturer & distributor of aluminum & vinyl windows -36.86% membership interest 372,256 3,900,0004,800,000 Sovereign Business Forms, Inc. August 1996 Business forms manufacturer -15% promissory notes 3,659,740 3,659,740 -18,710/(1)(3)/ 3,923,366 3,923,366 -19,561 shares of preferred stock 1,871,000 1,871,000/(1)(3)/ 1,956,100 1,735,000 -Warrant to buy 551,894 shares of common stock at $1 per share through August 2006 - 263,750-- -- -Warrant to buy 25,070 shares of common stock at $1.25 per share through October 2007 - 5,565-- -- -Warrant to buy 273,450 shares of common stock at $1 per share through October 2009 - 130,685-- -- Spectrum Management, LLC December 1999 Business & personal property protection -285,000 units of Class A equity interest 2,850,000 2,850,000 -16% subordinated promissory note /(1)/ 1,303,698 1,303,698
The accompanying notes are an integral part of these financial statements 109 EQUUS II INCORPORATED SCHEDULE OF PORTFOLIO SECURITIES SEPTEMBER 30, 2002MARCH 31, 2003 (Unaudited) (Continued)
Date of Portfolio Company Initial Investment Cost Fair Value ----------------- ------------------ ---- --------------------- ----------- Sternhill Partners I, LP March 2000 Venture capital fund -3% limited partnership interest $1,651,604 $1,100,000$ 1,801,604 $ 650,000 Strategic Holdings, Inc. September 1995 Processor of recycled glass -15% promissory note * 6,750,000 6,750,000 -3,822,157 shares of Series B preferred stock 3,820,624 3,250,0003,820,624 -Warrant to buy 225,000 shares of common stock at $0.4643 per share through August 2005 - --- 98,000 -Warrant to buy 100,000 shares of common stock at $1.50 per share through August 2005 - --- -- -Warrant to buy 2,219,237 shares of common stock at $0.01 per share through November 2005 - --- 2,035,000 -3,089,751 shares of common stock 3,088,389 -2,867,000 -15% promissory note of SMIP, Inc. * 175,000 175,000 -1,000 shares of SMIP, Inc. common stock 150,000 -24,000 Turfgrass America, Inc. May 1999 Grows, sells & installs warm season turfgrasses -12% subordinated promissory note 288,580 288,580 -12% subordinated promissory note 502,035 502,035 -12% subordinated promissory note with a face amount of $4,000,000 3,742,237 3,742,237/(3)/ 3,821,372 3,821,372 -1,507,226 shares of convertible preferred stock 768,638 768,638-- -Warrants to buy 250,412 shares of common stock at $0.51 per share through April 2010 - --- -- -211,184 shares of common stock 600,000 600,000-- Vanguard VII, L.P. June 2000 Venture capital fund -1.3% limited partnership interest 1,200,000 850,0001,500,000 750,000 ----------- ----------- Total $90,337,517 $82,035,084$82,088,042 $87,382,558 =========== ===========
* The(1) Income-producing. All other securities are considered non-income producing. (2) As of March 31, 2003, the Fund has reduced the fair value of these notes to zero and has discontinued recognizing any additional interest income on these notes due to conditions specific to the respective Portfolio Companies. However, the Portfolio Companies are still liable for such notes and related interest, and itthey may be collected in the future. As(3) Income on these securities is paid-in-kind by the issuance of September 30, 2002,additional securities or through the aggregate amountaccretion of accrued interest receivable on and estimated fair value of these notes, which are reflected in the accompanying balance sheet, is $2,317,992 and $8,388,500, respectively. Management believes that the recorded interest receivable and the value assigned to the related notes will be realized.original issue discount. The accompanying notes are an integral part of these financial statements 1110 EQUUS II INCORPORATED SCHEDULE OF PORTFOLIO SECURITIES SEPTEMBER 30, 2002MARCH 31, 2003 (Unaudited) (Continued) Substantially all of the Fund's portfolio securities are restricted from public sale without prior registration under the Securities Act of 1933. The Fund negotiates certain aspects of the method and timing of the disposition of the Fund's investment in each portfolio company, including registration rights and related costs. In connection with the investments in American Trenchless Technology, LLC, Champion Window Holdings, Inc., Container Acquisition, Inc., The Drilltec Corporation, Jones Industrial Holdings,Services, Inc., Sovereign Business Forms, Inc., Strategic Holdings, Inc. and Turfgrass America, Inc., rights have been obtained to demand the registration of such securities under the Securities Act of 1933, providing certain conditions are met. The Fund does not expect to incur significant costs, including costs of any such registration, in connection with the future disposition of its portfolio securities. As defined in the Investment Company Act of 1940, at September 30, 2002,March 31, 2003, the Fund was deemedconsidered to have a controlling interest in Champion Window Holdings, Inc., Container Acquisition, Inc., The Drilltec Corporation, Equicom, Inc., Jones Industrial Holdings, Inc., PalletOne, Inc., Reliant Window Holdings, LLC, Sovereign Business Forms, Inc., Spectrum Management LLC, and Strategic Holdings, Inc. The fair value of the Fund's investment in ENGlobal, Inc. includes a discount of $654,770 from the closing market price to reflect the estimated effect of restrictions on the sale of such securities at March 31, 2003. Income was earned in the amount of $1,725,576$522,868 and $1,177,552$929,273 for the ninethree months ended September 30,March 31, 2003 and 2002, and 2001, respectively, on portfolio securities of companies in which the Fund has a controlling interest. Income was earned in the amount of $1,062,749$250,032 and $786,033$179,876 for the ninethree months ended September 30,March 31, 2003 and 2002, and 2001, respectively, on portfolio securities of companies that are affiliates of the Fund but are not controlled by the Fund. As defined in the Investment Company Act of 1940, all of the Fund's investments are in eligible portfolio companies except Sternhill Partners I, L.P. and Vanguard VII, L.P. The Fund provides significant managerial assistance to all of the portfolio companies in which it has invested, except Doane PetCare Enterprises, Inc. ("Doane"), Equipment Support Services, Inc., Milam Enterprises, LLC, Sternhill Partners I, L.P., and Vanguard VII, L.P. The Fund provides significant managerial assistance to portfolio companies that comprise 89%93% of the total value of the investments in portfolio companies at September 30, 2002. The Fund's investments in portfolio securities consist of the following types of securities at September 30, 2002:
Percentage Type of Securities Cost Fair Value of Fair Value ------------------ ---- ---------- ------------- Common Stock $20,556,778 $22,951,881 28.0% Secured and Subordinated Debt 25,362,323 22,764,777 27.8% Preferred Stock 36,245,316 21,627,638 26.3% Limited Liability Company Investments 5,320,395 12,340,788 15.0% Limited Partnership Investments 2,851,604 1,950,000 2.4% Options and Warrants 1,101 400,000 0.5% ----------- ----------- ----- Total $90,337,517 $82,035,084 100.0% =========== =========== =====
March 31, 2003. The accompanying notes are an integral part of these financial statements 1211 EQUUS II INCORPORATED SCHEDULE OF PORTFOLIO SECURITIES SEPTEMBER 30, 2002MARCH 31, 2003 (Unaudited) (Continued) The investments in portfolio securities held by the Fund are not geographically diversified. All of the Fund's portfolio companies (except for Doane, and PalletOne, Inc. and certain investments in the venture capital funds) are headquartered in Texas, although several have significant operations in other states. In addition, approximately 22%The Fund's investments in portfolio securities consist of the total valuefollowing types of the investments are concentrated in three Portfolio Companies which hold investments in two operating companies that manufacture and distribute residential windows. Accordingly, a substantial portion of the Fund's investment are tied to the construction of new residential properties in the southern part of the United States, which may be more cyclical than the economy as a whole.securities at March 31, 2003:
Percentage Type of Securities Cost Fair Value of Fair Value ------------------ ----------- ----------- ------------- Common Stock $12,965,112 $32,365,154 37.1% Secured and Subordinated Debt 25,223,326 22,625,780 25.9% Preferred Stock 34,978,416 15,642,624 17.9% Limited Liability Company Investments 5,618,483 13,215,000 15.1% Options and Warrants 1,101 2,133,000 2.4% Limited Partnership Investments 3,301,604 1,400,000 1.6% ----------- ----------- ----- Total $82,088,042 $87,382,558 100.0% =========== =========== =====
The following is a summary by industry of the Fund's investments as of September 30, 2002:March 31, 2003: Industry Fair Value Percentage -------- ----------- ---------- Business Productsproducts and Services $ 10,280,740 12.5%9,812,064 11.2% Commercial Building Products 3,760,000 4.6%3,102,000 3.5% Consumer Goods 6,689,435 8.2%5,000,000 5.7% Energy 925,000 1.1%399,755 0.5% Engineering and Consulting Services 6,315,669 7.7%6,895,398 7.9% Industrial Products and Services 12,675,000 15.5%18,569,624 21.2% Media 3,567,750 4.3%3,191,730 3.7% Residential Building Products 17,900,000 21.8%26,800,000 30.7% Shipping Products and Services 10,970,000 13.4%7,000,000 8.0% Turfgrass and Landscape Products 5,901,490 7.2%4,611,987 5.3% Venture Funds and Other 3,050,000 3.7% ------------2,000,000 2.3% ----------- ----- Total $ 82,035,084$87,382,558 100.0% ======================= ===== The accompanying notes are an integral part of these financial statements 1312 EQUUS II INCORPORATED NOTES TO FINANCIAL STATEMENTS SEPTEMBER 30,MARCH 31, 2003 AND 2002 AND 2001 (Unaudited) (1) Organization and Business Purpose Equus II Incorporated (the "Fund"), a Delaware corporation with perpetual existence, 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. The shares of the Fund trade on the New York Stock Exchange under the symbol EQS. The Fund seeks 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. The Fund seeks to invest primarily in companies which intend to acquire other businesses, including leveraged buyouts. The Fund may also invest in recapitalizations of existing businesses or special situations from time to time. The Fund's investments in Portfolio Companies consist principally of equity