10-Q/A: Equus Total Return Net Assets Soar 33.7% on Energy Investment Gains

Equus Total Return, Inc. reports a significant 33.7% increase in net asset value per share to $3.49, driven by substantial unrealized appreciation in its energy portfolio, particularly Morgan E&P, LLC.

Summary

• Net assets increased by 33.7% to $3.49 per share as of September 30, 2023, from $2.61 at December 31, 2022.
• Net increase in net assets resulting from operations was $11.891 million for the nine months ended September 30, 2023, a significant improvement from a net decrease of $(0.135) million for the same period in 2022.
• Net unrealized appreciation of portfolio securities, primarily control investments, was $15.0 million for the nine months ended September 30, 2023, compared to $2.5 million in 2022.
• Morgan E&P, LLC's fair value increased by $15.0 million due to increased acreage rights, associated reserves, and rising oil and gas prices.
• The company made a $2.4 million debt investment and a $1.00 equity investment in Morgan E&P, LLC during the nine months ended September 30, 2023.
• Equus Energy, LLC's fair value remained unchanged during the nine months ended September 30, 2023, despite increased crude prices, due to decreased gas prices.
• The company repaid an $18.0 million margin loan on October 3, 2023, which was used to maintain RIC status.
• Advanced Morgan E&P an additional $3.9 million under its credit facility in October and November 2023.
• Morgan E&P sold certain wellbore rights for $5.0 million cash on November 9, 2023.

Sentiment

Score: 7

Explanation: The significant increase in net asset value and unrealized appreciation, primarily driven by the Morgan E&P investment, indicates a strong financial turnaround for the period. However, the persistent net investment loss, the stock trading at a deep discount to NAV, and the going concern doubts for Equus Energy temper the overall positive sentiment. The strategic shift to an operating company is a long-term positive but faces execution risks and delays.

Positives

• Net asset value per share increased by 33.7% from $2.61 to $3.49.
• Net increase in net assets resulting from operations was $11.891 million for the nine months ended September 30, 2023, a significant improvement from a net decrease of $(0.135) million in the prior year.
• Substantial net unrealized appreciation of portfolio securities, totaling $15.0 million for the nine months ended September 30, 2023, primarily from control investments.
• Morgan E&P, LLC's equity fair value increased by $15.0 million, driven by expanded acreage rights, reserves, and favorable oil and gas prices.
• Successful sale of wellbore rights by Morgan E&P for $5.0 million cash post-period end, indicating asset monetization capability.
• The company believes it has sufficient liquidity to meet operating requirements for the next 12 months.

Negatives

• Net investment loss increased to $(3.131) million for the nine months ended September 30, 2023, from $(2.635) million in the prior year.
• Compensation expense increased to $1.502 million for the nine months ended September 30, 2023, from $1.144 million in the prior year, partly due to bonuses.
• The common stock is trading at a 57.6% discount to net asset value as of September 30, 2023, worsening from 45.2% at December 31, 2022.
• Equus Energy, LLC's revenue, operating revenue less direct operating expenses, and net loss decreased for the three and nine months ended September 30, 2023, compared to 2022.
• Equus Energy, LLC faces substantial doubt about its ability to continue as a going concern without continued financial support from the Fund.
• Morgan E&P, LLC reported a net loss of $(523) thousand from inception (April 3, 2023) through September 30, 2023.
• Gas prices decreased from $4.48 at December 31, 2022, to $2.68 at the end of the third quarter of 2023.

Risks

• Market and economic volatility, particularly in the oil and gas sector, can affect portfolio company valuations and income.
• Availability of debt financing for small and medium-sized companies is constrained, with shorter maturities, higher interest rates, and more restrictive terms.
• The price of common stock remaining well below net asset value makes it undesirable to issue additional shares.
• Inability to secure sufficient funds for follow-on investments could negatively impact portfolio companies and reduce equity interest.
• Inability to borrow funds to make qualifying investments could lead to loss of RIC status, subjecting the company to corporate income tax.
• Equus Energy, LLC's ability to implement plans (secure financing, shut-in wells, sell holdings) to generate sufficient liquidity to continue as a going concern is not assured.
• The transformation into an operating company is subject to risks, including the ability to find a suitable transaction, shareholder approval, and the terms of any such transaction.
• Fair value determinations for Level 3 investments (which constitute a significant portion of the portfolio) are inherently uncertain and may differ materially from actual realized values.
• Changes in business or industry trends or in the financial condition of a single portfolio company will affect net asset value and market price to a greater extent due to non-diversified status.
• Morgan E&P, LLC is required to drill and complete a minimum of six wells within 18 months of receiving the first drilling permits, with an average cost of $8.2 million per well, representing significant capital expenditure.

Future Outlook

The company intends to continue evaluating opportunities to transform into an operating company, expecting to seek further shareholder authorization for BDC election withdrawal in late 2023 or 2024. They anticipate increased investment opportunities in private equity, particularly in energy, due to lower valuation multiples and increased seller motivation. Equus Energy plans to secure equity or debt financing, shut-in wells, or sell holdings to conserve cash and generate liquidity. Morgan E&P is expected to continue significant capital expenditures for oil and gas development in Q4 2023 and may secure capital from Equus or other institutional/private sources.

