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EQUUS TOTAL RETURN, INC. - Quarter Report: 2004 March (Form 10-Q)

Form 10-Q for the Period Ended March 31, 2004
Table of Contents

 

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

FORM 10-Q

 

(Mark One)

 

x QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

 

For the quarterly period ended March 31, 2004

 

or

 

¨ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

 

For the transition period              to             

 

Commission File Number 0-19509

 

EQUUS II INCORPORATED

(Exact name of registrant as specified in its charter)

 

Delaware   76-0345915
(State or other jurisdiction of
incorporation or organization)
  (I.R.S. Employer
Identification No.)
2727 Allen Parkway, 13th Floor
Houston, Texas
  77019
(Address of principal
executive offices)
  (Zip Code)

 

Registrant’s telephone number, including area code: (713) 529-0900

 

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x No ¨

 

Indicate by check mark whether the registrant is an accelerated filer (as defined in 12b-2 of the Exchange Act). Yes ¨ No x

 

There were 6,615,173 shares of the registrant’s common stock, $.001 par value, outstanding, as of May 14, 2004. The net asset value of a share at March 31, 2004 was $10.54

 



Table of Contents

EQUUS II INCORPORATED

(A Delaware Corporation)

 

INDEX

 

          PAGE

PART I.     FINANCIAL INFORMATION

    

Item 1.

   Financial Statements     
     Balance Sheets     
    

- March 31, 2004 and December 31, 2003

   1
     Statements of Operations     
    

- For the three months ended March 31, 2004 and 2003

   2
     Statements of Changes in Net Assets     
    

- For the three months ended March 31, 2004 and 2003

   3
     Statements of Cash Flows     
    

- For the three months ended March 31, 2004 and 2003

   4
     Selected Per Share Data and Ratios     
    

- For the three months ended March 31, 2004 and 2003

   6
     Schedule of Portfolio Securities     
    

- March 31, 2004

   7
    

Notes to Financial Statements

   13

Item 2.

  

Management’s Discussion and Analysis of Financial Condition and Results of Operations

   20

Item 3.

  

Quantitative and Qualitative Disclosure about Market Risk

   26

PART II.    OTHER INFORMATION

    

Item 4.

  

Controls and Procedures

   27

Item 6.

  

Exhibits and Reports on Form 8-K

   27

SIGNATURE

   28

 

ii


Table of Contents

Part I. Financial Information

 

Item 1. Financial Statements

 

EQUUS II INCORPORATED

BALANCE SHEETS

MARCH 31, 2004 AND DECEMBER 31, 2003

(Unaudited)

 

     2004

    2003

 

Assets

                

Investments in portfolio securities at fair value (cost $77,872,465 and $83,129,763, respectively)

   $ 71,093,474     $ 75,553,608  

Cash

     49,528       11,296  

Temporary cash investments, at cost which approximates fair value

     17,407       375,583  

Restricted cash & temporary investments, at cost which approximates fair value

     50,649,395       52,695,202  

Accounts receivable

     353,077       15,469  

Accrued interest receivable due from portfolio companies

     3,659,317       4,256,557  
    


 


Total assets

     125,822,198       132,907,715  
    


 


Liabilities and net assets

                

Liabilities:

                

Accounts payable and accrued liabilities

     148,018       240,186  

Dividends payable

     —         2,287,194  

Due to management company

     348,588       357,692  

Revolving line of credit

     4,109,044       5,000,000  

Payable for securities purchased

     49,998,800       51,984,089  

Note payable

     1,500,000       1,500,000  
    


 


Total liabilities

     56,104,450       61,369,161  
    


 


Commitments and contingencies

                

Net assets:

                

Preferred stock, $.001 par value, 5,000,000 shares authorized, no shares outstanding

     —         —    

Common stock, $.001 par value, 25,000,000 shares authorized, 6,615,173 shares outstanding

     6,615       6,615  

Additional paid-in capital

     84,196,899       84,497,378  

Undistributed net investment income (loss)

     3,107,135       (695,282 )

Undistributed net capital losses

     (10,813,910 )     (4,694,002 )

Unrealized depreciation of portfolio securities, net

     (6,778,991 )     (7,576,155 )
    


 


Total net assets

   $ 69,717,748     $ 71,538,554  
    


 


Net assets per share

   $ 10.54     $ 10.81  
    


 


 

The accompanying notes are an

integral part of these financial statements.

 

1


Table of Contents

EQUUS II INCORPORATED

STATEMENTS OF OPERATIONS

FOR THE THREE MONTHS ENDED MARCH 31, 2004 AND 2003

(Unaudited)

 

     2004

    2003

 

Investment income:

                

Interest income from portfolio securities

   $ 696,253     $ 803,958  

Dividend income from portfolio securities

     3,572,000       43,000  

Interest from temporary cash investments

     262       2,408  
    


 


Total investment income

     4,268,515       849,366  
    


 


Expenses:

                

Management fees

     348,588       398,570  

Director fees and expenses

     67,657       54,555  

Professional fees

     60,899       67,125  

Administrative fees

     12,500       12,500  

Mailing, printing and other expenses

     21,377       6,448  

Interest expense

     251,356       183,064  

Non-cash compensation expense (benefit)

     (300,480 )     —    

Franchise taxes

     4,200       —    
    


 


Total expenses

     466,097       722,262  
    


 


Net investment income

     3,802,418       127,104  
    


 


Realized loss on sales of portfolio securities, net

     (6,119,908 )     (8,100,724 )
    


 


Unrealized appreciation (depreciation) of portfolio securities, net:

                

End of period

     (6,778,991 )     5,294,516  

Beginning of period

     (7,576,155 )     (5,417,014 )
    


 


Unrealized appreciation (depreciation), net

     797,164       10,711,530  
    


 


Total increase (decrease) in net assets from operations

   $ (1,520,326 )   $ 2,737,910  
    


 


 

The accompanying notes are an

integral part of these financial statements.

 

2


Table of Contents

EQUUS II INCORPORATED

STATEMENTS OF CHANGES IN NET ASSETS

FOR THE THREE MONTHS ENDED MARCH 31, 2004 AND 2003

(Unaudited)

 

     2004

    2003

 

Operations:

                

Net investment income

   $ 3,802,418     $ 127,104  

Realized loss on sales of portfolio securities, net

     (6,119,908 )     (8,100,724 )

Unrealized appreciation (depreciation) of portfolio securities, net

     797,164       10,711,530  
    


 


Increase (decrease) in net assets from operations

     (1,520,326 )     2,737,910  
    


 


Capital Transactions:

                

Non-cash compensation expense (benefit)

     (300,480 )     —    
    


 


Decrease in net assets from capital transactions

     (300,480 )     —    
    


 


Increase (decrease) in net assets

     (1,820,806 )     2,737,910  

Net assets at beginning of period

     71,538,554       76,976,095  
    


 


Net assets at end of period

   $ 69,717,748     $ 79,714,005  
    


 


 

The accompanying notes are an

integral part of these financial statements.

