10-Q/A: Equus Total Return Q1 2024: NAV Declines Amid Energy Shifts

Equus Total Return, Inc. reported a net decrease in net assets for Q1 2024, driven by unrealized depreciation in portfolio securities and increased expenses, despite higher oil prices.

Summary

• Net assets decreased from $48.3 million at December 31, 2023, to $45.9 million at March 31, 2024.
• Net asset value per share declined from $3.55 to $3.38.
• Net decrease in net assets resulting from operations was $(2,395) thousand for Q1 2024, compared to $(1,131) thousand for Q1 2023.
• Net unrealized depreciation of portfolio securities (control investments) was $(1,350) thousand in Q1 2024, compared to $0 in Q1 2023.
• Total expenses increased to $1,373 thousand in Q1 2024 from $1,139 thousand in Q1 2023, primarily due to higher professional fees.
• Morgan E&P, LLC's fair value decreased by $1.35 million to $21.25 million, despite increased WTI prices.
• Equus Energy, LLC's fair value remained unchanged at $10.0 million.
• The company fully drew its $10.5 million senior debt facility with Morgan E&P, LLC.
• Oil prices (WTI) increased from $71.65 per barrel at December 31, 2023, to $83.17 per barrel at March 31, 2024, while natural gas prices decreased from $2.63 per MMBTU to $1.76 per MMBTU.

Sentiment

Score: 3

Explanation: The company experienced a significant decrease in net assets and net asset value per share, driven by unrealized depreciation in its key portfolio investment, Morgan E&P, LLC, and increased expenses. While oil prices improved, this did not prevent a valuation decrease for Morgan. The persistence of a material weakness in internal controls and the going concern doubts for Equus Energy are significant concerns. Strategic efforts to transform into an operating company are ongoing but lack certainty.

Positives

• Net investment loss improved slightly from $(1,133) thousand in Q1 2023 to $(1,090) thousand in Q1 2024.
• Equus Energy, LLC's revenue increased to $0.2 million in Q1 2024 from $0.1 million in Q1 2023, and its net loss improved significantly from $(0.5) million to $(0.02) million.
• The company believes it has sufficient liquidity to meet operating requirements for the next 12 months.
• The common stock's discount to net asset value narrowed slightly from 59.2% at December 31, 2023, to 57.1% at March 31, 2024.
• WTI crude oil prices increased significantly during Q1 2024, from $71.65 to $83.17 per barrel.

Negatives

• Net assets decreased by $2.395 million, from $48.287 million to $45.892 million, in Q1 2024.
• Net asset value per share decreased from $3.55 to $3.38.
• Net decrease in net assets resulting from operations worsened to $(2,395) thousand in Q1 2024 from $(1,131) thousand in Q1 2023.
• Net unrealized appreciation of portfolio securities showed a depreciation of $(1,350) thousand in Q1 2024, compared to zero in Q1 2023.
• Total expenses increased by $234 thousand to $1,373 thousand in Q1 2024, primarily due to higher professional fees.
• Morgan E&P, LLC's fair value decreased by $1.35 million, despite favorable oil price trends.
• Morgan E&P, LLC reported a net loss of $(1,440) thousand for Q1 2024.
• Equus Energy, LLC's operators have not yet undertaken significant capital expenditures, which could materially adversely affect its operations and long-term financial condition.
• Substantial doubt exists about Equus Energy, LLC's ability to continue as a going concern without continued financial support from the Fund.

Risks

• Market and economic volatility, along with the economic dislocation caused by the coronavirus, has constrained the availability of debt financing for small and medium-sized companies like Equus and its portfolio companies.
• Debt financing generally has shorter maturities, higher interest rates and fees, and more restrictive terms than previously available.
• The common stock price has remained well below net asset value, making it undesirable to issue additional shares below NAV.
• Inability to borrow funds to make qualifying investments could lead to loss of Regulated Investment Company (RIC) status, subjecting the company to corporate income tax and making distributions taxable as ordinary dividends.
• If the company lacks sufficient funds for follow-on investments, portfolio companies may be negatively impacted, and the company's equity interest in their fair value could be reduced.
• Fair value determinations for Level 3 investments (private companies) are inherently uncertain and may differ significantly from values if a ready market existed or from values ultimately received upon liquidation.
• The company is classified as a non-diversified investment company, with 91.0% of its net asset value (and 100% of portfolio securities at fair value) concentrated in the energy sector (two portfolio companies), increasing sensitivity to changes in these companies.
• Continued volatility of oil and natural gas prices can significantly impact the valuation and performance of portfolio companies.
• Substantial doubt exists about Equus Energy, LLC's ability to continue as a going concern without continued financial support from the Fund or successful implementation of its liquidity plans (securing financing, shutting in wells, selling holdings).
• Morgan E&P, LLC is expected to continue significant capital expenditures, requiring capital from Equus, institutional, or private sources, with no assurance of success.
• Risks are associated with the process of converting to an operating company, potential transactions, and specific risks of the commercial enterprise Equus may combine with, with no assurance of successful transformation within any particular time period or at all, or that terms will be acceptable.
• A material weakness in internal control over financial reporting related to management review over portfolio valuation persists, which could lead to material misstatement of portfolio fair values and related disclosures if undetected.
• Morgan E&P, LLC's activities are subject to stringent environmental regulations, which can increase costs and may be affected by future laws or interpretations.