securities such as common and preferred stock, but also include other equity-oriented securities such as debt convertible into common or preferred stock or debt combined with warrants, options or other rights to acquire common or preferred stock. Current income is not a significant factor in the selection of investments. The Fund has elected to be treated as a business development company under the Investment Company Act of 1940. For tax purposes, the Fund has elected to be treated as a regulated investment company ("RIC"). The Fund has entered into a management agreement with Equus Capital Management Corporation, a Delaware corporation (the "Management Company"). (2) Liquidity and Notes Payable to BankFinancing Arrangements Liquidity and Revolving Line of Credit - The Fund has a $100,000,000 line of credit promissory note with Bank of America N.A., with interest payable at 1/2% over the rate earned in its money market account. The line of credit promissory note is utilized to enable the Fund to achieve adequate diversification to maintain its pass-through tax status as a regulated investment company. The Fund had $56,000,000 and $62,000,000 outstanding on such notes at September 30, 2002 and December 31, 2001, respectively, that was secured by $56,000,000 and $62,000,000 of the Fund's temporary cash investments. The Fund has a $22,500,000$11,965,000 revolving line of credit with Bank of America, N.A. that expires on JanuaryJune 1, 2003. The Fund uses its revolving line of credit for liquidity to pay operating expenses of the Fund and for new and follow-on investments in portfolio securities. The Fund had $10,375,000 and $11,200,000$10,825,000 outstanding under suchthis line of credit at September 30, 2002 and DecemberMarch 31, 2001, respectively,2003, which is securedcollateralized by the Fund's investments in portfolio securities. As of May 13, 2003, the Fund's availability under the revolving line of credit is approximately $1,090,000. The line of credit, as amended, provides that any proceeds received from the sale of portfolio securities or from repayments by Portfolio Companies of the principal amount of loans must be used to pay down the line of credit. As such payments are made, the Fund's availability under the facility is reduced by a corresponding amount. The lender has asked the Fund to take steps to pay off the line of credit. Accordingly, the Fund is currently in discussions with interested parties regarding the sale of certain portfolio securities at values that could enable the Fund to repay the line of credit. The Fund is also pursuing arrangements to refinance the line of credit with another lender and has approached the current lender for another extension of the due date. There can be no assurance that the Fund can sell securities sufficient to pay off the line of credit, extend the existing line of credit or obtain a replacement facility by June 1, 2003. Should the Fund be unable to repay the line of credit, extend it or refinance it with another lender, portfolio securities may be required to be sold and such sales may be at values that are materially less than the Management Company's estimates of fair value. Under certain circumstances, the Fund may be called on to make follow-on investments in certain Portfolio Companies. The Fund has guaranteed obligations to financial institutions on behalf of Reliant 13 Window Holdings, LLC ("RWH"), Equicom, Inc. ("Equicom") and SMIP, Inc. ("SMIP") in the respective amounts of $1,439,000, $683,520 and $420,000. RWH is currently servicing its obligations to the financial institution, and the Management Company does not expect the Fund to be required to provide funding under this guarantee. The Fund has made loans to Equicom from time to time to enable the company to service its debt, but the Management Company does not expect the Fund to advance more than $100,000 for the last three quarters in 2003 for such purpose. In addition, the Fund has committed to invest up to $5,550,000 in the two venture capital funds in its portfolio. At March 31, 2003, $3,330,000 of such amount had been funded. The Management Company does not expect the Fund to advance more than $700,000 of its remaining commitments to the venture capital funds in 2003. If the Fund does not have sufficient funds to make follow-on investments, the portfolio company in need of the investment may be negatively impacted. Also, the Fund's equity interest in and its estimated fair value of the portfolio company could be reduced. The interest rate ranges fromon the line of credit is currently prime -1/2% to prime +1/4% or LIBOR + 1.65%4%. The Fund also pays interest at the rate of 1/4% per annum on the unused portion of the line of credit. The average daily balances outstanding on the Fund's notes payableline of credit during the ninethree months ended September 30,March 31, 2003 and 2002 was $12,076,389 and 2001, were $12,070,214$10,520,556, respectively. During the three months ended March 31, 2003 and $7,076,374,2002, the amount of interest paid in cash was $191,192 and $126,900, respectively. The line of credit promissory noterestricts the Fund's ability to incur additional indebtedness, pay dividends, merge with another entity, dispose of assets outside the ordinary course of business and the revolving line of credit expire on January 1, 2003.engage in certain transactions with affiliates. RIC Borrowings, Restricted Cash and Temporary Investments - The Fund is attempting to arrangehad a new$100,000,000 line of credit promissory note with Bank of America N.A. through January 1, 2003, with interest payable at 1/2% over the rate earned on its money market account. Because of the nature and linesize of credit. However, if this is not established by November 30, 2002,its portfolio investments, the Fund will have to pay a fee of $50,000 to the current lender. If the Fund is unable to maintain itsperiodically borrowed money under this line of credit promissory note it may loseto make qualifying investments to maintain its pass-through tax status as a regulated investment company ("RIC") under Subchapter M of the Internal Revenue Code. Also, ifThe Fund had $58,000,000 outstanding on such note at December 31, 2002, which was collateralized by restricted temporary cash investments of $58,000,000. Pursuant to the fundterms of the note, the Fund is required to repay the outstanding borrowings within five business days of the initial borrowing date. The Fund repaid the outstanding quarter end borrowings within this time period. The Fund's line of credit promissory note expired on January 1, 2003. During March 2003, the Fund borrowed $54,959,521 to make qualifying investments to maintain its RIC status by utilizing an established margin account with a securities brokerage firm. The Fund collateralized such borrowings with restricted cash and temporary investments of $55,432,419 and other portfolio securities of $3,274,189 in the margin account. The U.S. Treasury bills were sold, and the total amount borrowed was repaid on April 1, 2003. The Management Company believes the Fund will be able to use this financing arrangement to maintain its RIC status. However, there is no assurance that such arrangement will be available to the Fund in the future. If the Fund is unable to maintain its revolving line of credit itborrow funds in the future to make qualifying investments, the Fund may be requiredno longer qualify as a RIC. Failure to sellcontinue to qualify as a portion of its investment portfolio when it may be disadvantageous to do so. No assurances that these lines of credit will be refinanced can be given. The overall effect of not completing a refinancingRIC could be material to the Fund. 14 (3) Management The Fund has entered into a management agreement with Equus Capital Management Corporation, a Delaware corporation (the "Management Company"). Pursuant to such agreement, the Management Company performs certain services, including certain management and administrative services necessary for the operation of the Fund. The Management Company receives a management fee at an annual rate of 2% of the net assets ofFund's shareholders in that the Fund paid quarterly in arrears. The Management Company also receives compensation for providing certain investor communication services, of which $37,500 is included in the accompanying Statements of Operations for each of the nine months ended September 30, 2002would be subject to corporate income tax on its net investment income and 2001. The Management Company is controlled by a privately-owned corporation. As compensation for services providednet realized gains and distributions to the Fund, each director who is not an officer of the Fund receives an annual fee of $25,000 paid quarterly in arrears, a fee of $3,000 for each meeting of the Board of Directors attended in person, a fee of $1,500 for participation in each telephonic meeting of the Board of Directors and for each committee meeting attended ($500 for each committee meeting if attended on the same dayshareholders would be subject to income tax as a Board Meeting), and reimbursement of all out-of-pocket expenses relating to attendance at such meetings. In addition, each director who is not an officer of the Fund is granted incentive stock options to purchase shares of the Fund's stock from time to time. (See Note 9). Officers of the Fund serve as directors of certain Portfolio Companies, and may receive and retain fees, including non-employee director stock options, from such Portfolio Companies in consideration for such service. The aggregate amount of such cash fees paid by Portfolio Companies amounted to $141,125 and $150,652 for the nine months ended September 30, 2002 and 2001, respectively. Additionally, two officers of the Management Company serve as officers and directors of the Fund. The Management Agreement will continue in effect until June 30, 2003, and from year-to-year thereafter provided such continuance is approved at least annually by (i) a vote of a majority of the outstanding shares of the Fund or (ii) a majority of the directors who are not "interested persons" of the Fund, at a meeting called for the purpose of voting on such approval. The Management Agreement may be terminated at any time, without the payment of any penalty, by a vote of the Board of Directors of the Fund or the