10-K/A: Equus Total Return Navigates Transformation Amid Losses

Equus Total Return, Inc. reports continued net investment losses and a significant market discount in 2022, while pursuing a strategic transformation from a Business Development Company.

Summary

• Equus Total Return, Inc. (EQS) is a closed-end management investment company operating as a Business Development Company (BDC) and a Regulated Investment Company (RIC).
• The company's investment objective is to maximize total return through capital appreciation and current income, primarily by investing in debt and equity securities of small and middle-market companies ($5.0M-$75.0M enterprise value).
• A significant strategic initiative is underway to transform Equus into an operating company or a permanent capital vehicle, which would involve withdrawing its BDC election and potentially its RIC status.
• Shareholder authorization to withdraw the BDC election expired on February 28, 2023, but management expects to receive additional authorization in the future; however, withdrawal will only occur upon a definitive agreement for a transformative transaction, requiring a subsequent shareholder vote.
• The number of authorized common shares was increased from 50,000,000 to 100,000,000, and preferred shares from 5,000,000 to 10,000,000 on January 20, 2021, to facilitate this transformation and potential larger acquisitions.
• As of December 31, 2022, the company's sole active portfolio investment is a 100% member interest in Equus Energy, LLC, focused on income-producing oil & gas properties.
• Net asset value (NAV) per share decreased to $2.61 as of December 31, 2022, from $2.69 as of December 31, 2021.
• The common stock traded at a 45.2% discount to NAV as of December 31, 2022, a significant increase from 11.6% at December 31, 2021.
• The company reported net investment losses of $3.6 million for 2022, $3.5 million for 2021, and $4.9 million for 2020.
• Net unrealized appreciation of portfolio securities increased by $2.5 million in 2022, primarily due to an increase in the fair value of Equus Energy, LLC holdings, driven by increased cost basis and higher oil and gas prices.
• Equus Energy, LLC reported a net loss of $533,000 in 2022, compared to $69,000 in 2021 and $699,000 in 2020, with operating revenue of $1.063 million in 2022.
• The managed distribution policy and payment of quarterly dividends have been suspended indefinitely since March 24, 2009, with no dividends declared in 2020, 2021, or 2022.
• The company utilized a margin account to borrow funds ($5.998 million at Dec 31, 2022) to maintain RIC diversification requirements, which was repaid on January 3, 2023.

Sentiment

Score: 3

Explanation: The company faces significant challenges, including persistent net investment losses, a substantial market discount, and 'going concern' doubts for its primary asset. While a strategic transformation is underway, its success and timing are uncertain, and the expiration of BDC withdrawal authorization adds to this uncertainty. The lack of dividends further dampens investor sentiment. The increase in unrealized appreciation for Equus Energy is a positive, but it's offset by the underlying entity's losses and market volatility.

Positives

• Net unrealized appreciation of portfolio securities increased by $2.5 million in 2022, primarily driven by the increased fair value of Equus Energy, LLC holdings due to higher oil and gas prices and an increased cost basis.
• Management and the Board are actively pursuing a strategic transformation of Equus into an operating company or permanent capital vehicle, which could unlock new opportunities and potentially enhance shareholder value.
• The company's internal management structure is expected to achieve cost efficiencies as the fund grows, if it remains a BDC.
• The company successfully repaid a $6.0 million margin loan on January 3, 2023, demonstrating short-term liquidity management.

Negatives

• The company reported a net investment loss of $3.6 million for the year ended December 31, 2022, following losses of $3.5 million in 2021 and $4.9 million in 2020.
• The common stock traded at a significant discount to its net asset value, with a 45.2% discount as of December 31, 2022, compared to 11.6% at December 31, 2021.
• Equus Energy, LLC, the company's sole active portfolio investment, reported a net loss of $533,000 in 2022 and faces substantial doubt about its ability to continue as a going concern due to natural gas price volatility and potential capital expenditure postponements.
• The managed distribution policy and payment of quarterly dividends have been suspended indefinitely since March 24, 2009, and no dividends were declared in 2020, 2021, or 2022, impacting shareholder returns.
• The authorization for the Board to withdraw the BDC election expired on February 28, 2023, creating uncertainty regarding the timing and execution of the strategic transformation.