 

3


Table of Contents

EQUUS II INCORPORATED

STATEMENTS OF CASH FLOWS

FOR THE THREE MONTHS ENDED MARCH 31, 2004 AND 2003

(Unaudited)

 

     2004

    2003

 

Cash flows from operating activities:

                

Interest and dividends received

   $ 3,711,327     $ 95,411  

Cash paid to management company, directors, bank and suppliers

     (867,849 )     (407,692 )

Purchase of portfolio securities

     (446,800 )     (375,000 )

Proceeds from sales of portfolio securities

     266,018       1,159,854  

Principal payments from portfolio securities

     135,000       1,964,547  

Sales (purchases) of restricted cash & temporary investments, net

     2,045,807       2,567,581  

Advances to portfolio companies

     (8 )     (37 )
    


 


Net cash provided by operating activities

     4,843,495       5,004,664  
    


 


Cash flows from financing activities:

                

Borrowings under margin account

     49,998,800       54,959,521  

Repayments under margin account

     (51,984,089 )     —    

Advances from bank

     3,034,044       375,000  

Repayments to bank

     (3,925,000 )     (60,325,000 )

Dividends paid

     (2,287,194 )     —    
    


 


Net cash used by financing activities

     (5,163,439 )     (4,990,479 )
    


 


Net increase (decrease) in cash and cash equivalents

     (319,944 )     14,185  

Cash and cash equivalents at beginning of period

     386,879       516,678  
    


 


Cash and cash equivalents at end of period

   $ 66,935     $ 530,863  
    


 


 

The accompanying notes are an

integral part of these financial statements.

 

4


Table of Contents

EQUUS II INCORPORATED

STATEMENTS OF CASH FLOWS

FOR THE THREE MONTHS ENDED MARCH 31, 2004 AND 2003

(Unaudited)

(Continued)

 

     2004

    2003

 

Reconciliation of increase in net assets from operations to net cash provided by operating activities:

                

Increase (decrease) in net assets from operations

   $ (1,520,326 )   $ 2,737,910  

Adjustments to reconcile increase (decrease) in net assets from operations to net cash provided by operating activities:

                

Realized loss on sales of portfolio securities, net

     6,119,908       8,100,724  

Unrealized (appreciation) depreciation, net

     (797,164 )     (10,711,530 )

Accrued interest and dividends exchanged for portfolio securities

     (1,154,428 )     (326,943 )

(Increase) decrease in accrued interest receivable

     597,240       (427,011 )

Non-cash compensation expense (benefit)

     (300,480 )     —    

Decrease in accounts payable

     (92,168 )     (84,001 )

Increase (decrease) in due to management company

     (9,104 )     398,570  

Purchase of portfolio securities

     (446,800 )     (375,000 )

Proceeds from sales of portfolio securities

     266,018       1,159,854  

Principal payments from portfolio securities

     135,000       1,964,547  

Sales (purchases) of restricted cash & temporary investments, net

     2,045,807       2,567,581  

Advances to portfolio companies

     (8 )     (37 )
    


 


Net cash provided by operating activities

   $ 4,843,495     $ 5,004,664  
    


 


 

The accompanying notes are an

integral part of these financial statements.

 

5


Table of Contents

EQUUS II INCORPORATED

SUPPLEMENTAL INFORMATION – SELECTED PER SHARE DATA AND RATIOS

FOR THE THREE MONTHS ENDED MARCH 31, 2004 AND 2003

(Unaudited)

 

     2004

    2003

 

Investment income

   $ 0.65     $ 0.13  

Expenses

     0.07       0.11  
    


 


Net investment income

     0.58       0.02  

Realized loss on sale of portfolio securities, net

     (0.93 )     (1.30 )

Decrease in unrealized depreciation of portfolio securities, net

     0.12       1.72  
    


 


Increase (decrease) in net assets from operations

     (0.23 )     0.44  
    


 


Capital Transactions:

                

Non-cash compensation expense

     (0.04 )     —    
    


 


Decrease in net assets from capital transactions

     (0.04 )     —    
    


 


Net increase (decrease) in net assets

     (0.27 )     0.44  

Net assets at beginning of period

     10.81       12.35  
    


 


Net assets at end of period

   $ 10.54     $ 12.79  
    


 


Weighted average number of shares outstanding during period, in thousands

     6,615       6,233  

Market value

   $ 7.79     $ 6.91  

Ratio of expenses to average net assets

     0.66 %     0.92 %

Ratio of net investment income to average net assets

     5.38 %     0.16 %

Ratio of increase (decrease) in net assets from operations to average net assets

     (2.15 )%     3.49 %

Total return on market price

     (3.23 )%     4.07 %

 

The accompanying notes are an

integral part of these financial statements.

 

6


Table of Contents

EQUUS II INCORPORATED

SCHEDULE OF PORTFOLIO SECURITIES

MARCH 31, 2004

(Unaudited)

 

Portfolio Company


   Date of
Initial Investment


   Cost

   Fair Value

Alenco Holding Corporation

   February 2001              

(formerly Alenco Window Holdings II, LLC)

                  

Manufacturer & distributor of alumimnum and vinyl windows

                  

- 22,657 shares of common stock

        $ 227    $ 3,900,000

- 32.25% membership interest in Alenco Window Holdings, LLC (formerly Reliant Window Holdings, LLC)

          —        5,150,000

American Trenchless Technology, LLC

   February 2001              

Boring, tunneling and directional drilling

                  

- 4,160 shares of common stock

          1,324,694      —  

- 50% membership interest in Glendale, LLC

          300,000      —  

The Bradshaw Group

   May 2000              

Sells and services midrange and high-speed printing equipment

                  

- Prime + 2% promissory note with a face amount of $398,383(2)

          —        —  

- 15% promissory note(2)

          459,545      —  

- 1,335,000 shares of preferred stock

          1,335,000      —  

- Warrant to buy 2,229,450 shares of common stock for $0.01 through May 2008

          1      —  

Champion Window Holdings, Inc.

   March 1999              

Manufacturer & distributor of residential windows

                  

- 1,410,000 shares of common stock(1)

          1,471,800      16,100,000

CMC Investments, LLC

   December 2001              

Awaiting liquidation

                  

- 21% membership interest

          525,000      65,000

 

The accompanying notes are an

integral part of these financial statements.

 

7


Table of Contents

EQUUS II INCORPORATED

SCHEDULE OF PORTFOLIO SECURITIES

MARCH 31, 2004

(Unaudited)

(Continued)

 

Portfolio Company


   Date of
Initial Investment


   Cost

   Fair Value

Container Acquisition, Inc.

   February 1997              

Shipping container repair & storage

                  

- Promissory note

        $ 3,797,418    $ 1,100,000

- 78,318 shares of preferred stock

          7,831,800      —  

- Conditional warrant to buy upto 370,588 shares of common stock at $0.01 through February 2007

          1,000      —  

- 1,370,000 shares of common stock

          1,370,000      —  

- 85% membershi pinterest in CCI-ANI Finance, LLC

          1,571,000      650,000

Doane PetCare Enterprises, Inc.

   October 1995              

Manufacturer of private label pet food

                  

- 1,943,598 shares of common stock

          3,936,644      500,000

The Drilltec Corporation

   August 1998              

Provides protection & packaging for pipe & tubing

                  

- Prime + 9.75% promissory note(2)

          1,000,000      —  

ENGlobal, Inc. (AMEX: ENG)

   December 2001              

Engineering and consulting services

                  

- 9.5% promissory note(1)

          2,230,000      2,230,000

- 2,084,957 shares of common stock

          2,775,362      3,829,440

- Options to acquire 200,000 shares of common stock exercisable only upon change of control

          —        —  

Equicom, Inc.

