10-Q/A: Equus Total Return NAV Rises Amid Energy Sector Gains

Equus Total Return, Inc. reports an increase in net asset value per share and a positive market return for the first half of 2022, driven by appreciation in its sole energy investment.

Summary

• Net asset value per share increased to $2.75 as of June 30, 2022, up from $2.69 at December 31, 2021.
• Total return on market price was 9.66% for the six months ended June 30, 2022, a significant improvement from a negative 10.65% in the prior year period.
• The fair value of the company's control investment in Equus Energy, LLC increased by $2.5 million to $15.5 million, primarily due to higher mineral acreage prices and increased crude oil and natural gas prices.
• Equus Energy, LLC, the sole portfolio company, reported a net gain of $0.23 million for the six months ended June 30, 2022, a turnaround from a net loss of ($0.10) million in the same period last year.
• The company's market price per share increased to $2.61 at June 30, 2022, from $2.38 at the beginning of the period, narrowing the discount to net asset value from 13.0% to 3.7%.
• Net investment loss improved slightly to $(1.710) million for the six months ended June 30, 2022, compared to $(1.776) million in the prior year.
• The authorization for the company to withdraw its Business Development Company (BDC) election has expired, and a further shareholder authorization is expected later in 2022.
• Equus Energy, LLC continues to face substantial doubt about its ability to continue as a going concern, despite improved financial performance.

Sentiment

Score: 7

Explanation: The sentiment is moderately positive. While significant risks remain, particularly regarding the 'going concern' status of its sole investment and the BDC conversion, the company demonstrated strong financial improvements in NAV, market return, and the profitability of Equus Energy, LLC, driven by favorable energy market conditions. The narrowing discount to NAV is also a positive sign.

Positives

• Net asset value per share increased from $2.69 to $2.75 as of June 30, 2022.
• Total return on market price significantly improved to 9.66% for the six months ended June 30, 2022, compared to a negative 10.65% in the prior year.
• The market price discount to net asset value narrowed from 13.0% at December 31, 2021, to 3.7% at June 30, 2022.
• The fair value of the investment in Equus Energy, LLC increased by $2.5 million to $15.5 million, driven by higher mineral acreage and energy commodity prices.
• Equus Energy, LLC achieved a net gain of $0.23 million for the six months ended June 30, 2022, a positive shift from a net loss of ($0.10) million in the comparable prior period.
• Net investment loss decreased (improved) to $(1.710) million for the six months ended June 30, 2022, from $(1.776) million in the prior year.
• No net realized loss was recorded for the six months ended June 30, 2022, compared to a $(0.177) million loss in the prior year.
• The ratio of expenses to average net assets decreased from 5.19% to 4.65%, indicating improved cost efficiency.
• The company believes it has sufficient liquidity to meet operating requirements for the next 12 months.

Negatives

• Net increase in net assets resulting from operations decreased to $790k for the six months ended June 30, 2022, from $947k in the prior year.
• Net unrealized appreciation of portfolio securities decreased to $2.5 million for the six months ended June 30, 2022, from $2.9 million in the prior year.
• Cash and cash equivalents decreased from $23,465k at December 31, 2021, to $21,555k at June 30, 2022.
• Total liabilities increased from $3,351k at December 31, 2021, to $4,367k at June 30, 2022.
• Borrowing under margin account increased from $2,500k to $4,000k.
• Professional liability expenses increased to $0.3 million for the six months ended June 30, 2022, from $0.2 million in the prior year, due to higher premiums.
• Equus Energy, LLC's operators have not yet undertaken significant capital expenditures despite high energy prices, which could materially adversely affect its long-term operations and financial condition.
• The authorization for the company to withdraw its BDC election has expired, requiring further shareholder approval and introducing uncertainty to its transformation plans.

Risks

• Inherent uncertainty in determining the fair value of Level 3 investments, which may materially differ from values had a ready market existed.
• Investments are generally subject to legal and other restrictions or are less liquid than publicly traded instruments, potentially leading to significantly lower realized values in a forced liquidation.
• Market and economic volatility, including the impact of COVID-19 and geopolitical events like the conflict in Ukraine, significantly affect the oil and gas sector.
• Equus Energy, LLC faces substantial doubt about its ability to continue as a going concern.
• The inability to borrow funds to make qualifying investments could jeopardize the company's Regulated Investment Company (RIC) status, leading to corporate income tax.
• Risks associated with the process of converting Equus into an operating company, including the inability to find a suitable transformative transaction or secure acceptable terms.
• Dependence of future success on the general economy and its impact on the industries in which the company invests.
• Impact of fluctuations in interest rates on the company's business and borrowing costs.
• The valuation of investments in portfolio companies, particularly those with no liquid trading market, is subject to significant judgment and potential volatility.
• The company's ability to recover unrealized losses is uncertain.
• Market conditions and the ability to access additional capital, if deemed necessary, pose risks.
• Natural or man-made disasters and other external events may disrupt operations.
• Continued volatility of oil and natural gas prices directly impacts the value and prospects of Equus Energy, LLC.