Risks

• Investments in small capitalization companies are volatile and speculative, with shorter operating histories, narrower product lines, and greater vulnerability to market conditions and economic downturns.
• Uncertainty exists regarding the fair value of privately held securities, which are inherently subjective and may differ materially from actual disposition amounts.
• Dependence on management for future investment success, with risks related to retaining key personnel and successfully implementing new investment strategies in unfamiliar sectors.
• Inability to realize gains from equity investments, which may depreciate in value or not appreciate as expected.
• Holdings in Equus Energy are subject to commodity price declines endemic to the oil and gas sector, with significant volatility in crude and natural gas prices impacting operations and earnings.
• Inability to make additional follow-on investments in portfolio companies may dilute interests or negatively impact the companies.
• Investment in a limited number of portfolio companies (non-diversified status) means changes in a single company's performance will have a greater impact on net asset value and stock price.
• Lack of liquidity of privately held securities may adversely affect the ability to obtain cash equal to recorded values.
• Limited control over portfolio companies as a debt or minority equity investor, potentially leading to decisions that decrease investment value.
• Waiver or deferral of enforcement of debt covenants may lead to loss of investment.
• Limited public information regarding privately held portfolio companies, requiring reliance on management's diligence.
• Prospective portfolio companies may be highly leveraged, increasing business and financial risk and potential for substantial losses.
• Dependence on external financing, with potential difficulty in borrowing at desired levels or terms, especially given the illiquid nature of the portfolio.
• Costs of borrowing money may exceed income from portfolio securities, leading to a decline in net asset value.
• Failure to distribute a sufficient portion of net investment income and net realized capital gains could result in loss of pass-through tax status or subject the company to a 4% excise tax.
• If asset coverage for debt securities declines below 150%, the company may be forced to sell investments at disadvantageous times.
• Operating in a highly competitive market for investment opportunities, with many larger competitors having greater resources and less stringent regulation.
• An economic downturn could adversely affect small and medium-sized companies, impacting portfolio valuations and the ability to obtain funding.
• Fluctuations in quarterly results due to variations in realized/unrealized gains/losses, competition, and economic conditions.
• Due diligence process may not reveal all relevant facts, potentially leading to unsuccessful investments.
• Use of leverage may adversely affect performance and increase exposure to interest rate changes.
• Ability to invest in private companies may be limited if BDC status is not maintained.
• Failure to maintain BDC status could lead to regulation as a closed-end investment company with more stringent restrictions.
• Inability to continue to qualify as a RIC under the Code would result in corporate income tax and impact shareholder returns.
• Need for additional capital to finance growth if RIC status is maintained, potentially requiring equity issuance at disadvantageous times.
• Board of Directors may change investment objective, operating policies, and strategies without prior notice or stockholder approval (except as required by 1940 Act).
• Restrictions on transactions with affiliates under the 1940 Act.
• Changes in laws or regulations governing the business could negatively affect profitability.
• Uncertainty regarding the success of the plan to transform Equus into an operating company, with no assurance of identifying or consummating a transformative transaction or achieving anticipated benefits.
• Substantial costs associated with identifying and evaluating strategic alternatives for transformation.
• If reorganized as an operating company, the company would lose RIC status and be subject to corporate income tax.
• If reorganized as an operating company, the company would not continue to operate as a BDC, losing 1940 Act protections for stockholders.
• Potential loss of ability to utilize capital losses if reorganized as an operating company.
• Stockholders would lose certain protections under the 1940 Act if the BDC election is withdrawn, including leverage limits, range of investments, financial reporting changes, director/officer protection, fidelity bond requirements, director independence, affiliate transaction rules, share issuance restrictions, share repurchase restrictions, and change of business approval requirements.

Future Outlook

Management continues to believe that current market conditions and recent portfolio performance necessitate a more active role in managing remaining investments and seeking liquidity events to protect and enhance shareholder value. This includes continuous monitoring of portfolio companies, providing follow-on capital when needed, and exploring liquidity events. The company expects to receive additional shareholder authorization to withdraw its BDC election in the future, with the intent to transform into an operating company or a permanent capital vehicle. This transformation is anticipated to be consummated during 2023, though there is no assurance of success or acceptable terms. If the company remains a BDC, it intends to continue pursuing suitable new investments and growing as a closed-end fund, including progressively larger enterprises.

Management Comments

• Management and the Board believe current market conditions and portfolio performance dictate the need to pursue a more active role in managing remaining investments and seeking liquidity events to protect and enhance shareholder value.
• We expect to receive an additional authorization from our stockholders in the future to withdraw our BDC election.
• We will not submit any such withdrawal unless and until Equus has entered into a definitive agreement to effect a transformative transaction.
• We will require a subsequent affirmative vote from holders of a majority of our outstanding voting shares to enter into any such definitive agreement or change the nature of our business.
• We cannot assure you that we will be able to accomplish this transformation within any particular time period or at all, nor can we assure you that the terms of any such transformative transaction would be acceptable to us.
• We believe these actions (initiatives to enhance liquidity, lower operational cost, assist portfolio companies, and realize investments) continue to be necessary to protect capital and liquidity in order to preserve and enhance shareholder value.
• We expect to achieve efficiencies in our cost structure if we are able to grow the Fund (if we remain a BDC).