   July 1997              

Radio stations

                  

- 10% promissory notes

          3,806,730      2,000,000

- 657,611 shares of preferred stock

          6,576,110      —  

- 452,000 shares of common stock

          141,250      —  

Jones Industrial Services, Inc.

   July 1998              

Field service for petrochemical & power generation industries

                  

- 35,000 shares of preferred stock

          3,500,000      3,200,000

- Warrant to buy 63,637 shares of common stock at $0.01 through June 2008

          100      —  

 

The accompanying notes are an

integral part of these financial statements.

 

8


Table of Contents

EQUUS II INCORPORATED

SCHEDULE OF PORTFOLIO SECURITIES

MARCH 31, 2004

(Unaudited)

(Continued)

 

Portfolio Company


   Date of
Initial Investment


   Cost

   Fair Value

PalletOne, Inc.

   October 2001              

Wooden pallet manufacturer

                  

- 3,811,500 shares of preferred stock (1)(3)

        $ 3,811,500    $ 4,000,000

- 350,000 shares of common stock

          350,000      —  

Sovereign Business Forms, Inc.

   August 1996              

Business forms manufacturer

                  

- 15% promissory notes (1)(3)

          4,555,137      4,555,137

- 21,382 shares of preferred stock (1)(3)

          2,138,200      2,138,200

- Warrant to buy 551,894 shares of common stock at $1 per share through August 2006

          —        —  

- Warrant to buy 25,070 shares of common stock at $1.25 per share through October 2007

          —        —  

- Warrant to buy 273,450 shares of common stock at $1 per share through October 2009

          —        —  

Spectrum Management, LLC

   December 1999              

Business & personal property protection

                  

- 285,000 units of Class A equity interest

          2,850,000      4,000,000

- 16% subordinated promissory note (1)

          1,303,698      1,303,698

Sternhill Partners I, LP

   March 2000              

Venture capital fund

                  

- 3% limited partnership interest

          2,176,604      600,000

Strategic Holdings, Inc.

   September 1995              

Processor of recycled glass

                  

- 15% promissory note

          6,750,000      6,750,000

- 3,822,157 shares of Series B preferred stock

          3,820,624      3,820,624

- 3,089,751 shares of common stock and warrants

          3,088,389      3,279,375

- 15% promissory note of SMIP, Inc.

          175,000      172,000

- 1,000 shares of SMIP, Inc. common stock

          150,000      100,000

 

The accompanying notes are an

integral part of these financial statements.

 

9


Table of Contents

EQUUS II INCORPORATED

SCHEDULE OF PORTFOLIO SECURITIES

MARCH 31, 2004

(Unaudited)

(Continued)

 

Portfolio Company


  

Date of

Initial Investment


   Cost

   Fair Value

Turf Grass Holdings, Inc.

   May 1999              

Grows, sells & installs warm season turfgrasses

                  

- 1,000 shares of common stock

        $ 949,632    $ 900,000

Vanguard VII, L.P.

   June 2000              

Venture capital fund

                  

- 1.3% limited partnership interest

          1,800,000      750,000
         

  

Total

        $ 77,872,465    $ 71,093,474
         

  

 

(1) Income-producing. All other securities are considered non-income producing.

 

(2) As of March 31, 2004, the Fund has reduced the fair value of these notes to zero and has discontinued recognizing any additional interest income on these notes due to conditions specific to the respective Portfolio Companies. However, the Portfolio Companies are still liable for such notes and related interest, and they may be collected in the future.

 

(3) Income on these securities is paid-in-kind by the issuance of additional securities or through the accretion of original issue discount.

 

The accompanying notes are an

integral part of these financial statements.

 

10


Table of Contents

EQUUS II INCORPORATED

SCHEDULE OF PORTFOLIO SECURITIES

MARCH 31, 2004

(Unaudited)

(Continued)

 

Substantially all of the Fund’s portfolio securities are restricted from public sale without prior registration under the Securities Act of 1933. The Fund negotiates certain aspects of the method and timing of the disposition of the Fund’s investment in each portfolio company, including registration rights and related costs.

 

In connection with the investments in American Trenchless Technology, LLC (“ATT”), Champion Window Holdings, Inc., Container Acquisition, Inc., The Drilltec Corporation, Jones Industrial Services, Inc. Sovereign Business Forms, Inc. and Strategic Holdings, Inc., rights have been obtained to demand the registration of such securities under the Securities Act of 1933, providing certain conditions are met. The Fund does not expect to incur significant costs, including costs of any such registration, in connection with the future disposition of its portfolio securities.

 

As defined in the Investment Company Act of 1940, at March 31, 2004, the Fund was considered to have a controlling interest in Alenco Holding Corporation, Champion Window Holdings, Inc., Container Acquisition, Inc., The Drilltec Corporation, Equicom, Inc. (“Equicom”), PalletOne, Inc.,, Sovereign Business Forms, Inc., Spectrum Management LLC and Strategic Holdings, Inc. The fair value of the Fund’s investment in ENGlobal, Inc. (“ENG”) includes a discount of $551,601 from the closing market price to reflect the estimated effect of restrictions on the sale of such securities at March 31, 2004.

 

Income was earned in the amount of $4,213,288 and $531,920 for the three months ended March 31, 2004 and 2003, respectively, on portfolio securities of companies in which the Fund has a controlling interest. Income was earned in the amount of $54,965 and $315,038 for the three months ended March 31, 2004 and 2003, respectively, on portfolio securities of companies that are affiliates of the Fund but are not controlled by the Fund.

 

As defined in the Investment Company Act of 1940, all of the Fund’s investments are in eligible portfolio companies except Sternhill Partners I, L.P. and Vanguard VII, L.P. The Fund provides significant managerial assistance to all of the portfolio companies in which it has invested, except Doane PetCare Enterprises, Inc. (“Doane”), ENG, Equicom, Sternhill Partners I, L.P., and Vanguard VII, L.P. The Fund provides significant managerial assistance to portfolio companies that comprise 86% of the total value of the investments in portfolio companies at March 31, 2004.

 

The accompanying notes are an

integral part of these financial statements.

 

11


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EQUUS II INCORPORATED

SCHEDULE OF PORTFOLIO SECURITIES

MARCH 31, 2004

(Unaudited)

(Continued)

 

The investments in portfolio securities held by the Fund are not geographically diversified. All of the Fund’s portfolio companies (except for Doane, PalletOne, Inc. and certain investments in the venture capital funds) are headquartered in Texas, although several have significant operations in other states.

 

The Fund’s investments in portfolio securities consist of the following types of securities at March 31, 2004:

 

Type of Securities


   Cost

   Fair Value

   Percentage
of Fair Value


 

Common Stock

   $ 15,557,997    $ 28,608,815    40.2 %

Secured and Subordinated Debt

     24,077,529      18,110,835    25.5 %

Preferred Stock

     29,013,234      13,158,824    18.5 %

Limited Liability Company Investments

     5,246,000      9,865,000    13.9 %

Options and Warrants

     1,101      —      0.0 %

Limited Partnership Investments

     3,976,604      1,350,000    1.9 %
    

  

  

Total

   $ 77,872,465    $ 71,093,474    100.0 %
    

  

  

 

The following is a summary by industry of the Fund’s investments as of March 31, 2004:

 

Industry


   Fair Value

   Percentage

 

Business Products and Services

   $ 11,997,035    16.9 %

Consumer Goods

     500,000    0.7 %

Engineering and Consulting Services

     6,059,440    8.5 %

Industrial Products and Services

     17,321,999    24.3 %

Media

     2,000,000    2.8 %

Residential Building Products

     25,150,000    35.4 %

Shipping Products and Services

     5,750,000    8.1 %

Turfgrass and Landscape Products

     900,000    1.3 %

Venture Funds and Other

     1,415,000    2.0 %
    

  

Total

   $ 71,093,474    100.0 %
    

  

 

The accompanying notes are an

integral part of these financial statements.