holders of a majority of the Fund's shares on 60 days' written notice to the Management Company, and would automatically terminate in the event of its "assignment" (as defined in the Investment Company Act). (4)ordinary dividends. (3) Significant Accounting Policies 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 14 United States 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 valued at their quoted market price at the close of business on the valuation date, less a discount to reflect the estimated effects of restrictions on the sale of such securities ("Valuation Discount"), if applicable. Privately-held portfolio securities - The fair value of investments for which no market exists (including 95%96% of the investments of the Fund at September 30, 2002)March 31, 2003) is determined on the basis of procedures established in good faith by the Board of Directors of the Fund. As a general principle, the 15 current "fair value" of an investment would beis the amount the Fund might reasonably expect to receive for it upon its current sale, in an orderly disposition.manner. Appraisal valuations are necessarily subjective and the Management Company's estimate of values may differ materially from amounts actually received upon the disposition of portfolio securities.securities Generally, cost is the primary factor used to determine fair value until significant developments affecting the Portfolio Company (such as results of operations or changes in general market conditions) provide a basis for use of an appraisal valuation. Thereafter, portfolio investments are carried at appraised values as determined quarterly by the Management Company, subject to the approval of the Board of Directors. Appraisal valuations are based upon such factors as a 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, the appraisal may be based upon liquidation value. Most of the Fund's common equity investments are appraised at a multiple of historical free cash flow generated by the Portfolio Company in its most recent fiscal year, less outstanding funded indebtedness and other senior securities such as preferred stock. Projections of current year free cash flow may be utilized and adjustments for non-recurring items are considered. Multiples utilized are estimated based on the Management Company's experience in the private company marketplace, and are necessarily subjective in nature. ManyMost of the Portfolio Companies utilize a high degree of leverage. The banking environment currently has resulted in pressure on several of these Portfolio Companies to reduce the amount of leverage in order to maintain such financing. From time to time, Portfolio Companies are in default of certain covenants in their loan agreements. When the Management Company has a reasonable belief that the Portfolio Company will be able to restructure the loan agreements to adjust for any defaults, the Portfolio Company's securities continue to be valued assuming that the company is a going concern. In the event a Portfolio Company cannot generate adequate cash flow to meet the principal and interest payments on such indebtedness or is not successful in refinancing the debt upon its maturity, the Fund's investment could be reduced or eliminated through foreclosure on the Portfolio Company's assets or the Portfolio Company's reorganization or bankruptcy. The banking environment currently has resulted in pressure on several of these Companies to reduce the amount of leverage in order to maintain such financing. From time to time, Portfolio Companies may be in default of certain covenants in their loan agreements. When the Management Company has a reasonable belief that the Portfolio Company will be able to restructure the loan agreements to adjust for any defaults, the Portfolio Company's securities continue to be valued assuming that the company is a going concern. The Fund 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. The fair values of debt securities, which are generally held to maturity, are determined on the basis of the terms of the debt securities and the financial conditions of the issuer. Certificates of deposit purchased by the Fund generally will be valued at their face value, plus interest accrued to the date of valuation. 15 Because of the inherent uncertainty of the valuation of portfolio securities which do not have readily ascertainable market values, amounting to $77,970,872$84,113,200 (including $837,669$1,637,398 in publicly-traded securities, net of a $155,195$654,770 Valuation Discount) and $79,750,789$82,653,260 (including $605,860$1,230,650 in publicly-traded securities, net of a $276,686$228,003 Valuation Discount) at September 30, 2002March 31, 2003 and December 31, 2001,2002, respectively, the Fund's estimate of fair value may significantlymaterially differ from the value that would have been used had a ready market existed for the securities. Appraised values do not reflect brokers' fees or other normal selling costs which might become payable on disposition of such investments. 16 On a daily basis, the Fund adjusts its net asset value for the changes in the value of its publicly held securities and material changes in the value of its private securities and reports those amounts to Lipper Analytical Services, Inc. The reportedWeekly and daily net asset values also appear in various publications, including Barron's and The Wall Street Journal. Investment Transactions - Investment transactions are recorded on the accrual method. Realized gains and losses on investments sold are computed on a specific identification basis. Cash Flows - For purposes of the Statements of Cash Flows, the Fund considers all highly liquid temporary cash investments purchased with an original maturity of three months or less to be cash equivalents. Federal Income Taxes - The Fund intends 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 shareholders. Therefore, no provision for federal income taxes is recorded in the financial statements. AsThe Fund borrows money from time to time to maintain its tax status under the Internal Revenue Code as a RIC. See Note 2 for further discussion of December 31, 2001,the Fund's RIC borrowings. Stock-Based Compensation - The Fund accounts for stock-based compensation using the intrinsic value method in accordance with the provisions of APB No. 25. Had the Fund accounted for the options using the fair value method under SFAS 123, the decrease in net assets from operations for the three months ended March 31, 2003 and 2002, respectively, would have been: 2003 2002 ---------- ---------- Increase in net assets from operations, as reported $2,737,910 $1,621,461 Stock-based employee compensation expense included in increase in net assets from operations -- 41,859 Stock-based employee compensation expense determined using fair value method (18,636) (26,726) ---------- ---------- Pro forma increase in net assets from operations $2,719,274 $1,636,594 ========== ========== (4) Management The Fund has entered into a capital loss carryforwardmanagement agreement with the Management Company. Pursuant to such agreement, the Management Company performs certain services, including certain management and administrative services necessary for the operation of $5,047,823 (whichthe Fund. The Management Company receives a management fee at an annual rate of 2% of the net assets of the Fund, paid quarterly in arrears. The Management Company also receives compensation for providing certain investor communication services, of which $12,500 is included in the accompanying Statements of Operations for each of the three months ended March 31, 2003 and 2002. The management fees paid by the Fund represent the 16 Management Company's primary source of revenue and support. The Management Company is controlled by a privately-owned corporation. As compensation for services rendered to the Fund, each director who is not an officer of the Fund 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 each committee meeting attended, and reimbursement of all out-of-pocket expenses relating to attendance at such meetings. In addition, each director who is not an officer of the Fund is granted incentive stock options to purchase shares of the Fund's stock from time to time. (See Note 8). Certain officers and directors of the Fund serve as directors of Portfolio Companies, and may receive and retain fees, including non-employee director stock options, from such Portfolio Companies in consideration for such service. Additionally, two officers of the Management Company serve as directors of the Fund. The Management Agreement will continue in effect until June 30, 2003, and from year-to-year thereafter provided such continuance is approved at least annually by (i) a vote of a majority of the outstanding shares of the Fund or (ii) a majority of the directors who are not "interested persons" of the Fund, at a meeting called for the purpose of voting on such approval. The Management Agreement may be carried forwardterminated at any time, without the payment of any penalty, by a vote of the Board of Directors of the Fund or the holders of a majority of the Fund's shares on 60 days' written notice to offset future taxable capital gains, if any)the Management Company, and would automatically terminate in the event of its "assignment" (as defined in the Investment Company Act). (5) Federal Income Tax Matters The Fund cannotis required to make distributions of any net taxable investment income on an annual basis, and may elect to distribute or retain net taxable realized capital gains to shareholders until the tax loss carryforwards have been utilized. (5) Book to Tax Reconciliationgains. The Internal Revenue Service approved the Fund's request, effective October 31, 1998, to change its year-end for determining capital gains for purposes of Section 4982 of the Internal Revenue Code from December 31 to October 31, which allows current year dividends to be paid prior to the end of the calendar year.31. The Fund realized net capital gains (losses)was not required to make any distributions for 2002 under income tax purposesregulations. As of $2,384,831 and $(3,884,515) forDecember 31, 2002, the nine months ended September 30, 2002 and 2001, respectively. The Fund had net investment income for tax purposesa capital loss carryforward of $879,252 and $332,063 for$2,218,000, which may be used to offset future taxable capital gains. If not utilized, the nine months ended September 30, 2002 and 2001, respectively. The following is a reconciliation of the differenceloss carryforward will expire in the Fund's net realized gain or loss on the sale of portfolio securities for book and tax purposes for the nine months ended September 30, 2002 and 2001, respectively. 