Industry Context

The company's primary investment, Equus Energy, LLC, operates in the highly volatile oil and gas sector. Crude prices experienced significant swings, from 18-year lows in March 2020 to multi-year highs in H1 2022, then decreased due to recessionary headwinds. Gas prices showed even greater volatility, peaking in August 2022 before a marked decrease by December 2022 and further into Q1 2023. This volatility significantly impacts the outlook for small oil and gas firms. The broader M&A and private equity markets experienced a slowdown in 2022, with global M&A dropping 28% from 2021 and private equity investment falling 38.6%, primarily due to higher interest rates. Technology, energy, and healthcare remained key sectors for dealmaking. Equus Total Return's strategy to transform into an operating company or permanent capital vehicle aligns with a broader trend of companies seeking to optimize their structure and potentially exit specific regulatory frameworks, but it faces challenges in a contracting M&A environment.

Comparison to Industry Standards

• The company's net investment losses for 2022, 2021, and 2020, coupled with a significant market discount to NAV (45.2% in 2022), indicate underperformance compared to typical BDC expectations for income generation and market valuation.
• The high ratio of expenses to average net assets (10.14% in 2022) suggests a less efficient cost structure compared to larger, more diversified BDCs or investment funds that benefit from economies of scale.
• The indefinite suspension of dividends since 2009 contrasts with many BDCs that aim to provide consistent income distributions to shareholders to maintain RIC status and attract investors.
• Equus Energy, LLC's 'going concern' doubt, despite parental support, highlights a higher risk profile for the company's sole portfolio investment compared to more diversified energy holdings or those with stronger financial positions in the sector.
• The company's reliance on a single portfolio company (Equus Energy, LLC) for 100% of its portfolio investments (at fair value as of December 31, 2022) makes it significantly less diversified than most BDCs, which typically hold a broader range of investments across various industries and companies to mitigate risk.

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. No material effect on financial condition or results of operations is expected.

Related Party Transactions

• Kenneth I. Denos, a director of the Fund, received $349,725 for services provided on an hourly basis during 2020.
• Effective November 1, 2020, an agreement with Mr. Denos provides base compensation of $360,000 per annum, plus various annual and periodic bonuses based on achievement of certain criteria (e.g., transformative acquisitions, disposition of portfolio investments).

Stakeholder Impact

• Shareholders: Face continued net investment losses, a significant market discount, and no dividends, impacting their total return. The strategic transformation offers potential upside but carries substantial execution risk and uncertainty regarding future protections under the 1940 Act.
• Employees/Management: Key management personnel are crucial for future success, and the 2016 Equity Incentive Plan aims to align their interests with shareholders. The transformation plan could lead to changes in roles or structure.
• Customers (Portfolio Companies): May be impacted by the company's ability to provide follow-on capital, especially if liquidity is constrained or the transformation process is disruptive.
• Creditors: The company's use of margin loans and potential future borrowings for the transformation exposes creditors to risks related to the illiquidity of the portfolio and the company's financial performance.

Next Steps

• Seek additional shareholder authorization to withdraw the BDC election.
• Evaluate various opportunities to transform Equus into an operating company or a permanent capital vehicle.
• Enter into a definitive agreement for a transformative transaction, which will require a subsequent affirmative shareholder vote.
• Continue continuous monitoring and intensive reviews of portfolio company performance and expectations.
• Provide follow-on capital to portfolio companies when necessary.
• Explore liquidity events for certain portfolio companies to maximize investment returns.
• Actively pursue suitable new investments for the Fund, if it remains a BDC.

Key Dates

Recommendation

The company exhibits several concerning indicators for investors. It has consistently reported net investment losses over the past three years, and its stock trades at a substantial 45.2% discount to its net asset value, indicating significant market skepticism. The primary portfolio asset, Equus Energy, LLC, faces 'going concern' doubts due to commodity price volatility and has been unprofitable. Furthermore, the indefinite suspension of dividends means no direct cash returns to shareholders. While a strategic transformation is being pursued, its success is uncertain, and the recent expiration of shareholder authorization for a key step adds to the execution risk. The lack of diversification, high expense ratio relative to net assets, and reliance on external financing in a competitive market further compound the risks. Given these factors, a seasoned investor would likely recommend selling to mitigate exposure to a company with persistent underperformance, significant operational and strategic uncertainties, and a lack of shareholder returns.

Keywords

Business Development Company, BDC, Regulated Investment Company, RIC, SEC Filing, 10-K/A, Equus Total Return, EQS, Investment Company Act of 1940, Oil and Gas, Energy Sector, Private Equity, Small Cap Investments, Middle Market, Net Asset Value, Market Discount, Unrealized Appreciation, Net Investment Loss, Strategic Transformation, Corporate Governance, Commodity Prices, Shareholder Value, Financial Reporting