10-Q/A: Equus NAV Jumps on New Energy Investment, Strategic Shift

Equus Total Return, Inc. reports a significant increase in net asset value per share, driven by unrealized appreciation in a new energy investment, while pursuing a strategic transformation into an operating company.

Summary

• Equus Total Return, Inc. filed an Amendment No. 1 on Form 10-Q/A solely to provide required Inline XBRL tagging for its Quarterly Report for the period ended June 30, 2023.
• Net assets increased to $40.051 million as of June 30, 2023, from $35.237 million at December 31, 2022.
• Net asset value per share rose to $2.96 at June 30, 2023, from $2.61 at December 31, 2022, representing a 13.4% increase.
• The company recorded a net increase in net assets from operations of $4.814 million for the six months ended June 30, 2023, significantly up from $0.790 million for the same period in 2022.
• This increase was primarily driven by $6.800 million in net unrealized appreciation of portfolio securities for the six months ended June 30, 2023, compared to $2.500 million in 2022.
• A new investment in Morgan E&P, LLC, a wholly-owned subsidiary focused on oil and gas development in the Williston Basin, contributed $6.800 million in unrealized appreciation due to expectations of new wells and operating cash flow.
• Equus committed up to $10.0 million in senior debt financing to Morgan E&P, with $0.75 million drawn by June 30, 2023, and an additional $0.2 million advanced on July 26, 2023.
• The company's common stock traded at a 48.6% discount to its net asset value as of June 30, 2023, widening from 45.2% at December 31, 2022.
• Equus is evaluating opportunities to transform into an operating company and expects to seek further shareholder authorization to withdraw its Business Development Company (BDC) election later in 2023.
• Both Equus Energy, LLC and Morgan E&P, LLC face substantial doubt about their ability to continue as a going concern without continued financial support from Equus Total Return, Inc., which has committed to provide such support for at least one year and one day past the report date.

Sentiment

Score: 6

Explanation: The filing presents a mixed but generally positive outlook due to significant NAV growth driven by a new investment's unrealized appreciation. However, this is tempered by increased net investment loss, a widening discount to NAV, and going concern warnings for both key subsidiaries, despite parental support. The strategic shift to an operating company introduces significant future uncertainty.

Positives

• Net assets increased by $4.814 million for the six months ended June 30, 2023, compared to $0.790 million in the prior year.
• Net asset value per share increased by 13.4% to $2.96 as of June 30, 2023, from $2.61 at December 31, 2022.
• Significant net unrealized appreciation of portfolio securities, totaling $6.800 million, primarily from the new investment in Morgan E&P, LLC.
• The company has sufficient liquidity to meet operating requirements and finance routine capital expenditures for the next twelve months.
• Equus Total Return, Inc. has committed to provide financial support to its subsidiaries, Equus Energy, LLC and Morgan E&P, LLC, alleviating their going concern doubts for at least one year.

Negatives

• Net investment loss increased to $(1.997) million for the six months ended June 30, 2023, from $(1.710) million for the same period in 2022.
• The market price per share of common stock decreased to $1.52 at June 30, 2023, from $2.61 at June 30, 2022.
• The discount of the common stock market price to net asset value widened to 48.6% at June 30, 2023, from 45.2% at December 31, 2022.
• Equus Energy, LLC's operators have not yet undertaken significant capital expenditures, which could materially adversely affect its operations and long-term financial condition.
• Both Equus Energy, LLC and Morgan E&P, LLC have going concern uncertainties without the parent company's financial support.