Management Comments

• "Our Management and 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."
• "We believe these actions continue to be necessary to protect capital and liquidity in order to preserve and enhance shareholder value."
• "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 has experienced substantial volatility, with WTI oil prices reaching multi-year highs in March 2022, retreating, then stabilizing and rising in Q3 2023. Gas prices also saw highs but decreased in Q3 2023. This volatility, coupled with increased demand and reluctance of producers to increase supply, has led to increased consolidation activity in key basins like the Permian and Williston. The U.S. economy saw strong GDP growth in Q3 2023, but a mild recession is projected for 2024. Inflation remains a concern, leading to Federal Reserve interest rate hikes, increasing borrowing costs and recession risks. Global M&A activity is recovering, with energy being a key sector, and private equity expects increased investment opportunities due to lower valuation multiples.

Comparison to Industry Standards

• The significant increase in net asset value (33.7%) and net increase in net assets from operations ($11.891 million) for the nine months ended September 30, 2023, contrasts sharply with the prior year's decrease, indicating a strong turnaround in portfolio performance, particularly in the energy sector.
• The company's common stock trading at a 57.6% discount to NAV is a notable underperformance compared to typical BDC valuations, which often trade closer to or above NAV, especially with positive NAV growth.
• The U.S. Energy Information Administration's August 2023 estimate of $87.00 per barrel for Brent crude by the end of 2023 and $2.62 per MMBTU for gas prices provides a benchmark for the company's energy investments. The company's valuation of Morgan E&P reflects these market conditions and its specific reserve and production multiples (e.g., Proved Reserve Multiple 8,878x-12,716x, Daily Production Multiple 32,565x-59,790x).
• The company's strategy to transform into an operating company is a significant deviation from its BDC classification, aiming to capitalize on market conditions differently than traditional BDCs.

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 legal proceedings cannot be predicted with certainty, but they are not expected to have a material effect upon the Fund's financial condition or results of operations.

Related Party Transactions

• Accounts receivable from affiliates: $140,000 as of September 30, 2023, compared to $350,000 at December 31, 2022.
• Accounts payable to related parties: $305,000 as of September 30, 2023, compared to $1,000 at December 31, 2022.
• The Fund provides financial support to Equus Energy, LLC, and has agreed to continue doing so for at least one year and one day past the report date.
• The Fund committed to invest up to $10.0 million in senior debt financing into Morgan E&P, LLC, a wholly-owned subsidiary. As of September 30, 2023, Morgan had drawn $2.4 million, and an additional $3.9 million was advanced in October and November 2023.
• Independent Directors receive an annual fee of $40,000, meeting fees ($2,000 in-person, $1,000 telephonic), and reimbursement of expenses.
• Chairs of standing committees receive an additional annual fee of $50,000.
• The Fund pays $300 per hour for services provided by Board members not in their director roles.

Stakeholder Impact

• Shareholders: Experience a significant increase in NAV per share (33.7%), but the stock trades at a deep discount to NAV. Potential for future capital appreciation if the operating company transformation is successful. Distributions are subject to RIC requirements.
• Employees/Management: Benefit from the 2016 Equity Incentive Plan (fully vested). Internalized management structure aims for cost efficiencies if the Fund grows.
• Portfolio Companies (Equus Energy, Morgan E&P): Receive financial support and debt financing from the Fund, crucial for their operations and development. Equus Energy faces going concern doubts without continued support. Morgan E&P is undertaking significant capital expenditures.
• Creditors: Margin loans are collateralized by U.S. Treasury bills, and the company has a reduced asset coverage ratio (150%) allowing for more debt.

Next Steps

• Equus Energy intends to secure equity or debt financing, request operators to shut-in additional wells, or sell certain oil and gas holdings to generate liquidity.
• Morgan E&P is expected to continue significant capital expenditures for oil and gas development during the fourth quarter of 2023.
• The company expects to receive a further authorization from shareholders in late 2023 or 2024 to withdraw its BDC election.
• The company will not submit BDC withdrawal unless a definitive agreement for a transformative transaction is entered into.
• A subsequent affirmative vote from shareholders will be required to enter into any definitive agreement or change the nature of the business.
• The company will identify and include risks associated with the conversion to an operating company and any consolidation transactions in subsequent filings.

Key Dates

Recommendation

While the significant increase in net asset value and unrealized appreciation from energy investments is a strong positive, the stock's deep discount to NAV, persistent net investment losses, and the going concern issues for Equus Energy present considerable uncertainties. The planned transformation into an operating company is a long-term strategic move with potential upside, but it is subject to significant execution risks and further shareholder approvals. Given the mixed signals and the speculative nature of the transformation, a "hold" recommendation is appropriate for investors to monitor the execution of the strategic shift and the performance of the core energy assets.

Keywords

Equus Total Return, EQS, SEC Filing, 10-Q/A, Quarterly Report, Financial Results, Net Asset Value, NAV, Oil and Gas, Energy Investments, Morgan E&P, Equus Energy, Williston Basin, Permian Basin, Business Development Company, BDC, Regulated Investment Company, RIC, Unrealized Appreciation, Portfolio Securities, Capital Appreciation, Liquidity, Corporate Governance, Market Risk, Shareholder Value, SEC Compliance, XBRL