2002 2001 ---- ---- Net realized gain (loss) on the sale of portfolio securities, book $ 399,301 $(4,040,983) Book/tax differences 1,985,530 156,468 --------- ----------- Net realized gain (loss) on the sale of portfolio securities, tax $2,384,831 $(3,884,515) ========== =========== 17 2006. (6) Dividends The Fund declared no dividends during the ninethree months ended September 30, 2002March 31, 2003 and 2001, respectively.2002. (7) Temporary Cash Investments Temporary cash investments, which represent the short-term utilization of cash prior to investment in securities of portfolio companies, distributions to the shareholders or payment of loans and expenses, consist of $56,026,144 in money market accounts with Bank of America, N.A. earning interest ranging in rates of 1.21% to 1.30% per annum at September 30, 2002. (8) Portfolio Securities During the ninethree months ended September 30, 2002,March 31, 2003, the Fund invested $483,749 in one new limited liability company which invested in an existing Portfolio Company, and made follow-on investments of $6,367,389$701,943 in elevenfive companies, including $1,485,165$326,943 in accrued interest and dividends in the form of additional portfolio securities and accretion of original issue discount on promissory notes. In addition, the Fund realized a net capital gainloss of $399,301$8,100,724 during the ninethree months ended September 30, 2002.March 31, 2003. During the ninethree months ended September 30, 2001,March 31, 2002, the Fund invested $1,120,236$483,749 in twoone new companiescompany and made follow-on investments of $7,970,878$3,045,952 in eleveneight companies, including $1,950,830$415,372 in accrued interest and dividends received in the form of additional portfolio securities and accretion of original issue discount on a promissory note.notes. In addition, the Fund realized a net capital loss of $4,040,983$666,922 during the ninethree months ended September 30, 2001. (9)March 31, 2002. 17 (8) Stock Option Plan Shareholders have approved the Equus II Incorporated 1997 Stock Incentive Plan ("Stock Incentive Plan"), which authorizes the Fund to issue options to the directors and officers of the Fund in an aggregate amount of up to 20% of the outstanding shares of common stock of the Fund. The Stock Incentive Plan provides that each director who is not an officer of the Fund is, on the first business day following each annual meeting, granted an incentive stock option to purchase 2,0002,200 shares of the Fund's common stock. Options are issued to the officers of the Fund at the discretion of the compensation committee in accordance with the Stock Incentive Plan. The options have a ten year life and vest 50% six months after the grant date with the remaining 50% vesting equallyand 16 2/3% on the first, second and third anniversaries of the date of the grant. Under the Stock Incentive Plan, options to purchase 1,085,6001,086,800 and 83,6001,073,600 shares of the Fund's common stock with a weighted average exercise price of $8.42 and $17.17$8.43 per share were outstanding at September 30,March 31, 2003 and 2002, and 2001, respectively. Of these options, 571,988743,588 and 63,79370,388 shares, with a weighted average exercise price per share of $9.07$8.75 and $19.64$18.60 were exercisable at September 30,March 31, 2003 and 2002, and 2001, respectively. Of the outstanding options at September 30, 2002, 1,039,400March 31, 2003, 1,027,400 have exercise prices ranging from $7.69$7.60 to $14.15 and the remaining options have exercise prices ranging from $21.82 to $24.95. These options expire in May 2007 through May 2012. On September 30, 1999, options to purchase 719,794 shares of common stock of the Fund were exercised by the officers of the Fund for $15.45 per share. The exercise price of $11,124,086 was paid in the form of promissory notes from the officers to the Fund. On April 1, 2001, a former officer of the Fund surrendered 41,471 shares in payment of his note receivable and accrued interest aggregating 18 $548,542. In September 2001, the current officers of the Fund surrendered 802,662 shares in payment of their notes receivable and accrued interest aggregating $10,505,551. These payments were recorded as decreases in common stock and additional paid in capital. The Fund released 71,824 shares to the officers relating to these payments. There was no change in total net assets as a result of the note repayment and surrendering of the shares.November 2011. In April 2001, officers of the Fund surrendered options to acquire 247,077 shares of common stock pursuant to the Stock Incentive Plan back to the Fund, and such options were cancelled. The notes receivable, as well as 849,120 shares of common stock pledged as collateral, were not included in the Fund's reported net asset value per share in 2001 or 2000. Under variable plan accounting applicable to these transactions, compensation expense was recorded to reflect the change in benefit that the officers would have received assuming that their notes were settled with their pledged common stock at the end of each reporting period, based on the net asset value of the Fund. Interest earned on the notes receivable of $384,388 was recorded as an increase to additional paid in capital for the nine months ended September 30, 2001. On May 7, 2002 and May 4, 2001, options to acquire a total of 12,000 and 13,200 shares at $7.80 and $8.4455 per share were issued to the non-officer directors, respectively.directors. In addition, on November 14, 2001, options to acquire a total of 990,000 shares at $7.69 per share (market price on date of grant) were issued to officers of the Fund. These options include dividend equivalent rights. Generally accepted accounting principles require that the options be accounted for using variable plan accounting as a result of the terms of the dividend equivalent rights. SuchThe Fund is currently discussing with the Securities and Exchange Commission whether a business development company is authorized to issue dividend equivalent rights with options. Since November 2001, no cash dividends have been declared by the Fund. Consequently, no amounts have accumulated to the option holders related to the dividend equivalent rights. Variable plan accounting resulted in additional non-cash compensation (benefit)expense of $(14,434)$41,859 during the nine monthsquarter ended September 30,March 31, 2002, related to the 990,000 options issued in 2001. As of September 30,March 31, 2003 and December 31, 2002, and 2001, all outstanding options were "out of the money" and would not have had a dilutive effect on net assets per share if exercised, assuming the Fund had used the proceeds from the exercise of such options to repurchase shares at the market price pursuant to the treasury stock method. (10) Commitments and Contingencies The Fund has made commitments to invest, under certain circumstances, up to an additional $300,000 in American Trenchless Technology, LLC, $807,500 in Equicom, Inc., $408,334 in FS Strategies, Inc., $5,527,000 (including the letter of credit described below) in Reliant Window Holdings, LLC, $1,303,698 in Spectrum Management, LLC, $1,320,000 in Sternhill Partners I, L.P. and $1,800,000 in Vanguard VII, L.P. In the event that these commitments are called for but not met by(9) Subsequent Events On April 1, 2003, the Fund sold the ownership positionU.S. Treasury bills for $54,964,465 and repaid the margin loan. In April and May 2003, the Fund sold 4,432 shares of common stock of Weatherford International, Inc. for $183,005, realizing a capital loss of $73,829. On May 9, 2003, the Independent Directors approved an extension of the Fund in the Portfolio Companies may be diluted and/or the existing investments may be decreased in value. The Fund has provided irrevocable letters of credit in the aggregate amount of $3,719,584 for the benefit of one Portfolio Company. If such letters of credit were called, other co-investors in the Portfolio Company are required to reimburseManagement Agreement through June 30, 2004. 18 On May 13, 2003, the Fund for 63% of the amount called. The Fund and certain of the portfolio companies are involved in asserted claims and have the possibility for unasserted claims which may ultimately affect the fair value of the Fund's portfolio investments. In the opinion of Management, the financial position or operating results of the Fund will not be materially affected by any claims that have been asserted. (11) Subsequent Events From October 1, 2002, through November 14, 2002, the Fund repaid a net $53,850,000 of notes payableadvanced $75,000 to the bank. 19 On October 9, 2002, the Fund invested an additional $150,000 in Sternhill Partners I, L.P.Equicom, Inc. pursuant to itsa 10% promissory note, thereby reducing the guarantee commitment made in March 2000. On October 17, 2002 the Fund invested $300,000 in Glendale, LLC, which was formed to invest in American Trenchless Technology, LLC in connection withEquicom's lender by a restructuring of its debt and a recapitalization of its balance sheet. On October 30, 2002, the Fund invested $1,303,698 in Spectrum Management, LLC, in exchange for a 16% senior subordinated promissory note. On November 4, 2002, the Fund received $402,935 from Milam Enterprises, LLC ("Milam"), as a partial distribution of the assets of Milam. Milam continues to hold certain assets and certain retained and contingent liabilities related to the sale of the operations of Travis International, Inc. 20like amount. 