Risks

• Market and economic volatility, particularly in the oil and gas sector, can constrain debt financing for small and medium-sized companies.
• The common stock trading well below net asset value makes it undesirable to issue additional shares, limiting capital raising options.
• Equus Energy, LLC faces substantial doubt about its ability to continue as a going concern without continued financial support from Equus Total Return, Inc.
• Morgan E&P, LLC also faces substantial doubt about its ability to continue as a going concern without continued financial support from Equus Total Return, Inc.
• There is no assurance that Equus Energy will be able to successfully implement its plans (securing financing, shutting in wells, selling holdings) to generate sufficient liquidity.
• The company's ability to transform into an operating company is uncertain, with no guarantee of timing, acceptable terms for a transformative transaction, or subsequent shareholder approval.
• Failure to qualify as a Regulated Investment Company (RIC) could subject the company to corporate income tax on net investment income and realized capital gains.
• The company is classified as a non-diversified investment company, meaning changes in a single portfolio company's performance will have a greater impact on net asset value and stock price.
• Significant changes in market equity prices can have a longer-term effect on valuations of private companies, impacting carrying value and realized gains/losses.

Future Outlook

Equus Total Return, Inc. is actively evaluating opportunities to transform into an operating company, a strategic shift that would require further shareholder authorization to withdraw its BDC election and a subsequent affirmative vote for any definitive agreement. The company anticipates seeking this authorization later in 2023 but does not expect to withdraw its BDC election before September 30, 2023. Morgan E&P, LLC is expected to undertake significant capital expenditures for oil and gas development during the third and fourth quarters of 2023, potentially securing capital from Equus or other institutional/private sources. Equus Energy, LLC intends to secure equity or debt financing, request operators to shut-in wells, or sell certain oil and gas holdings to conserve or create cash resources over the next year. The U.S. Energy Information Administration forecasts Brent crude at $85.00 per barrel and gas prices at $2.62 per MMBTU by the end of 2023. Economists project a mild U.S. recession in H2 2023, with GDP growth of 1.3% for 2023 and 0.1% for 2024, though these forecasts may be revised upward. Inflation is expected to decrease further throughout the rest of the year.

Management Comments

• Management and the Board of Directors believe it prudent to continue to review alternatives to refine and further clarify current strategies given market conditions and portfolio performance.
• We believe we have sufficient liquidity to meet our operating requirements for 12 months from the date of this filing.
• Because our Management is internalized, certain of our expenses should not increase commensurate with an increase in the size of the Fund and, therefore, to the extent we remain a BDC, we expect to achieve efficiencies in our cost structure if we are able to grow the Fund.
• We believe we have followed valuation techniques in a reasonably consistent manner; however, we are cognizant of current market conditions that might affect future valuations of portfolio securities.

Industry Context

The oil and gas sector has experienced substantial volatility, with WTI oil prices reaching multi-year highs in March 2022 and gas prices in mid-2022, followed by significant retreats due to recessionary headwinds. Natural gas prices declined through Q1 2023 before stabilizing in Q2 2023. Recent oil price stability has spurred increased consolidation activity in key basins like the Permian and Williston. The broader U.S. economy saw 2.4% annualized GDP growth in Q2 2023, exceeding expectations, though a mild recession is still projected for H2 2023. Inflation rates have retreated, influenced by Fed monetary responses and slowing economic growth, leading to increased borrowing costs. Global M&A activity picked up in H1 2023, with predictions for continued increases, especially in energy, driven by lower valuation multiples and seller motivation.

Comparison to Industry Standards

• The company's investment strategy targets companies with a total enterprise value between $5.0 million and $75.0 million, which is consistent with typical Business Development Company (BDC) focus on small and medium-sized enterprises.
• The asset coverage ratio reduction to 150% aligns with amendments made to the 1940 Act in March 2018, allowing BDCs to incur debt up to two times their net asset value, providing greater financial flexibility compared to the previous 200% standard.
• The company's classification as a non-diversified investment company under the 1940 Act means it is not limited in the proportion of assets invested in a single user, which differs from diversified funds that typically have stricter concentration limits. This implies higher risk compared to diversified BDCs.
• The significant unrealized appreciation in Morgan E&P, LLC, driven by expectations of new wells and operating cash flow in the Bakken shale region, suggests a potentially strong performance for a new energy investment, though specific comparable project results are not detailed.
• The going concern issues for both Equus Energy, LLC and Morgan E&P, LLC, despite parental support, highlight challenges that may be more pronounced in smaller, less diversified energy investment vehicles compared to larger, more established industry players.