 

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EQUUS II INCORPORATED

NOTES TO FINANCIAL STATEMENTS

MARCH 31, 2004 AND 2003

(Unaudited)

 

(1) Organization and Business Purpose

 

Equus II Incorporated (the “Fund”), a Delaware corporation, was formed by Equus Investments II, L.P. (the “Partnership”) on August 16, 1991. On July 1, 1992, the Partnership was reorganized and all of the assets and liabilities of the Partnership were transferred to the Fund in exchange for shares of common stock of the Fund. The shares of the Fund trade on the New York Stock Exchange under the symbol EQS.

 

The Fund seeks to achieve capital appreciation by making investments in equity and equity-oriented securities issued by privately-owned companies in transactions negotiated directly with such companies. The Fund seeks to invest primarily in companies which intend to grow internally or by acquiring other businesses. The Fund may also invest in recapitalizations of existing businesses or special situations from time to time. The Fund’s investments in Portfolio Companies consist principally of equity securities such as common and preferred stock, but also include other equity-oriented securities such as debt convertible into stock or debt combined with warrants, options or other rights to acquire common or preferred stock. The Fund elected to be treated as a business development company under the Investment Company Act of 1940. For tax purposes, the Fund has elected to be treated as a regulated investment company (“RIC”). The Fund has entered into a management agreement with Equus Capital Management Corporation, a Delaware corporation (the “Management Company”).

 

Pursuant to the rules and regulations of the Securities and Exchange Commission, certain information and footnote disclosures normally included in the annual financial statements prepared in accordance with generally accepted accounting principles have been omitted. The unaudited financial statements have been prepared consistent with the accounting policies reflected in the Fund’s annual financial statements included in the Company’s Form 10-K for the year ended December 31, 2003 filed with the Securities and Exchange Commission and should be read in conjunction therewith. In management’s opinion, the unaudited financial statements include all adjustments, consisting of normal recurring adjustments, considered necessary for a fair presentation of such financial statements. Interim results are not necessarily indicative of results for a full year.

 

(2) Liquidity and Financing Arrangements

 

Liquidity and Revolving Line of Credit – Effective March 15, 2004, the Fund entered into a $6,500,000 revolving line of credit loan with Frost National Bank. The new line of credit extends through March 31, 2005. The proceeds of the new line of credit were utilized to payoff the $6,600,000 line of credit with Bank of America, N.A. that expired on March 15, 2004. The Fund had $4,109,044 outstanding under the line of credit at March 31, 2004.

 

The new loan is collateralized by the Fund’s investments in portfolio securities. The provisions of the new revolver include a borrowing base which cannot exceed 10% of the total value of eligible portfolio securities, as defined.

 

Interest on the new revolving line of credit is payable quarterly at a rate of .50% above the Frost National Bank floating prime rate, adjusted daily. A facility fee of .25% per annum on the unused portion of the line of credit is payable quarterly in arrears and the Fund paid a commitment fee of $65,000 at the closing of the loan. The line of credit restricts the Fund’s ability to incur additional indebtedness, pay

 

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dividends, merge with another entity, dispose of assets outside the ordinary course of business and engage in certain transactions with affiliates.

 

In December 2003, the Fund borrowed an additional $1,500,000 from an individual pursuant to a 9% promissory note, secured by 240,000 shares of common stock of Champion Window Holdings, Inc., due January 31, 2005, in order to fund a follow-on investment.

 

In April 2004, the Fund sold its interest in Strategic Holdings, Inc. Proceeds of such sale included cash of $12.5 million, which was used to repay the outstanding balance under the line of credit and the promissory note to the individual.

 

Under certain circumstances, the Fund may be called on to make follow-on investments in certain Portfolio Companies. The Fund has made loans to Equicom, Inc. (“Equicom”) from time to time to enable the company to service its debt and has guaranteed obligations to financial institutions on behalf of Equicom in the amount of $178,000. In addition, as of March 31, 2004, the Fund has committed to invest up to an additional $1,545,000 in the two venture capital funds in its portfolio. If the Fund does not have sufficient funds to make follow-on investments, the Portfolio Company in need of the investment may be negatively impacted, and the estimated fair value of the Fund’s investment in the Portfolio Company could be reduced.

 

At March 31, 2004 and 2003, the Fund was being charged interest at a rate of 4.5% and 8.0%, respectively, on its line of credit. The average daily balances outstanding on the Fund’s line of credit during the three months ended March 31, 2004, and 2003 was $5,090,520 and $12,076,389, respectively. During the three months ended March 31, 2004 and 2003, the amount of interest and loan fees paid in cash was $241,512 and $191,192, respectively.

 

RIC Borrowings, Restricted Cash and Temporary Investments - Because of the nature and size of its portfolio investments, the Fund periodically borrows money utilizing a margin account with a securities brokerage firm to make qualifying investments to maintain its tax status as a RIC under the Internal Revenue Code. As of March 31, 2004 and 2003, the Fund borrowed $49,998,800 and $54,959,521, respectively. The Fund collateralized such borrowings with restricted cash and temporary investments of $50,649,357 and $55,432,419 at March 31, 2004 and 2003, respectively. The U.S. Treasury bills were sold, and the total amount borrowed was repaid on April 1, 2004 and 2003, respectively. The Management Company believes the Fund will be able to use this financing arrangement to maintain its RIC status. However, there is no assurance that such arrangement will be available to the Fund in the future. If the Fund is unable to borrow funds in the future to make qualifying investments, the Fund may no longer qualify as a RIC. Failure to continue to qualify as a RIC could be material to the Fund and the Fund’s shareholders in that the Fund would be subject to corporate income tax on its net investment income and net realized gains, and any distributions to stockholders would be subject to income tax as ordinary dividends.

 

(3) Significant Accounting Policies

 

Valuation of Investments – Portfolio investments are carried at fair value with the net change in unrealized appreciation or depreciation included in the determination of net assets. Valuations of portfolio securities are performed in accordance with accounting principles generally accepted in the United States and the financial reporting policies of the Securities and Exchange Commission (“SEC”). The applicable methods prescribed by such principles and policies are described below:

 

Publicly-traded portfolio securities - Investments in companies whose securities are publicly traded are valued at their quoted market price at the close of business on the valuation date, less a discount to reflect the estimated effects of restrictions on the sale of such securities (“Valuation Discount”), if applicable.

 

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Privately-held portfolio securities – The fair value of investments for which no market exists is determined on the basis of procedures established in good faith by the Board of Directors of the Fund. As a general principle, the current “fair value” of an investment would be the amount the Fund might reasonably expect to receive for it upon its current sale, in an orderly manner. Appraisal valuations are necessarily subjective and the Management Company’s estimate of values may differ materially from amounts actually received upon the disposition of portfolio securities.