19 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations. Significant Accounting Policies 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 preformed in accordance with accounting principles generally accepted in the United States 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 valued at their quoted market price at the close of business on the valuation date, less a discount to reflect the estimated effects of restrictions on the sale of such securities ("Valuation Discount"), if applicable. Privately-held portfolio securities - The fair value of investments for which no market exists (95%(96% of the investments held by the Fund at September 30, 2002)March 31, 2003) is determined on the basis of procedures established in good faith by the Board of Directors of the Fund. As a general principle, the current "fair value" of an investment would be the amount the Fund might reasonably expect to receive for it upon its current sale, in an orderly disposition.manner. Appraisal valuations are necessarily subjective and the Management Company's estimate of values may differ materially from amounts actually received upon the disposition of portfolio securities.securities Generally, cost is the primary factor used to determine fair value until significant developments affecting the Portfolio Company (such as results of operations or changes in general market conditions) provide a basis for use of an appraisal valuation. Thereafter, portfolio investments are carried at appraised values as determined quarterly by the Management Company, subject to the approval of the Board of Directors. Appraisal valuations are based upon such factors as a 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, the appraisal may be based upon liquidation value. Most of the Fund's common equity investments are appraised at a multiple of historical free cash flow generated by the Portfolio Company in its most recent fiscal year, less outstanding funded indebtedness and other senior securities such as preferred stock. Projections of current year free cash flow may be utilized and adjustments for non-recurring items are considered. Multiples utilized are estimated based on the Management Company's experience in the private company marketplace, and are necessarily subjective in nature. ManyMost of the Portfolio Companies utilize a high degree of leverage. The banking environment currently has resulted in pressure on several of these Companies to reduce the amount of leverage in order to maintain such financing. From time to time, Portfolio Companies are in default of certain covenants in their loan agreements. When the Management Company has a reasonable belief that the Portfolio Company will be able to restructure the loan agreements to adjust for any defaults, the Portfolio Company's securities continue to be valued assuming that the company is a going concern. In the event a Portfolio Company cannot generate adequate cash flow to meet the principal and interest payments on such indebtedness or is not successful in refinancing the debt upon its maturity, the Fund's investment could be reduced or eliminated through foreclosure on the Portfolio Company's assets or the Portfolio Company's reorganization or bankruptcy. The banking environment currently has resulted in pressure on several of these Companies to reduce the amount of leverage in order to maintain such financing. From time to time, Portfolio Companies may be in default of certain covenants in their loan agreements. When the Management Company has a reasonable belief that the Portfolio Company will be able to restructure the loan agreements to adjust for any defaults, the Portfolio Company's securities continue to be valued assuming that the company is a going concern. 21 The Fund 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 20 used only with respect to completed transactions or firm offers made by sophisticated, independent investors. The fair values of debt securities, which are generally held to maturity, are determined on the basis of the terms of the debt securities and the financial conditions of the issuer. Certificates of deposit purchased by the Fund generally will be valued at their face value, plus interest accrued to the date of valuation. Because of the inherent uncertainty of the valuation of portfolio securities which do not have readily ascertainable market values, the Fund's estimate of fair value may significantlymaterially differ from the value that would have been used had a ready market existed for the securities. On a daily basis, the Fund adjusts its net asset value for the changes in the value of its publicly held securities and material changes in the value of its private securities and reports those amounts to Lipper Analytical Services, Inc. The reportedWeekly and daily net asset values also appear in various publications, including Barron's and The Wall Street Journal. Investment Transactions - Investment transactions are recorded on the accrual method. Realized gains and losses on investments sold are computed on a specific identification basis. Cash Flows - For purposes of the Statements of Cash Flows, the Fund considers all highly liquid temporary cash investments purchased with an original maturity of three months or less to be cash equivalents.Federal Income Taxes - NoThe Fund intends 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 shareholders. Therefore, no provision for federal income taxes has been madeis recorded in the accompanying financial statements as thestatements. The Fund has qualified for pass-through treatment as a "regulated investment company"borrows money from time to time to maintain its tax status under Subchapter M of the Internal Revenue Code of 1986. As such, all net income is allocable to the stockholdersas a RIC. See Note 2 for inclusion in their respective tax returns. Net capital losses are not allocable to the shareholders but can be carried over to offset future earningsfurther discussion of the Fund.Fund's RIC borrowings. Liquidity and Capital Resources At September 30, 2002,March 31, 2003, the Fund had $82,035,084$87,382,558 of its assets invested in portfolio securities of 2419 companies and two venture capital funds. The Fund has a $11,965,000 revolving line of credit with Bank of America, N.A. that expires on June 1, 2003. The Fund uses its revolving line of credit for liquidity to pay operating expenses of the Fund and for new and follow-on investments in portfolio securities. The Fund had $10,825,000 outstanding under this line of credit at March 31, 2003, which is collateralized by the Fund's investments in portfolio securities. As of May 13, 2003, the Fund's availability under the revolving line of credit is approximately $1,090,000. The line of credit, as amended, provides that any proceeds received from the sale of portfolio securities or from repayments by portfolio companies of the principal amount of loans must be used to pay down the line of credit. As such payments are made, the Fund's availability under the facility is reduced by a corresponding amount. The line of credit also restricts the Fund's ability to incur additional indebtedness, pay dividends, merge with another entity, dispose of assets outside the ordinary course of business and engage in certain transactions with affiliates. The lender has asked the Fund to take steps to pay off the line of credit. Accordingly, the Fund is currently in discussions with interested parties regarding the sale of certain portfolio securities at values that could enable the Fund to repay the line of credit. The Fund is also pursuing arrangements to refinance the line of credit with another lender and has approached the current lender for another extension of the due date. There can be no assurance that the Fund can sell securities sufficient to pay off the line of credit, extend the existing line of credit or obtain a replacement facility by June 1, 2003. Should the Fund be unable to repay the line of credit, extend it or refinance it with another lender, portfolio securities may be required to be sold and such sales may be at values that are materially less than Management's estimates of fair value. 21 Under certain circumstances, the Fund may be called on to make follow-on investments in certain Portfolio Companies. The Fund has guaranteed obligations to financial institutions on behalf of Reliant Window Holdings, LLC ("RWH"), Equicom, Inc. ("Equicom") and SMIP, Inc. ("SMIP") in the respective amounts of $1,439,000, $683,520 and $420,000. RWH is currently servicing its obligations to the financial institution, and the Management Company does not expect the Fund to be required to provide funding under this guarantee. The Fund has made loans to Equicom from time to time to enable the company to service its debt, but the Management Company does not expect the Fund to advance more than $100,000 for the last three quarters in 2003 for such purpose. In addition, the Fund has committed to invest up to an additional $11,466,532$5,550,000 in seventhe two venture capital funds in its portfolio. At March 31, 2003, $3,330,000 of such companies under certain circumstances.amount had been funded. The follow-on commitments include $3,719,584 in stand-by letters of credit to enable a PortfolioManagement Company to maintain its insurance program. Of the current commitments,does not expect the Fund expects to advance or invest no more than $3.0 million in the next twelve months. Current temporary cash investments, anticipated future investment income, proceeds from borrowings, and proceeds from the sale$700,000 of existing portfolio securities are believed to be sufficient to finance these commitments. At September 30, 2002, the Fund had $10,375,000 in borrowings plus $3,719,584 in letters of credit outstanding on a $22,500,000 revolving line of credit loan from a bank. The revolving credit loan agreement was scheduled to expire on October 1, 2002. However, it has been extended until January 1, 2003, and the Fund is attempting to replace this line upon expiration. The Fund will have to pay a fee of $50,000its remaining commitments to the current lender if a replacement line is not established by November 30, 2002. If the Fund is unable to maintain its revolving line of credit it may be required to sell a portion of its investment portfolio when it may be disadvantageous to do so. Also, the $100,000,000 line of credit promissory note was scheduled to expire on October 1, 2002 and has been extended until January 1,venture capital funds in 2003. If the Fund is unabledoes not have sufficient funds to maintain its line of credit it may lose its pass-through tax status as a regulated investmentmake follow-on investments, the portfolio company under Subchapter Min need of the Internal Revenue Code. No assurances that these linesinvestment may be negatively impacted. Also, the Fund's equity interest in and its estimated fair value of credit will be refinanced can be given. 