Corporate Governance

Legal Proceedings

• The Fund is a party to certain proceedings incidental to the normal course of business, including enforcement of rights under contracts with portfolio companies. The outcome of these proceedings cannot be predicted with certainty, but they are not expected to have a material effect on the Fund's financial condition or results of operations.

Related Party Transactions

• Independent Directors receive an annual fee of $40,000, a fee of $2,000 for each in-person Board/committee meeting, and $1,000 for each telephonic meeting, plus expense reimbursement.
• Chairs of the audit, compensation, and nominating and governance committees receive an additional annual fee of $50,000.
• The Fund pays a rate of $300 per hour for services provided by Board members not in connection with their director roles.
• Equus Total Return, Inc. provides financial support to its wholly-owned subsidiaries, Equus Energy, LLC and Morgan E&P, LLC, to alleviate their going concern doubts.
• Equus Total Return, Inc. entered into an agreement to provide Morgan E&P, LLC up to $10.0 million in senior debt financing, with $0.75 million drawn by June 30, 2023, and an additional $0.2 million advanced on July 26, 2023.

Stakeholder Impact

• Shareholders: Potential for increased value through NAV growth and strategic transformation, but also face risks from increased net investment loss, widening discount to NAV, and uncertainties surrounding the operating company conversion. The non-diversified nature means performance of a few key investments heavily impacts shareholder value.
• Employees/Management: The 2016 Equity Incentive Plan aims to encourage equity interest and retention, with all awards fully vested as of March 31, 2020. Internalized management structure is expected to lead to cost efficiencies if the Fund grows.
• Portfolio Companies (Equus Energy, Morgan E&P): Directly impacted by the Fund's financial support, which is crucial for their going concern status and future development plans. Morgan E&P benefits from committed debt financing for its development activities.
• Creditors: The company's ability to borrow up to twice its net assets (150% asset coverage ratio) provides a larger buffer for debt, but the going concern issues of subsidiaries could be a concern if not adequately mitigated by parental support.

Next Steps

• Equus Total Return, Inc. will continue to evaluate opportunities to transform into an operating company.
• The company expects to receive a further authorization from shareholders later in 2023 to withdraw its BDC election.
• Morgan E&P, LLC is expected to undertake significant capital expenditures for oil and gas development during the third and fourth quarters of 2023.
• Equus Energy, LLC intends to attempt to secure equity or debt financing, request operators to shut-in additional wells, or sell certain oil and gas holdings to conserve or create additional cash resources during the next year.

Key Dates

Recommendation

The significant increase in Net Asset Value (NAV) per share, driven by unrealized appreciation in the new Morgan E&P investment, is a positive indicator. However, this is counterbalanced by an increased net investment loss and the widening discount of the market price to NAV. Both key subsidiaries, Equus Energy and Morgan E&P, have explicit 'going concern' warnings, albeit mitigated by parental support. The company's strategic pivot to become an operating company introduces substantial uncertainty regarding its future business model, execution, and required shareholder approvals. Given the strong NAV growth but also the inherent risks and strategic unknowns, a 'hold' recommendation is appropriate for investors to monitor the progress of the operating company transformation and the performance of the energy investments.

Keywords

Equus Total Return, EQS, BDC, Business Development Company, SEC Filing, 10-Q/A, Quarterly Report, Net Asset Value, NAV, Energy Investments, Oil and Gas, Morgan E&P, Equus Energy, Williston Basin, Permian Basin, Operating Company Transformation, XBRL Tagging, Financial Performance, Unrealized Appreciation, Liquidity, Going Concern, Shareholder Approval