 

Generally, cost is the primary factor used to determine fair value until significant developments affecting the Portfolio Company (such as results of operations or changes in general market conditions) provide a basis for use of an appraisal valuation. Thereafter, portfolio investments are carried at appraised values as determined quarterly by the Management Company, subject to the approval of the Board of Directors. Appraisal valuations are based upon such factors as a Portfolio Company’s earnings, cash flow and net worth, the market prices for similar securities of comparable companies, an assessment of the company’s current and future financial prospects and various other factors and assumptions. In the case of unsuccessful operations, the appraisal may be based upon liquidation value.

 

Most of the Fund’s common equity investments are appraised at a multiple of free cash flow generated by the Portfolio Company in its most recent fiscal year, less outstanding funded indebtedness and other senior securities such as preferred stock. Projections of current year free cash flow may be utilized and adjustments for non-recurring items are considered. Multiples utilized are estimated based on the Management Company’s experience in the private company marketplace, and are necessarily subjective in nature.

 

Most of the Portfolio Companies utilize a high degree of leverage. The banking environment currently has resulted in pressure on several of these Portfolio Companies to reduce the amount of leverage in order to maintain such financing. From time to time, Portfolio Companies are in default of certain covenants in their loan agreements. When the Management Company has a reasonable belief that the Portfolio Company will be able to restructure the loan agreements to adjust for any defaults, the Portfolio Company’s securities continue to be valued assuming that the company is a going concern. In the event a Portfolio Company cannot generate adequate cash flow to meet the principal and interest payments on such indebtedness or is not successful in refinancing the debt upon its maturity, the Fund’s investment could be reduced or eliminated through foreclosure on the Portfolio Company’s assets or the Portfolio Company’s reorganization or bankruptcy.

 

The Fund may also use, when available, third-party transactions in a Portfolio Company’s securities as the basis of valuation (the “private market method”). The private market method will be used only with respect to completed transactions or firm offers made by sophisticated, independent investors.

 

The fair values of debt securities, which are generally held to maturity, are determined on the basis of the terms of the debt securities and the financial condition of the issuer. Certificates of deposit purchased by the Fund generally will be valued at their face value, plus interest accrued to the date of valuation.

 

Because of the inherent uncertainty of the valuation of portfolio securities which do not have readily ascertainable market values, amounting to $71,093,474 (including $3,829,440 in publicly-traded securities, net of a $551,601 valuation discount) and $75,553,608 (including $3,494,377 in publicly-traded securities, net of a $1,069,676 valuation discount) at March 31, 2004 and December 31, 2003, respectively, the Fund’s estimate of fair value may materially differ from the value that would have been used had a ready market existed for the securities. Appraised values do not reflect brokers’ fees or other normal selling costs which might become payable on disposition of such investments.

 

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On a daily basis, the Fund adjusts its net asset value for the changes in the value of its publicly held securities and material changes in the value of its private securities and reports those amounts to Lipper Analytical Services, Inc. Weekly and daily net asset values appear in various publications, including Barron’s and The Wall Street Journal.

 

Investment Transactions - Investment transactions are recorded on the accrual method. Realized gains and losses on investments sold are computed on a specific identification basis.

 

Cash Flows - For purposes of the Statements of Cash Flows, the Fund considers all highly liquid temporary cash investments purchased with an original maturity of three months or less to be cash equivalents. The Fund includes its investing activities within cash flows from operations.

 

Stock-Based Compensation – The Fund accounts for stock-based compensation using the intrinsic value method in accordance with the provisions of APB No. 25. Had the Fund accounted for the options using the fair value method under SFAS 123, the increase (decrease) in net assets from operations for the three months ended March 31, 2004 and 2003, respectively, would have been:

 

     2004

    2003

 

Increase (decrease) in net assets from operations, as reported

   $ (1,520,326 )   $ 2,737,910  

Stock-based employee compensation expense (benefit) included in increase (decrease) in net assets from operations

     300,480       —    

Stock-based employee compensation expense determined using fair value method

     (8,543 )     (18,636 )
    


 


Pro forma increase (decrease) in net assets from operations

   $ (1,228,389 )   $ 2,719,274  
    


 


 

Federal Income Taxes – The Fund intends to comply with the requirements of the Internal Revenue Code necessary to qualify as a regulated investment company and, as such, will not be subject to federal income taxes on otherwise taxable income (including net realized capital gains) which is distributed to stockholders. Therefore, no provision for federal income taxes is recorded in the financial statements. The Fund borrows money from time to time to maintain its tax status under the Internal Revenue Code as a RIC. See Note 2 for further discussion of the Fund’s RIC borrowings.

 

(4) Management

 

The Fund has entered into a management agreement with the Management Company. Pursuant to such agreement, the Management Company performs certain services, including management and administrative services necessary for the operation of the Fund. The Management Company receives a management fee at an annual rate of 2% of the net assets of the Fund, paid quarterly in arrears. The Management Company also receives compensation for providing certain investor communication services. The accompanying Statements of Operations include $12,500 related to such services for each of the three months ended March 31, 2004 and 2003. The management fees paid by the Fund represent the Management Company’s primary source of revenue and support. The Management Company is controlled by a privately-owned corporation.

 

As compensation for services rendered to the Fund, each director who is not an officer of the Fund receives an annual fee of $20,000 paid quarterly in arrears, a fee of $2,000 for each meeting of the

 

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Board of Directors attended in person, a fee if $1,000 for participation in each telephonic meeting of the Board of Directors and a fee of $2,000 for each committee meeting attended ($1,000 for each committee meeting if attended on the same day as a Board Meeting), and reimbursement of all out-of-pocket expenses relating to attendance at such meetings. In addition, each director who is not an officer of the Fund is granted incentive stock options to purchase shares of the Fund’s stock from time to time. (See Note 8). Certain officers of the Fund serve as directors of Portfolio Companies, and may receive and retain fees, including non-employee director stock options, from such Portfolio Companies in consideration for such service.

 

The Management Agreement will continue in effect until June 30, 2004, and from year-to–year thereafter provided such continuance is approved at least annually by (i) a vote of a majority of the outstanding shares of the Fund or (ii) a majority of the directors who are not “interested persons” of the Fund, at a meeting called for the purpose of voting on such approval. The Management Agreement may be terminated at any time, without the payment of any penalty, by a vote of the Board of Directors of the Fund or the holders of a majority of the Fund’s shares on 60 days’ written notice to the Management Company, and would automatically terminate in the event of its “assignment” (as defined in the Investment Company Act).

 

(5) Federal Income Tax Matters

 

The Fund is required to make distributions of any net taxable investment income on an annual basis, and may elect to distribute or retain net taxable realized capital gains. The Internal Revenue Service approved the Fund’s request, effective October 31, 1998, to change its year-end for determining capital gains for purposes of Section 4982 of the Internal Revenue Code from December 31 to October 31.

 

The Fund was required to make a distribution for 2003 under income tax regulations. As of December 31, 2003, the Fund had a capital loss carryforward of $8,023,608, which may be used to offset future taxable capital gains. If not utilized, the loss carryforward will expire beginning in 2007.

 

(6) Dividends

 

The Fund declared no dividends during the three months ended March 31, 2004 and 2003. On January 16, 2004, the Fund paid $2,287,194 in cash for a dividend which had been declared in 2003.