22 The overall effect of not completing a refinancingthe portfolio company could be material to the Fund.reduced. Net cash used by operating activities was $1,100,542$239,569 and $2,045,932$161,981 for the ninethree months ended September 30,March 31, 2003 and 2002, respectively. Management believes that borrowings available under the revolving line of credit, net investment income and 2001, respectively.proceeds from sales of portfolio securities will be sufficient for the liquidity needs of the Fund. Approximately $22.8$22.6 million in estimated value of the Fund's investments are in the form of notes receivable from Portfolio Companies. At September 30, 2002, the Fund has elected not to continue accruing interest receivable onMarch 31, 2003, two of these notes, with an aggregateestimated fair value of $8,388,500, and an additional $5,349,175 of such notes are paying$7,744,738, provide that interest is paid in kind or that the original issue discount is accreted over the life of the notes, by adding the interestsuch amount to the faceprincipal of the note. Management believes thatnotes. Because of the nature and size of its portfolio investments, the Fund will ultimately realize the carrying value of such notes plus the recorded interest receivable. At September 30, 2002, the Fund had $56,026,144 of its total assets of $141,277,152 invested in temporary cash investments consisting ofperiodically borrowed money market securities. This amount includes proceeds of $56,000,000 fromunder a $100,000,000 line of credit promissory note to make qualifying investments to maintain its tax status under the Internal Revenue Code as a bankregulated investment company ("RIC"). The Fund's line of credit promissory note expired on January 1, 2003. Management believes the Fund will be able to borrow sufficient funds to maintain its RIC status in the future by utilizing an established margin account with a securities brokerage firm, supplemented by collateralized loans from banks, if necessary. However, there are no assurances that such arrangement will be available to the Fund in the future. If the Fund is unable to borrow funds to make qualifying investments, the Fund may no longer qualify as a RIC. The Fund would then be subject to corporate income tax on its net investment income and realized capital gains and distributions to shareholders would be subject to income tax as ordinary dividends. Failure to continue to qualify as a RIC could be material to the Fund's shareholders. At March 31, 2003, the Fund had $54,959,521 of its total assets of $146,398,857 invested in U.S. Treasury bills. These securities were held by a securities brokerage firm in an established margin account that is utilized to enable the Fund to achieve adequate diversification to maintain its pass-through tax status as a regulated investment company.company, and were pledged along with cash and securities to secure the payment of the margin account balance. Such amount was repaid to the bankbrokerage firm on OctoberApril 1, 2002.2003. The Fund has the ability to borrow funds and issue forms of senior securities representing indebtedness or stock, such as preferred stock, subject to certain restrictions. Net investment income and net realized gains from the sales of portfolio investments are intended to be distributed at least annually, to the extent such amounts are not reserved for payment of contingencies or to make follow-on or new investments. Management believes thatPursuant to the availability under itsrestrictions in the Fund's existing line of credit, as well as the abilityFund is not allowed to sell its investments in publicly traded securities, are adequate to provide payment for any expenses and contingencies ofincur additional indebtedness unless approved by the Fund.lender. The Fund reserves the right to retain net long-term capital gains in excess of net short-term capital losses for reinvestment or to pay contingencies and expenses. Such retained amounts, if any, will be taxable to the Fund as long-term capital gains and stockholdersshareholders will be able to claim their proportionate 22 share of the federal income taxes paid by the Fund on such gains as a credit against their own federal income tax liabilities. StockholdersShareholders will also be entitled to increase the adjusted tax basis of their Fund shares by the difference between their undistributed capital gains and their tax credit. Results of Operations Investment Income and Expense Net investment income after all expenses amounted to $893,686$127,104 and $1,484,531$506,084 for the ninethree months ended September 30,March 31, 2003 and 2002, and 2001, respectively. The decrease in investment income is primarily due to a decrease in the credit to non-cash compensation expense in accordance with variable plan accounting required in connection with the Fund's stock option plan. Income from portfolio securities was $2,652,139$846,958 for the ninethree months ended September 30, 2002March 31, 2003 and $2,008,731$1,246,984 for the comparable period in 2001.2002. The increasedecrease from 2003 to 2002 is attributable primarilydue to dividends received during 2002 on the redemption of Champion Window, Inc.'s preferred stock. Other income was $240,000 for the nine months ended September 30, 2002 and $55,000 for the comparable period in 2001. This increase is primarily attributable to fees charged to GCS RE, Inc. in 2002 for maintaining its accounting and financial statements and for assisting in the sale of its real estate. Professional fees decreased to $143,204 in 2002 from $271,260Champion Window Holdings, Inc., when the preferred stock was redeemed, and from Container Acquisition, Inc. This decrease is partially offset by interest income accrued in 2001 due to legal fees incurred in 2001 related to2003 on the sale of the Fund's investment in Stephen L. LaFrancenote receivable from Strategic Holdings, Inc. and a potential purchase of a portfolio company that did not occur.Professional fees increased to $67,125 in 2003 from $40,953 in 2002. Director fees and expenses decreased to $183,513$54,555 in 20022003 from $192,976$61,556 in 2001 due to additional meetings held in the first quarter of 2001.2002. Interest expense increased to $384,608$183,064 in 20022003 from $295,191$154,314 in 20012002 due to an increase in the average daily balances outstanding on the lines of credit to $12,070,214 23 $12,076,389 during the ninethree months ended September 30, 2002March 31, 2003 from $7,076,374$10,520,556 during the comparable period in 2001.2002. The Management Company receives management fee compensation at an annual rate of 2% of the net assets of the Fund paid quarterly in arrears. Such fees amounted to $1,147,271$398,570 and $1,233,950$393,151 during the ninethree months ended September 30,March 31, 2003 and 2002, and 2001, respectively. The decrease in management fees during the ninethree months ended September 30, 2002March 31, 2003 was due to thea decrease in net assets. Shareholders have approvedassets between the Equus II Incorporated 1997 Stock Incentive Plan ("Stock Incentive Plan"), which authorizes the Fund to issue options to the directors and officers of the Fund in an aggregate amount of up to 20% of the outstanding shares of common stock of the Fund. The Stock Incentive Plan provides that each director who is not an officer of the Fund is, on the first business day following each annual meeting, granted an incentive stock option to purchase 2,000 shares of the Fund's common stock. Options are issued to the officers of the Fund at the discretion of the compensation committee in accordance with the Stock Incentive Plan. The options have a ten year life and vest 50% six months after the grant date with the remaining 50% vesting equally on the first, second and third anniversaries of the date of the grant. Under the Stock Incentive Plan, options to purchase 1,085,600 and 83,600 shares of the Fund's common stock with a weighted average exercise price of $8.42 and $17.17 per share were outstanding at September 30, 2002 and 2001, respectively. Of these options, 571,988 and 63,793 shares, with a weighted average exercise price per share of $9.07 and $19.64 were exercisable at September 30, 2002 and 2001, respectively. Of the outstanding options at September 30, 2002, 1,039,400 have exercise prices ranging from $7.69 to $14.15 and the remaining options have exercise prices ranging from $21.82 to $24.95. These options expire in May 2007 through May 2012.two periods. On September 30, 1999, options to purchase 719,794 shares of common stock of the Fund were exercised by the officers of the Fund for $15.45 per share. The exercise price of $11,124,086 was paid in the form of promissory notes from the officers to the Fund. On April 1, 2001, a former officer of the Fund surrendered 41,471 shares in payment of his note receivable and accrued interest aggregating $548,542. In September 2001, the current officers of the Fund surrendered 802,662 shares in payment of their notes receivable and accrued interest aggregating $10,505,551. These payments were recorded as decreases in common stock and additional paid in capital. The Fund released 71,824 shares to the officers relating to these payments. There was no change in total net assets as a result of the note repayment and surrendering of the shares. In April 2001, officers of the Fund surrendered options to acquire 247,077 shares of common stock pursuant to the Stock Incentive Plan, and such options were cancelled. The notes receivable, as well as 849,120 shares of common stock pledged as collateral, were not included in the Fund's reported net asset value per share in 2001 or 2000. Under variable plan accounting applicable to these transactions, compensation expense was recorded to reflect the change in benefit that the officers would have received assuming that their notes were settled with their pledged common stock at the end of each reporting period, based on the net asset value of the Fund. Interest earned on the notes receivable of $384,388 was recorded as an increase to additional paid in capital for the nine months ended September 