Future Outlook

The company is actively evaluating opportunities to transform into an operating company and expects to seek further shareholder authorization for this in 2024, though no definitive agreement has been reached, and success is not assured. Equus Energy, LLC plans to secure equity or debt financing, shut-in wells, or sell oil and gas holdings to conserve cash, but success is not guaranteed. Morgan E&P, LLC is expected to continue significant capital expenditures for oil and gas development later in 2024, potentially securing capital from Equus or other institutional/private sources. The U.S. Energy Information Administration estimates average WTI prices of $82.15 and $80.30 for 2024 and 2025, respectively. Economists project a slight increase in the U.S. unemployment rate to 4.1% by the end of 2024, with a steady decline thereafter, and a decrease in inflation throughout the remainder of 2024 and into 2025. Global M&A activity is predicted to increase in 2024, particularly in healthcare, technology, and energy, with private equity focusing on AI-driven enterprises and energy infrastructure.

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.
• 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.
• Management believes that the financial statements included in this Quarterly Report on Form 10-Q present fairly in all material respects the Funds financial condition, results of its operations, changes in its net assets and its cash flows for the periods presented.
• We believe that the consolidated financial statements included in this Quarterly Report on Form 10-Q are accurate.
• We are committed to the continuous improvement of our internal control over financial reporting and will continue to diligently review our internal control over financial reporting.

Industry Context

The energy sector, where Equus's portfolio companies Equus Energy and Morgan E&P operate, experienced significant WTI crude price increases in Q1 2024, reaching $83.17 per barrel, while natural gas prices declined. This oil price stability and increase have driven consolidation activity in key regions like the Permian and Williston Basins. Broader economic indicators show U.S. GDP growth slowing to 1.6% in Q1 2024, with unemployment slightly rising but remaining low, and inflation stabilizing. High borrowing costs continue to impact small businesses and homebuyers. Global M&A activity is increasing, with energy being a key sector, and private equity is targeting AI and energy infrastructure. Equus's performance is directly tied to the volatile energy market and the broader economic environment affecting financing and investment opportunities.

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 upon the Fund's financial condition or results of operations.

Related Party Transactions

• The Fund provides financial support to Equus Energy, LLC.
• The Fund provides senior debt financing to Morgan E&P, LLC, with a facility increased to $10.5 million and fully drawn as of March 31, 2024.
• Independent Directors receive annual fees, meeting fees, and reimbursement of expenses; committee chairs receive additional annual fees.
• The Fund pays $300 per hour for services provided by Board members not in their director roles.
• Morgan E&P, LLC has a 'Due to parent' liability of $13 thousand and a 'Note payable Due to parent' of $10.5 million as of March 31, 2024.
• Equus Energy, LLC has a 'Due to affiliate' liability of $126 thousand as of March 31, 2024.

Stakeholder Impact

• Shareholders face a negative impact due to the decrease in net asset value per share and net decrease in net assets from operations. Potential for future value creation exists if the transformation to an operating company is successful, but also risks if it fails or if RIC status is lost.
• Employees and Management are encouraged by the Incentive Plan to acquire equity and remain with the Fund, with an internalized management structure aiming for cost efficiencies if the Fund grows.
• Portfolio Companies (Equus Energy, Morgan E&P) are directly impacted by the Fund's financing decisions and market conditions in the oil and gas sector. Equus Energy faces going concern doubts without continued support, and Morgan E&P relies on the Fund for capital for significant expenditures.
• Creditors are exposed to the company's utilization of margin loans for RIC compliance and the increased debt capacity allowed by the reduced asset coverage ratio, requiring prudent management.
• Regulatory Authorities oversee the company's compliance with SEC and 1940 Act regulations, including BDC and RIC status requirements, and its efforts to address a material weakness in internal controls.

Next Steps

• Seek further shareholder authorization in 2024 to withdraw BDC election and transform into an operating company.
• Enter into a definitive agreement to effect a transformative transaction (conversion to an operating company).
• Obtain a subsequent affirmative vote from shareholders to enter into any definitive agreement or change the nature of the business.
• Equus Energy, LLC intends to attempt to secure equity or debt financing, request operators shut-in additional wells, or sell certain oil and gas holdings to conserve cash or create liquidity.
• Morgan E&P, LLC is expected to continue significant capital expenditures for oil and gas development later in 2024.
• Continue efforts to enhance effective internal control measures to improve internal control over financial reporting and remediate the material weaknesses.

Key Dates

Recommendation

The company is in a transitional phase, actively pursuing a transformation into an operating company, which could be a significant catalyst for future value. However, current financial results show a decline in net asset value and net assets from operations, driven by unrealized depreciation in a key portfolio investment and increased expenses. The persistence of a material weakness in internal controls and the going concern risk for Equus Energy are notable concerns. While oil prices are favorable, the impact on portfolio valuations is mixed. Given the high uncertainty surrounding the strategic transformation and the current financial headwinds, a 'hold' recommendation is appropriate. Investors should monitor progress on the operating company conversion and remediation of internal control weaknesses, as well as the performance of its energy investments.

Keywords

Business Development Company, Regulated Investment Company, Oil and Gas, Energy Sector, Portfolio Investments, Net Asset Value, SEC Filing, 10-Q/A, Financial Reporting, Internal Controls, Valuation, Equus Energy, Morgan E&P, Williston Basin, Permian Basin, Bakken/Three Forks, Senior Debt, Capital Appreciation, Liquidity, Corporate Governance, Shareholder Value, Transformative Transaction