 

(7) Portfolio Securities

 

During the three months ended March 31, 2004, the Fund made follow-on investments of $1,650,860 in four companies and a venture fund, including $254,428 in accrued interest and dividends in the form of additional portfolio securities and $949,632 recorded as the cost of securities of a former portfolio company exchanged for securities of a new company that acquired the business and assets of the portfolio company. In addition, the Fund realized a net capital loss of $6,119,908 during the three months ended March 31, 2004.

 

During the three months ended March 31, 2003, the Fund made follow-on investments of $701,943 in five companies, including $326,943 in accrued interest and dividends in the form of additional portfolio securities and accretion of original issue discount on promissory notes. In addition, the Fund realized a net capital loss of $8,100,724 during the three months ended March 31, 2003.

 

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(8) Stock Option Plan

 

Shareholders have approved the Equus II Incorporated 1997 Stock Incentive Plan (“Stock Incentive Plan”), which authorizes the Fund to issue options to the directors and officers of the Fund in an aggregate amount of up to 20% of the outstanding shares of common stock of the Fund. The Stock Incentive Plan provides that each director who is not an officer of the Fund is, on the first business day following each annual meeting, granted an incentive stock option to purchase 2,200 shares of the Fund’s common stock. Options are issued to the officers of the Fund at the discretion of the compensation committee. The options have a ten year life and vest 50% six months after the grant date and 16  2/3% on the first, second and third anniversaries of the date of the grant.

 

Under the Stock Incentive Plan, options to purchase 1,033,800 and 1,086,800 shares of the Fund’s common stock with a weighted average exercise price of $8.47 and $8.42 per share were outstanding at March 31, 2004 and 2003, respectively. Of these options, 829,338 and 743,588 shares, with a weighted average exercise price per share of $8.65 and $8.75 were exercisable at March 31, 2004 and 2003, respectively. Of the outstanding options at March 31, 2004, 987,600 have exercise prices ranging from $7.43 to $14.15 and the remaining options have exercise prices ranging from $21.82 to $24.95. These options expire in May 2007 through December 2013.

 

On May 12, 2003, options to acquire a total of 13,200 shares at $7.43 per share were issued to the non-officer directors. On August 8, 2003, options to purchase 5,500 shares of the Fund’s common stock at a price of $8.63 per share were issued to a new director, upon his election to the board of directors of the Fund. On December 24, 2003, options to purchase 40,000 shares of the Fund’s common stock at a price of $7.85 per share were issued to a new officer.

 

On November 14, 2001, options to acquire a total of 990,000 shares at $7.69 per share were issued to officers of the Fund. These options included dividend equivalent rights. Generally accepted accounting principles require that the options be accounted for using variable plan accounting. Variable plan accounting resulted in non-cash compensation expense (benefit) of ($300,480) during the three months ended March 31, 2004.

 

Dividend equivalent rights represent the right of the officers of the Fund to receive a credit against the option exercise price for the amount of any dividends paid by the Fund during the option period. In January 2002, the Fund filed an application with the SEC seeking an amendment to an exemptive order previously issued by the SEC to permit the Fund to grant dividend equivalent rights to the Fund’s independent directors as part of their stock option awards. During its review of such application, the SEC staff advised the Fund that it does not believe that dividend equivalent rights are permitted under the Investment Company Act. Accordingly, the Fund may be required to obtain a new exemptive order from the SEC permitting the Fund to issue dividend equivalent rights. Based on the ongoing discussion with the SEC, the Fund has not recorded any associated compensation expense for the 2003 dividend applicable to dividend equivalent rights. If the dividend equivalent rights had been in effect, additional non-cash compensation expense of approximately $650,000, with an offsetting credit to additional paid in capital, would have been recognized under variable plan accounting in the fourth quarter of 2003. Such recognition of the non-cash compensation expense would not have changed the Fund’s reported net assets.

 

Options to purchase 95,200 shares were exercised by one officer, one former officer and one director of the Fund during 2003 and the Fund received $732,036 in cash from the exercise of such options.

 

On September 30, 1999, options to purchase 719,794 shares of common stock of the Fund were exercised by the officers of the Fund for $15.45 per share. The exercise price of $11,124,086 was paid in

 

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the form of promissory notes from the officers to the Fund. On April 1, 2001, a former officer of the Fund surrendered 41,471 shares in satisfaction of his note receivable and accrued interest aggregating $548,542. In September 2001, the officers of the Fund surrendered 802,662 shares in satisfaction of their notes receivable and accrued interest aggregating $10,505,551. These transactions were recorded as decreases in common stock and additional paid in capital. The Fund released 71,824 shares to the officers relating to these transactions. There was no change in total net assets as a result of the note repayment and surrendering of the shares. Under variable plan accounting applicable to these transactions, compensation expense was adjusted to reflect the change in benefit that the officers would have received assuming that their notes were settled with their pledged common stock at the end of each reporting period, based on the net asset value of the Fund.

 

During its review of the exemptive application discussed above, the SEC staff also raised certain issues with respect to the manner in which the officer notes were settled. The Fund has responded to the staff’s questions and supplied additional information. Although the ultimate resolution of this matter cannot be determined at this time, management of the Fund believes that the resolution of this matter will not have an adverse financial impact on the Fund.

 

If all outstanding options for which the market price exceeds the exercise price at March 31, 2004 and December 31, 2003, had been exercised, the fund’s net asset value would have been reduced by $0.02 and $0.06 per share, respectively, assuming the Fund had used the proceeds from the exercise of such options to repurchase shares at the market price pursuant to the treasury stock method.

 

(9) Subsequent Events

 

On April 1, 2003, the Fund sold U.S. Treasury bills for $50,000,000 and repaid our margin loan.

 

Subsequent to March 31, 2004, the Fund sold 866,989 shares of ENG common stock for $1,991,794, realizing a capital gain of $71,639.

 

On April 8, 2004, the Fund sold its interest in Strategic Holdings, Inc. and SMIP, Inc. (“Strategic”). The Fund received $12.5 million in cash (including $1.8 million in interest), and could receive up to $4.1 million more from amounts being held in escrow to support representations and warranties made by the Fund and other shareholders of Strategic in conjunction with the sale. The Fund realized a capital gain of approximately $140,000 on this transaction, which would increase by approximately $600,000 if all escrowed amounts are received.

 

On April 9, 2004, the Fund paid the total outstanding balance on the revolving line of credit at Frost National Bank. On April 15, 2004, the Fund paid in full the $1.5 million promissory note from an individual.

 

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Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations.

 

Overview

 

Equus II Incorporated is a business development company which invests in equity and equity-oriented securities issued by privately-owned companies in transactions negotiated directly with such companies. We had investments in 16 Portfolio Companies and two venture capital funds at March 31, 2004 and December 31, 2003. We did not make any new investments during the three months ended March 31, 2004 or 2003.

 

We attempt to limit risk by investing in a portfolio of companies involved in different industries. We limit our initial investment in any company to no more than 15% of the Fund’s net assets. However, at March 31, 2004, 36% of our net assets were invested in two companies in the residential window industry, and 20% was invested in a third company which processes recycled glass. On April 8, 2004, we sold our interest in Strategic Holdings, Inc. Proceeds from such sale were used to pay off our existing borrowings, and the remaining proceeds may be used for new or follow-on investments or other corporate purposes.