30, 2001. On May 7, 2002 and May 4, 2001, options to acquire a total of 12,000 and 13,200 shares at $7.80 and $8.4455 per share were issued to the non-officer directors, respectively. In addition, on November 14, 2001, options to acquire a total of 990,000 shares of common stock at $7.69 per share (market price on date of grant) were issued to officers of the Fund. These options include dividend equivalent rights. Generally accepted accounting principles require that the options be accounted for using variable plan accounting as a result of the terms of the dividend equivalent rights. Such accounting resulted in additional non-cash 24 compensation (benefit)expense of $(14,434)$41,859 during the nine monthsquarter ended September 30,March 31, 2002, related to the 990,000 options issued in 2001. As of September 30, 2002 and 2001, all outstanding options were "out of the money" and would not have had a dilutive effect on net assets per share if exercised, assuming the Fund had used the proceeds from the exercise of such options to repurchase shares at the market price pursuant to the treasury stock method. The following reflects stock option activity for the nine months ended September 30, 2002 and the year ended December 31, 2001: 2002 2001 ---- ---- Options outstanding at the 1,073,600 337,450 beginning of the period Options granted during the period 12,000 1,003,200 Options exercised during the period - - Options surrendered during the period - (247,077) Options expired during the period - (19,973) --------- --------- Options outstanding at the end of the period 1,085,600 1,073,600 --------- --------- Options exercisable 571,988 70,388 ========= ========= Realized Gains and Losses on Sales of Portfolio Securities During the ninethree months ended September 30, 2002,March 31, 2003, the Fund realized net capital gainslosses of $399,301$8,100,724 from the sale of securities of three Portfolio Companies. The Fund received $108,004 for its remaining investment in Milam Enterprises, LLC, realizing a capital gain of $106,093. The Fund received $2,406,398 from Doane PetCare Enterprises, Inc. for payment in full of its 15% promissory note, realizing a capital gain of $551,850 relating to the unamortized original issue. In addition, the Fund received $500,000 for its investment in FS Strategies, Inc., realizing a capital loss of $8,758,667. During the three months ended March 31, 2002, the Fund realized net capital losses of $666,922 from the sale of securities of one Portfolio Company. The Fund sold 60,595 shares of its investment in Weatherford International for $2,844,558, realizing a capital loss of $666,922. In addition, the Fund sold its investment in Travis International, Inc. for $921,577, realizing a capital gain of $918,091. Also, the Fund received proceeds from Jones Industrial Holdings, Inc. for the redemption of 18,667 warrants, realizing a capital gain of $148,132. During the nine months ended September 30, 2001, the Fund realized net capital losses of $4,040,983 from the sale of securities of two Portfolio Companies and realized losses on four Portfolio Companies. The Fund sold its investment in Stephen L. LaFrance Holdings, Inc. for $10,000,000, realizing a capital gain of $7,501,548. In addition, the Fund wrote off its remaining investment in Paracelsus Healthcare Corporation, Hot & Cool Holdings, Inc. and CRC Holdings, Corp., realizing capital losses of $4,299,450, $5,775,000 and $1,192,114, respectively. Also, the Fund received proceeds from the sale of an investment in Sternhill Partners, L.P., realizing a capital gain of $7,056. In addition, the Fund sold its investment in Raytel Medical Corporation for $66,527, realizing a capital loss of $264,203. The Fund also received Weatherford International common stock in payment of a note receivable and accrued interest related to the note from Tulsa Industries, Inc. for $672,325, realizing a capital loss of $18,820. Depreciation of Portfolio Securities Net unrealized depreciationappreciation (depreciation) on investments increased $3,809,439changed by $10,711,530 during the ninethree months ended September 30, 2002March 31, 2003 from $4,492,994unrealized depreciation of $(5,417,014) to $8,302,433. Such increase resulted from increases in the 25 estimated fair value of eleven of the Fund's Portfolio Companies aggregating $10,011,215, decreases in the estimated fair value of thirteen of the Fund's Portfolio Companies aggregating $13,407,271 and the transfer of $413,383 in unrealized appreciation to net capital gain from the sale or disposition of investments in three of the Fund's Portfolio Companies. Net unrealized depreciation on investments increased $5,814,784 during the nine months ended September 30, 2001, from $818,963 to $6,633,747.$5,294,516. Such increasechange resulted from increases in the estimated fair value of securities of threesix of the Fund's Portfolio Companies aggregating $3,069,641,$5,177,935, decreases in the estimated fair value of securities of nine of the Fund's Portfolio Companies aggregating $13,435,783$3,626,983 and the transfer of $4,551,358$9,160,578 in net unrealized depreciation to net realized lossescapital loss from the sale or disposition of investments in two of the Fund's Portfolio Companies. 23 Net unrealized depreciation on investments decreased by $1,782,299 during the three months ended March 31, 2002 from $4,492,995 to $2,710,696. Such decrease resulted from increases in the estimated fair value of seven of the Fund's Portfolio Companies aggregating $4,370,080, decreases in the estimated fair value of six of the Fund's Portfolio Companies aggregating $3,369,000 and the transfer of $781,219 in unrealized depreciation to net capital loss from the sale or disposition of investments in two of the Fund's Portfolio Companies. Dividends The Fund declared no dividends for the ninethree months ended September 30, 2002March 31, 2003 and 2001.2002. Portfolio Investments During the ninethree months ended September 30, 2002,March 31, 2003, the Fund invested $483,749 in one new limited liability company, which in turn invested in an existing Portfolio Company, and made follow-on investments of $6,367,389$701,943 in elevenfive portfolio companies, including $1,485,165$326,944 in accrued interest and dividends received in the form of additional portfolio securities and accretion of original issue discount on a promissory note. For the nine monthsquarter ended September 30, 2002,March 31, 2003, the Fund received an additional 5,576 and 1,208430 shares of preferred stock of Container Acquisition, Inc and Sovereign Business Forms, Inc. ("Sovereign") in payment of $557,600 and $120,800 in dividends, respectively.dividends. In addition, Sovereign elected to convert $416,664$177,630 of accrued interest into the balance of the 15% promissory notes due to the Fund. On January 4, 2002, the Fund invested $483,749 to acquire a 24% member interest in Alenco Window Holdings II, LLC, which was formed to loan $2,000,000 to Alenco Holding Corporation ("AHC") in exchange for a secured promissory note and a warrant to acquire 93,675 shares of AHC common stock for $0.01 per share. This amount plus interest was repaid on September 16, 2002. On January 7, 2002, the Fund invested an additional $425,000 in FS Strategies, Inc. ("FSS") as a capital contribution. On March 29, 2002, the Fund invested an additional $1,667,000 in FSS in exchange for 1,667 shares of preferred stock. On February 27, 2002, the Fund invested an additional $150,000 in the form of a working capital loan to Spectrum Management, LLC, which was repaid on August 7, 2002. On April 5, 2002, the Fund invested an additional $180,000 in Sternhill Partners I, L.P. pursuant to a $3,000,000 commitment made in March 2000. $1,680,000 of such commitment has been funded through September 30, 2002. On April 29, 2002, the Fund invested an additional $1,571,000 in a limited liability company which acquired a subordinated promissory note of Container Care International, Inc. ("Container Care"). The note, with a face value of $2,000,000 plus accrued interest, was purchased for $1,850,000 from the former owner of Container Care. 26 On April 30, 2002, the Fund transferred its investment in Travis International, Inc. ("Travis") to Milam Enterprises, LLC ("Milam"). The Fund received $921,577 in cash and an interest in Milam, which was formed to hold certain assets of Travis not included in the sale of its business operations. On May 8, 2002, the Fund received $878,667 from Jones Industrial Services, Inc. for payment of a note receivable plus accrued interest and the redemption of 18,887 warrants. During the nine months ended September 30, 2002,19, 2003, ENGlobal, Inc. made a principal payment on its 9.5% promissory note of $110,000, bringingreducing the note balance to $2,890,000. During$2,670,000. On February 28, 2003, the nine months ended September 30, 2002,Fund received $2,406,398 from Doane PetCare Enterprises, Inc. for payment in full of its 15% promissory note, realizing a capital gain of $551,850. On March 3, 2003, the Fund invested an additional $300,000 in Vanguard VII, L.P. pursuant to a $3,000,000 commitment made in June 2000. $1,500,000 of such commitment has been funded through March 31, 2003. On March 7, 2003, the Fund advanced $392,500$75,000 to Equicom, Inc. pursuant to a 10% promissory note.note, thereby reducing the guarantee commitment to Equicom's lender by a like amount. During the nine monthsquarter ended September 30, 2002, the Fund exchanged two 15% promissory notes from The Bradshaw Group in the amount of $222,945 each for a 15% promissory note in the amount of $459,545, including $13,655 of accrued interest. For the nine months ended September 30, 2002, theMarch 31, 2003, original issue discount accretion and interestof $39,568 was accreted on the discounted 15% promissory note from Doane Pet Care Company amounted to $261,210, bringing the balance of the note to $1,689,435 at September 30, 2002. During the nine months ended September 30, 2002, the Fund received a 12% promissory note from Turfgrass America, Inc. ("Turfgrass") in exchange for accrued interest in the amount of $288,580. In addition, the original issue discount was accreted on the 12% subordinated promissory note from Turfgrass,, bringing the note balance to $3,742,237 at September 30, 2002.