10-Q/A: Equus Total Return Q3 2022: NAV Dips, Energy Investment Gains

Equus Total Return, Inc. reported a slight decrease in net asset value per share to $2.68 for Q3 2022, despite unrealized appreciation in its sole energy portfolio company, Equus Energy, LLC.

Summary

• Net assets decreased slightly to $36.23 million as of September 30, 2022, from $36.37 million at December 31, 2021.
• Net asset value per share declined to $2.68 from $2.69 over the same period.
• The company experienced a net decrease in net assets from operations of $(135) thousand for the nine months ended September 30, 2022, a significant decline from a net increase of $2.47 million in the prior year period.
• Net investment loss for the nine months ended September 30, 2022, was $(2.64) million, compared to $(2.53) million in the prior year.
• Unrealized appreciation of portfolio securities was $2.5 million for the nine months ended September 30, 2022, lower than the $4.65 million in the prior year period.
• Cash and cash equivalents decreased to $20.09 million as of September 30, 2022, from $23.47 million at December 31, 2021.
• The company's common stock traded at a 38.8% discount to its net asset value as of September 30, 2022, significantly wider than the 13.0% discount at December 31, 2021.
• Shareholders approved the cessation as a Business Development Company (BDC) and authorized the Board to withdraw its BDC election by February 28, 2023, as part of a plan to transform into an operating company.
• Equus Energy, LLC, the sole portfolio company, saw its fair value increase by $2.5 million during the nine months ended September 30, 2022, primarily due to higher mineral acreage and oil/gas prices.
• Equus Energy, LLC reported a net loss of $(0.09) million for the nine months ended September 30, 2022, compared to $(0.07) million in the prior year, with significantly increased general and administrative expenses.

Sentiment

Score: 3

Explanation: The company faces significant financial deterioration with a shift from net asset increase to decrease, substantial cash burn from operations, and a widening market discount. While its sole energy investment saw fair value appreciation, the underlying subsidiary faces going concern doubts and increased losses. The strategic shift to an operating company is a long-term positive but carries near-term uncertainty and risks.

Positives

• Fair value of the sole control investment, Equus Energy, LLC, increased by $2.5 million during the nine months ended September 30, 2022, reaching $15.5 million.
• The increase in Equus Energy's fair value was attributed to higher mineral acreage prices and substantial increases in shortand long-term crude oil and natural gas prices.
• Shareholders approved the cessation of BDC status and authorized withdrawal of the BDC election, signaling progress towards a potential transformation into an operating company.
• The company believes it has sufficient liquidity to meet operating requirements for the next 12 months.
• U.S. GDP increased at an annualized rate of 2.6% in the third quarter of 2022, exceeding most analysts' expectations.
• The U.S. unemployment rate remained stable at 3.5% from March through September 2022, well below the 4.7% rate of September 30, 2021.

Negatives

• Net assets decreased slightly from $36.37 million at December 31, 2021, to $36.23 million at September 30, 2022.
• Net asset value per share declined from $2.69 to $2.68.
• The company reported a net decrease in net assets resulting from operations of $(135) thousand for the nine months ended September 30, 2022, a significant reversal from a $2.47 million increase in the prior year.
• Net investment loss worsened to $(2.64) million for the nine months ended September 30, 2022, from $(2.53) million in the prior year.
• Net cash used in operating activities significantly increased to $(4.86) million for the nine months ended September 30, 2022, compared to $23.01 million provided in the prior year.
• The common stock market price per share decreased significantly from $2.38 at the beginning of the period to $1.64 at the end of the period.
• The common stock traded at a substantial 38.8% discount to net asset value as of September 30, 2022, widening from 13.0% at December 31, 2021.
• Equus Energy, LLC, the sole portfolio company, faces substantial doubt about its ability to continue as a going concern due to operators not undertaking significant capital expenditures and the need to secure additional financing or sell assets.
• Equus Energy, LLC's general and administrative expenses increased significantly to $778 thousand for the nine months ended September 30, 2022, from $178 thousand in the prior year.
• Total return on market price was a negative (31.09%) for the nine months ended September 30, 2022, compared to a positive 7.41% in the prior year.

Risks

• Market and economic volatility, including the impact of the coronavirus pandemic and the conflict in Ukraine, could affect portfolio company valuations and their ability to provide current income.
• Debt financing for small and medium-sized companies like Equus and its portfolio companies is constrained, with shorter maturities, higher interest rates, and more restrictive terms.
• The company's common stock price remaining well below its net asset value makes it undesirable to issue additional shares.
• Failure to successfully implement plans for Equus Energy, LLC (securing financing, shutting in wells, selling holdings) could jeopardize its ability to continue as a going concern.
• The company cannot assure that it will be able to effect a transformative transaction to become an operating company within any particular time period or at all, or that the terms would be acceptable.
• If the company is unable to borrow funds to make qualifying investments, it may no longer qualify as a Regulated Investment Company (RIC), leading to corporate income tax on net investment income and realized capital gains, and distributions to stockholders being taxed as ordinary dividends.
• Changes in business or industry trends or in the financial condition of Equus Energy, LLC will affect the net asset value and market price of common stock to a greater extent due to the company's non-diversified investment status.
• The inherent uncertainty of determining the fair value of Level 3 investments (like Equus Energy, LLC) means actual values received could differ significantly from recorded values.
• Operators of Equus Energy's leasehold interests have not yet undertaken significant capital expenditures, which could materially adversely affect Equus Energy's operations and long-term financial condition.
• Heightened recession risks and increased borrowing costs due to Federal Reserve interest rate increases.