Future Outlook

The company expects to seek further shareholder authorization later in 2022 to withdraw its BDC election, as part of its intent to transform into an operating company or a permanent capital vehicle. However, there is no assurance that this transformation will be successful or that acceptable terms for a transformative transaction will be found. Equus Energy, LLC plans to secure equity or debt financing, request operators to shut-in wells, or sell certain oil and gas holdings to conserve cash. The company anticipates achieving cost efficiencies if it grows, due to its internalized management structure. Broader economic forecasts suggest a decrease in inflation rates and continued interest rate increases by the Federal Reserve throughout the remainder of 2022, with a stable unemployment rate but potentially downward revised GDP growth for the U.S. economy.

Management Comments

• Management and the Board of Directors believe it prudent to continue to review alternatives to refine and further clarify the current strategies.
• 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.

Industry Context

The oil and gas sector experienced substantial volatility, with crude and natural gas prices reaching multi-year highs in the first half of 2022 due to high industrial and consumer demand, limited supply increases from U.S. producers and OPEC, and the conflict in Ukraine. This improved the outlook for small oil and gas firms like Equus Energy. The U.S. economy showed signs of recession with GDP declines in Q1 and Q2 2022, while inflation reached 9.1%, the highest since 1981, primarily driven by energy prices. The Federal Reserve responded with significant interest rate hikes, increasing borrowing costs and recession risks. Global merger and acquisition activity, after a record 2021, saw a significant cooling in the first half of 2022, with private equity activity also declining. The SPAC market became highly unfavorable due to poor post-acquisition performance.

Comparison to Industry Standards

• The filing notes that Equus Energy holds development rights in low-cost production reservoirs such as those underlying the Permian Basin and the Eagle Ford Shale regions, which are generally considered attractive areas in the energy sector.
• The valuation of Equus Energy, LLC was supported by advice and assistance from a third-party valuation firm, consistent with industry best practices for valuing Level 3 investments.
• The company's shift from a negative total return on market price in 2021 to a positive 9.66% in H1 2022 contrasts with the general cooling trend observed in M&A and private equity markets during the same period, suggesting a strong performance relative to broader investment market slowdowns.

Corporate Governance

Legal Proceedings

• The Fund is a party to certain proceedings incidental to the normal course of business, including the enforcement of rights under contracts with portfolio companies. The outcome cannot be predicted with certainty, but these proceedings 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, paid quarterly in arrears, plus meeting fees ($2,000 in-person, $1,000 telephonic) and expense reimbursements.
• Chairs of standing committees (audit, compensation, nominating and governance) receive an additional annual fee of $50,000, payable quarterly in arrears.
• The Fund pays members of the Board $300 per hour for services not related to their director roles.
• Accounts payable to related parties decreased from $13,000 at December 31, 2021, to $1,000 at June 30, 2022.
• Accounts receivable from affiliates remained at $350,000 at both June 30, 2022, and December 31, 2021.
• The Fund provided an additional $0.3 million in capital to Equus Energy, LLC during the six months ended June 30, 2021.
• Equus Energy, LLC's balance sheet shows 'Due to affiliate' of $350,000 at both June 30, 2022, and December 31, 2021.

Stakeholder Impact

• Shareholders: Experienced an increase in net asset value per share and a positive total return on market price, but face uncertainty regarding the BDC conversion and the going concern status of the primary investment.
• Employees/Management: Internalized management structure is expected to lead to cost efficiencies if the Fund grows.
• Creditors: The company's increased borrowing under margin accounts and overall increase in liabilities could be a consideration, though the asset coverage ratio remains strong at 150% (allowing borrowing up to twice net assets).
• Portfolio Companies (specifically Equus Energy, LLC): The company provides significant managerial assistance to Equus Energy, LLC, which is exploring financing options that could include the Fund, impacting its operational stability.

Next Steps

• Seek further shareholder authorization later in 2022 to withdraw the BDC election.
• Evaluate various opportunities to transform into an operating company or a permanent capital vehicle.
• Require a subsequent affirmative vote from shareholders to enter into any definitive agreement for a transformative transaction or change the nature of the business.
• 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 cash.

Key Dates

Recommendation

The company shows improved financial performance with an increased NAV per share and a positive market return, largely driven by the appreciation of its sole energy investment, Equus Energy, LLC, which also turned profitable. The narrowing discount to NAV is a positive indicator. However, significant uncertainties persist, including the expired authorization for BDC conversion, the 'substantial doubt' about Equus Energy's going concern, and the reliance on a single, illiquid investment. These factors present both potential upside from a successful transformation and considerable downside risks, warranting a cautious 'hold' position for investors awaiting clearer strategic direction and resolution of key operational challenges.

Keywords

Business Development Company, BDC, SEC Filing, 10-Q/A, Equus Total Return, EQS, Energy Investments, Oil and Gas, Portfolio Valuation, Net Asset Value, RIC Status, Operating Company Conversion, Equus Energy LLC, Financial Performance, Market Return, Unrealized Appreciation, Corporate Governance, Risk Factors