$3,821,372. The original issue discount is being accreted over the life of the note. Subsequent Events From OctoberOn April 1, 2002, through November 14, 2002,2003, the Fund sold the U.S. Treasury bills for $54,964,465 and repaid a net $53,850,000 of notes payable to the bank. On October 9, 2002,margin loan. In April and May 2003, the Fund investedsold 4,432 shares of common stock of Weatherford International, Inc. for $183,005, realizing a capital loss of $73,829. On May 9, 2003, the Independent Directors approved an additional $150,000 in Sternhill Partners I, L.P. pursuant to its commitment made in March 2000. On October 17, 2002 the Fund invested $300,000 in Glendale, LLC, which was formed to invest in American Trenchless Technologies, LLC in connection with a restructuring of its debt and a recapitalization of its balance sheet. On October 30, 2002, the Fund invested $1,303,698 in Spectrum Management, LLC, in exchange for a 16% senior subordinated promissory note. On November 4, 2002, the Fund received $402,935 from Milam Enterprises, LLC ("Milam"), as a partial distributionextension of the assets of Milam. Milam continues to hold certain assets and certain retained and contingent liabilities related to the sale of the operations of Travis International, Inc.Management Agreement through June 30, 2004. 24 Item 3. Quantitative and Qualitative Disclosure about Market Risk The Fund is subject to financial market risks, including changes in interest rates with respect to its investments in debt securities and its outstanding debt payable, as well as changes in marketable equity 27 security prices. The Fund does not use derivative financial instruments to mitigate any of these risks. The return on the Fund's investments is generally not affected by foreign currency fluctuations. The Fund's investment in portfolio securities consists of some fixed rate debt securities. Since the debt securities are generally priced at a fixed rate, changes in interest rates do not directly impact interest income. In addition, changes in market interest rates are not typically a significant factor in the Fund's determination of fair value of these debt securities, since the securities are generally held to maturity. These fair values are determined on the basis of the terms of the debt security and the financial condition of the issuer. The Fund's liabilities consist of debt payable to a financial institution. The revolving credit facilities are priced at floating rates of interest, with a basis of LIBOR or prime rate at the Fund's option. As a result of the floating rate, a change in interest rates could result in either an increase or decrease in the Fund's interest expense. A major portion of the Fund's investment portfolio consists of debt and equity investments in private companies. Modest changes in public market equity pricesprocess generally do not significantly impact the estimated fair value of these investments. SignificantHowever, significant changes in market equity prices occur, can have a longer-term effect on valuations of private companies, which could affect the carrying value and the amount and timing of gains realized on these investments. A portion of the Fund's investment portfolio also consists of common stocks and warrants to purchase common stock in publicly traded companies. These investments are directly exposed to equity price risk, in that a hypothetical ten percent change in these equity prices would result in a similar percentage change in the fair value of these securities. Part II. Other Information Item 4. Controls and Procedures The Fund maintains disclosure controls and other procedures that are designed to ensure that information required to be disclosed by the Fund in the reports that it files or submits under the Exchange Act is recorded, processed, summarized, and reported within the time periods specified in the SEC's rules and forms, and that such information is accumulated and communicated to the Fund's management, including its Chairman and Chief Executive Officer and President and Principal Financial and Accounting Officer, as appropriate, to allow timely decisions regarding required disclosure. The Fund's Chairman and Chief Executive Officer and President and Principal Financial and Accounting Officer have reviewed and evaluated the effectiveness of the Fund's disclosure controls and procedures within 90 days prior to the date of this report. Based on their review and evaluation, the Fund's Chairman and Chief Executive Officer and President and Principal Financial and Accounting Officer concluded that the Fund's disclosure controls and procedures were effective in ensuring that information relating to the Fund was made known to them by others within the Fund in a timely manner, particularly during the period in which this Quarterly Report on Form 10-Q was being prepared, and that no changes are required at this time. There have been no significant changes in the Fund's internal controls or in other factors that could significantly affect the Fund's internal controls subsequent to the date the Fund completed its evaluation 28evaluation. 25 Item 6. Exhibits and Reports on Form 8-K. (a) Exhibits (a) Exhibits 10. Material Contracts 99.1 Certification by the Chief Executive Officer 99.2 Certification by the President and Principal Financial and Accounting Officer (b) Reports on Form 8-K filed subsequent to quarter ended June 30, 2002. July 10, 2002 Our current reportMarch 31, 2003 No reports on Form 8-K accepting Arthur Andersen LLP's resignation as accountantswere filed by the Fund during the period for the fiscal year 2002 and appointing PricewaterhouseCoopers LLP as accountants for the fiscal year 2002.which this report is filed. 26 SIGNATURE Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has caused this report to be signed by the undersigned, thereunto duly authorized. Date: November 14, 2002May 15, 2003 EQUUS II INCORPORATED /s/ Nolan Lehmann --------------------------------- Nolan Lehmann President and Principal Financial and Accounting Officer 2927 EXHIBIT A Form of Quarterly Certification Required by Rules 13a-14 and 15d-14 under the Securities Exchange Act of 1934 I, Sam P. Douglass, certify that: 1. I have reviewed this quarterly report on Form 10-Q of Equus II Incorporated; 2. Based on my knowledge, this quarterly report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this quarterly report; 3. Based on my knowledge, the financial statements, and other financial information included in this quarterlyannual report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this quarterly report; 4. The registrant's other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have: a. designed such disclosure controls and procedures to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this quarterly report is being prepared; b. evaluated the effectiveness of the registrant's disclosure controls and procedures as of a date within 90 days prior to the filing date of this quarterly report (the "Evaluation Date"); and c. presented in this quarterly report our conclusions and about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date; 5. The registrant's other certifying officer and I have disclosed, based on our most recent evaluation, to the registrant's auditors and the audit committee of registrant's board of directors (or persons performing the equivalent function): a. all significant deficiencies in the design or operation of internal controls, which could adversely affect the registrant's ability to record, process, summarize and report financial data and have identified for the registrant's auditors any material weaknesses in internal controls; and b. any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal controls; and 1 6. The registrant's other certifying officer and I have indicated in this quarterly report whether or not there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any 28 corrective actions with regard to significant deficiencies and material weaknesses. Date: November 14, 2002 ---------------------------------May 15, 2003 /s/ Sam P. Douglass --------------------------------- Sam P. Douglass Chairman Chief Executive Officer 229 EXHIBIT A Form of Quarterly Certification Required by Rules 13a-14 and 15d-14 under the Securities Exchange Act of 1934 I, Nolan Lehmann, certify that: 1. I have reviewed this quarterly report on Form 10-Q of Equus II Incorporated; 2. Based on my knowledge, this quarterly report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this quarterly report; 3. Based on my knowledge, the financial statements, and other financial information included in this quarterly report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this quarterly report; 4. The registrant's other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have: a. designed such disclosure controls and procedures to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this quarterly report is being prepared; b. evaluated the effectiveness of the registrant's disclosure controls and procedures as of a date within 90 days prior to the filing date of this quarterly report (the "Evaluation Date"); and c. presented in this quarterly report our conclusions and about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date; 5. The registrant's other certifying officer and I have disclosed, based on our most recent evaluation, to the registrant's auditors and the audit committee of registrant's board of directors (or persons performing the equivalent function): a. all significant deficiencies in the design or operation of internal controls, which could adversely affect the registrant's ability to record, process, summarize and report financial data and have identified for the registrant's auditors any material weaknesses in internal controls; and b. any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal controls; and 3 6. The registrant's other certifying officer and I have indicated in this quarterly report whether or not there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any 30 corrective actions with regard to significant deficiencies and material weaknesses. Date: November 14, 2002 -------------------------May 15, 2003 /s/ Nolan Lehmann -------------------------------------------------------------------- Nolan Lehmann President Principal Financial and Accounting Officer 431