 

The valuation of our investments is the most significant area of judgment impacting our financial statements. Our portfolio investments are valued at our estimates of fair value, with the net change in unrealized appreciation or depreciation included in the determination of net assets. Almost all of our long-term investments are in privately-held or restricted securities, the valuation of which is necessarily subjective. Actual values may differ materially from the Fund’s estimated fair value. Portfolio valuations are determined quarterly by the Management Company, subject to the approval of the Board of Directors, and are based on a number of relevant factors.

 

Most of our Portfolio Companies utilize leverage, and the leverage magnifies the return on our investments. For example, if a Portfolio Company has a total enterprise value of $10 million and $7.5 million in funded indebtedness, its equity is valued at $2.5 million. If the enterprise value increases or decreases by 20%, to $12 million or $8 million, respectively, the value of the equity increases or decreases by 80%, to $4.5 million or $0.5 million, respectively. This disproportionate increase or decrease adds a level of volatility to our equity-oriented portfolio securities.

 

We derive our cash flow from interest and dividends received and sales of securities from our investment portfolio. We pay certain administrative costs, management fees to the Management Company overseeing the portfolio, and interest expense on our existing debt. We also spend our cash on new investments, or follow-on investments which may be required by certain Portfolio Companies. Historically, our cash flow from interest and dividends has not been sufficient to cover our expenses and follow-on investments. Because our investments are illiquid, we have utilized leverage to provide the required funds, and the leverage is then repaid from the sale of portfolio securities. Since the fourth quarter of 2002, our previous lender required that all proceeds from sale or repayment of our portfolio securities be applied to its loan, and reduced its commitment to advance funds under the loan agreement by a like amount.

 

We have distributed to our stockholders any net taxable investment income or realized capital gains on an annual basis. We declared a dividend of $0.72 per share in 2003, including $0.57 per share in qualifying dividend income and $0.15 per share as a return of capital. We did not declare a dividend for the three months ended March 31, 2004.

 

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Since we are a closed-end business development company, stockholders have no right to present their shares to the Fund for redemption. Because our shares might trade at a discount, our Board of Directors has determined that it would be in the best interest of our stockholders for the Fund to be authorized to attempt to reduce or eliminate the market value discount from net asset value. Accordingly, from time to time we may, but we are not required to, repurchase our shares (including by means of tender offers) to attempt to reduce or eliminate the discount or to increase the net asset value of our shares.

 

Significant Accounting Policies

 

Valuation of Investments - The valuation of our Portfolio Companies is the most significant area of judgment impacting the financial statements. Portfolio investments are carried at fair value with the net change in unrealized appreciation or depreciation included in the determination of net assets. Valuations of portfolio securities are performed in accordance with accounting principles generally accepted in the United States and the financial reporting policies of the SEC. The applicable methods prescribed by such principles and policies are described below:

 

Publicly-traded portfolio securities - Investments in companies whose securities are publicly traded are valued at their quoted market price at the close of business on the valuation date, less a discount to reflect the estimated effects of restrictions on the sale of such securities (“Valuation Discount”), if applicable.

 

Privately-held portfolio securities – The fair value of investments for which no market exists is determined on the basis of procedures established in good faith by our Board of Directors. As a general principle, the current “fair value” of an investment is the amount we might reasonably expect to receive for it upon its current sale, in an orderly manner. Appraisal valuations are necessarily subjective and the Management Company’s estimate of values may differ materially from amounts actually received upon the disposition of portfolio securities.

 

Generally, cost is the primary factor used to determine fair value until significant developments affecting the Portfolio Company (such as results of operations or changes in general market conditions) provide a basis for use of an appraisal valuation. Thereafter, portfolio investments are carried at appraised values as determined quarterly by the Management Company, subject to the approval of our Board of Directors. Appraisal valuations are based upon such factors as a Portfolio Company’s earnings, cash flow and net worth, the market prices for similar securities of comparable companies, an assessment of the company’s current and future financial prospects and various other factors and assumptions. In the case of unsuccessful operations, the appraisal may be based upon liquidation value.

 

Most of our common equity investments are appraised at a multiple of free cash flow generated by the Portfolio Company in its most recent fiscal year, less outstanding funded indebtedness and other senior securities such as preferred stock. Projections of current year free cash flow may be utilized and adjustments for non-recurring items are considered. Multiples utilized are estimated based on the Management Company’s experience in the private company marketplace, and are necessarily subjective in nature. Most of the Portfolio Companies utilize a high degree of leverage. From time to time, Portfolio Companies are in default of certain covenants in their loan agreements. When the Management Company has a reasonable belief that a Portfolio Company will be able to restructure its loan agreements to adjust for any defaults, the Portfolio Company’s securities continue to be valued assuming that the company is a going concern. In the event a Portfolio Company cannot generate adequate cash flow to meet the principal and interest payments on its indebtedness or is not successful in refinancing the debt upon its maturity, the value of our investment could be reduced or eliminated through foreclosure on the Portfolio Company’s assets or the Portfolio Company’s reorganization or bankruptcy.

 

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We may also use, when available, third-party transactions in a Portfolio Company’s securities as the basis of valuation (the “private market method”). The private market method will be used only with respect to completed transactions or firm offers made by sophisticated, independent investors.

 

The fair values of debt securities, which are generally held to maturity, are determined on the basis of the terms of the debt securities and the financial conditions of the issuer. Certificates of deposit generally will be valued at their face value, plus interest accrued to the date of valuation.

 

On a daily basis, we adjust our net asset value for changes in the value of our publicly held securities and material changes in the value of our private securities, and report those amounts to Lipper Analytical Services, Inc. Weekly and daily net asset values appear in various publications, including Barron’s and The Wall Street Journal.

 

Federal Income Taxes – We intend to comply with the requirements of the Internal Revenue Code necessary to qualify as a regulated investment company (“RIC”) and, as such, will not be subject to federal income taxes on otherwise taxable income (including net realized capital gains) which is distributed to stockholders. Therefore, no provision for federal income taxes is recorded in the financial statements. As of December 31, 2003, we had a capital loss carryforward of approximately $8,024,000, which may be used to offset future taxable capital gains. We borrow money from time to time to maintain our tax status as a RIC.

 

Liquidity and Capital Resources

 

At March 31, 2004, we had $71,093,474 of our total assets of $125,822,198 invested in portfolio securities of 16 operating companies and two venture capital funds. $49,998,800 of our remaining assets were invested in U.S. Treasury Bills for the purpose of satisfying the diversification requirement to maintain our pass-through tax treatment. These securities were held by a securities brokerage firm and were pledged along with cash and other securities to secure the payment of the margin account balance. The U.S. Treasury bills were sold and the margin loan was repaid to the brokerage firm on April 1, 2004.

 

We had a revolving line of credit with Bank of America, N.A. that expired on March 15, 2004. Effective March 15, 2004, we entered into a new $6,500,000 revolving line of credit loan with Frost National Bank. At March 31, 2004, the amount outstanding on the line of credit was $4,109,044. The new line of credit extends through March 31, 2005. We use our revolving line of credit to pay operating expenses and for new and follow-on investments in portfolio securities. The proceeds of the new loan were utilized to pay off the previous line of credit. As of May 14, 2004, there is no amount outstanding under the new line of credit and the availability of such line is $6,500,000 at such date.