Future Outlook

The company is actively evaluating opportunities to transform into an operating company, with shareholder approval to cease BDC status by February 28, 2023, contingent on a definitive transformative transaction. Management believes it has sufficient liquidity to meet operating requirements for the next twelve months. However, there is no assurance that a transformative transaction will be achieved or on acceptable terms. Equus Energy, LLC, the sole portfolio company, intends to seek equity or debt financing, request operators to shut-in wells, or sell oil and gas holdings to conserve cash, but success is not assured, raising substantial doubt about its going concern ability.

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 [monetizations, dividend suspension, internalization of management] 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 cannot assure you that Equus Energy will be able to implement these plans successfully, or that such plans will generate sufficient liquidity to continue as a going concern.

Industry Context

The oil and gas sector experienced significant volatility, with crude and natural gas prices reaching multi-year highs in the first half of 2022 before decreasing in Q3 2022, yet remaining above year-end 2021 levels. This improved the outlook for small oil and gas firms like Equus Energy. However, the broader U.S. economy faces persistent inflation, rising interest rates, and heightened recession risks, leading to a significant cooling in M&A and private equity activity. While U.S. GDP showed a Q3 2022 increase, forecasts for 2023 predict zero growth, indicating a challenging economic environment for investment companies and their portfolio holdings.

Comparison to Industry Standards

• The company's common stock trading at a 38.8% discount to NAV as of September 30, 2022, is a significant widening compared to 13.0% at December 31, 2021, indicating a substantial underperformance relative to its intrinsic value, which is generally unfavorable for BDCs.
• The significant shift from net increase in net assets from operations of $2.47 million in 9M 2021 to a net decrease of $(135) thousand in 9M 2022, along with a negative total return on market price of (31.09%), suggests a performance that is likely worse than industry averages for BDCs during a period of energy price appreciation.
• The explicit mention of "substantial doubt about Equus Energy's ability to continue as a going concern" for its sole portfolio company is a critical red flag, indicating a higher level of operational risk compared to diversified investment funds.
• The company's reliance on margin loans to maintain RIC status, while a common practice for some BDCs, highlights a specific liquidity management strategy that could be more sensitive to market interest rate fluctuations and collateral requirements than BDCs with more robust, diversified funding sources.

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 the company does not expect them to have a material effect upon its financial condition or results of operations.

Related Party Transactions

• The Fund has accounts receivable from affiliates of $350 thousand as of September 30, 2022, unchanged from December 31, 2021.
• The Fund has accounts payable to related parties of $1 thousand as of September 30, 2022, a decrease from $13 thousand at December 31, 2021.
• 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.
• The Fund has a follow-on commitment of $150,000 to invest in additional equity of Equus Energy, LLC.
• Equus Energy, LLC has a "Due to affiliate" liability of $350 thousand as of September 30, 2022, unchanged from December 31, 2021.

Stakeholder Impact

• Shareholders: Experienced a negative total return on market price of (31.09%) and a widening discount to NAV (38.8%). The potential conversion to an operating company could offer long-term value creation but introduces significant uncertainty and requires further shareholder approval.
• Employees/Management: The internalization of management and the 2016 Equity Incentive Plan (now fully vested) aim to align interests with the Fund's success. Compensation expense for 9M 2022 was $1.14 million.
• Creditors: The company utilizes margin accounts for RIC compliance, with borrowings of $3.999 million collateralized by U.S. Treasury bills. The approved reduction in asset coverage ratio allows for increased leverage, potentially impacting credit risk if fully utilized.
• Portfolio Companies (specifically Equus Energy, LLC): Equus Energy, LLC faces substantial doubt about its ability to continue as a going concern, which could impact its operations and the Fund's investment. The Fund has a follow-on commitment to Equus Energy.

Next Steps

• Enter into a definitive agreement to effect a transformative transaction to become an operating company.
• Obtain a subsequent affirmative vote from shareholders to enter into any definitive agreement or change the nature of the business.
• Withdraw the election to be classified as a Business Development Company (BDC) by February 28, 2023, contingent on a transformative transaction.
• Equus Energy, LLC plans to secure equity or debt financing, request operators to shut-in additional wells, or sell certain oil and gas holdings to address liquidity concerns.
• Continue to evaluate potential opportunities for transformation into an operating company.

Key Dates

Recommendation

The company's financial performance for the nine months ended September 30, 2022, shows a significant deterioration, moving from a net increase in net assets to a net decrease, coupled with a substantial increase in cash used in operating activities. The market price of the common stock has declined sharply, and the discount to net asset value has widened considerably to 38.8%, indicating a lack of investor confidence. Furthermore, the sole portfolio company, Equus Energy, LLC, faces 'substantial doubt about its ability to continue as a going concern,' which is a critical risk given the company's non-diversified investment strategy. While the strategic intent to convert to an operating company could be transformative, it is highly uncertain, contingent on future events, and carries significant execution risks. The current financial trajectory and the severe going concern risk for its primary asset outweigh the potential long-term benefits of a speculative transformation, making the stock a high-risk holding with significant downside potential.

Keywords

Business Development Company, BDC, Equus Total Return, EQS, SEC Filing, Quarterly Report, Investment Company, Energy Sector, Oil and Gas, Equus Energy LLC, Net Asset Value, NAV, Market Discount, RIC Status, Operating Company Conversion, Portfolio Valuation, Financial Performance, Shareholder Approval, Market Risk, Liquidity, Capital Appreciation