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