 

The new line of credit is collateralized by our investments in portfolio securities. The provisions of the new line of credit include a borrowing base that cannot exceed 10% of the total value of eligible portfolio securities. Interest on the new revolving line of credit is payable quarterly at a rate of .50% above the floating prime rate, adjusted daily. A facility fee of .25% per annum on the unused portion of the line of credit is payable quarterly in arrears, and we paid a commitment fee of $65,000 at the closing of the loan. Management believes the new line of credit will provide us with sufficient liquidity to meet our known obligations, including expected follow-on investments, during 2004.

 

In December 2003, we borrowed an additional $1,500,000 from an individual pursuant to a 9% promissory note, secured by 240,000 shares of common stock of Champion Window Holdings, Inc., due January 31, 2005, in order to fund a follow-on investment.

 

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On April 8, 2004, we sold our interest in Strategic Holdings, Inc and SMIP, Inc. Proceeds from such sale were used to pay off our existing borrowings under our line of credit and the promissory note referenced above. The remaining proceeds may be used for new or follow-on investments or other corporate purposes.

 

We declared a dividend of $0.72 per share for 2003, or $4,556,472. We paid $2,287,194 in cash and issued 286,540 additional shares of common stock at $7.919 per share on January 16, 2004.

 

Under certain circumstances, we may be called on to make follow-on investments in certain Portfolio Companies. If we do not have sufficient funds to make follow-on investments, the Portfolio Company in need of the investment may be negatively impacted. Also, our equity interest in and our estimated fair value of the Portfolio Company could be reduced. We have made loans to Equicom, Inc. (“Equicom”) from time to time to enable the company to service its debt, and have guaranteed obligations to financial institutions on behalf of Equicom in the amount of $178,000. In addition, as of March 31, 2004, we have committed to invest up to an additional $1,545,000 in the two venture capital funds in our portfolio.

 

Net cash provided by operating activities was $4,843,495 and $5,004,664 for the three months ended March 31, 2004 and 2003, respectively. Approximately $18.1 million in estimated value of our investments are in the form of notes receivable from Portfolio Companies. However, only two of the Portfolio Companies are currently paying cash interest to us in accordance with their respective notes receivable, which aggregate $3,533,698 in fair value. At March 31, 2004, one of the promissory notes, with an estimated fair value of $4,555,137, provides that interest is paid in kind or that the original issue discount is accreted over the life of the notes, by adding such amount to the principal of the notes.

 

Because of the nature and size of our portfolio investments, we periodically borrow funds to make qualifying investments to maintain our tax status as a RIC. During the three months ended March 31, 2004 and 2003, we borrowed such funds by utilizing a margin account with a securities brokerage firm. There is no assurance that such arrangement will be available in the future. If we are unable to borrow funds to make qualifying investments, we may no longer qualify as a RIC. We would then be subject to corporate income tax on our net investment income and realized capital gains, and distributions to stockholders would be subject to income tax as ordinary dividends.

 

We have the ability to borrow funds and issue forms of senior securities representing indebtedness or stock, such as preferred stock, subject to certain restrictions. Net taxable investment income and net taxable realized gains from the sales of portfolio investments are intended to be distributed at least annually, to the extent such amounts are not reserved for payment of expenses and contingencies or to make follow-on or new investments. Pursuant to the restrictions in our existing line of credit, we are not allowed to incur additional indebtedness unless approved by the lender.

 

We reserve the right to retain net long-term capital gains in excess of net short-term capital losses for reinvestment or to pay contingencies and expenses. Such retained amounts, if any, will be taxable to us as long-term capital gains and stockholders will be able to claim their proportionate share of the federal income taxes paid by us on such gains as a credit against their own federal income tax liabilities. Stockholders will also be entitled to increase the adjusted tax basis of their Fund shares by the difference between their undistributed capital gains and their tax credit.

 

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Results of Operations

 

Investment Income and Expense

 

Net investment income after all expenses amounted to $3,717,818 and $127,104 for the three months ended March 31, 2004 and 2003, respectively. Income from portfolio securities was $4,268,253 for the three months ended March 31, 2004 and $846,958 for the comparable period in 2003. The increase from 2003 to 2004 is due to a cash dividend of $3,525,000 received in 2004 from Champion Window Holdings, Inc. Director fees and expenses increased to $67,657 in 2004 from $54,555 in 2003. Interest expense increased to $251,356 in 2004 from $183,064 in 2003 due to fees paid to extend the line of credit at Bank of America, NA and fees related to acquiring the new line of credit with Frost National Bank.

 

The Management Company receives management fee compensation at an annual rate of 2% of the net assets of the Fund paid quarterly in arrears. Such fees amounted to $348,588 and $398,570 during the three months ended March 31, 2004 and 2003, respectively. The decrease in management fees during the three months ended March 31, 2004 was due to a decrease in net assets between the two periods.

 

Generally accepted accounting principles require that the options issued by the Fund be accounted for using variable plan accounting. Such accounting resulted in non-cash compensation expense (benefit) of $(215,880) during the quarter ended March 31, 2004.

 

Realized Gains and Losses on Sales of Portfolio Securities

 

During the three months ended March 31, 2004, we realized net capital losses of $6,119,908 from the sale or disposition of securities of two Portfolio Companies. We sold 286,294 shares of ENGlobal, Inc. (“ENG”) common stock, realizing a capital loss of $72,640. We exchanged our investment in Turfgrass America, Inc. (“TAI”) for an investment in a new entity which acquired the assets and business of TAI, realizing a capital loss of $6,049,696. The $6,049,696 had been recorded as an unrealized loss at December 31, 2003, so this transaction had no effect on net assets during the quarter ended March 31, 2004. In addition, we realized a short term capital gain of $2,428.

 

During the three months ended March 31, 2003, we realized net capital losses of $8,100,724 from the sale of securities of three Portfolio Companies. We received $108,004 for our remaining investment in Milam Enterprises, LLC, realizing a capital gain of $106,093. We received $2,406,398 from Doane PetCare Enterprises, Inc. for payment in full of our 15% promissory note, realizing a capital gain of $551,850 relating to the unamortized original issue discount. In addition, we received $500,000 for our investment in FS Strategies, Inc., realizing a capital loss of $8,758,667.

 

Changes in Unrealized Appreciation/Depreciation of Portfolio Securities

 

Net unrealized depreciation on investments decreased by $797,164 during the three months ended March 31, 2004 from $7,576,155 to $6,778,991. Such decrease resulted from increases in the estimated fair value of seven of our Portfolio Companies aggregating $2,848,265, decreases in the estimated fair value of nine of our Portfolio Companies aggregating $8,226,256 and the transfer of $6,175,155 in unrealized depreciation to realized capital losses from the sale or disposition of investments in two of our Portfolio Companies.

 

Net unrealized appreciation (depreciation) on investments changed by $10,711,530 during the three months ended March 31, 2003 from unrealized depreciation of $(5,417,014) to unrealized appreciation of $5,294,516. Such change resulted from increases in the estimated fair value of six of our

 

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Portfolio Companies aggregating $5,177,935, decreases in the estimated fair value of nine of our Portfolio Companies aggregating $3,626,983 and the transfer of $9,160,578 in net unrealized depreciation to realized capital losses from the sale or disposition of investments in two of our Portfolio Companies.

 

Dividends

 

We declared no dividends for the three months ended March 31, 2004 and 2003. On January 16, 2004, we paid cash dividends of $2,287,194 for dividends declared in 2003.

 

Portfolio Investments

 

During the three months ended March 31, 2004, we made follow-on investments of $1,650,860 in four portfolio companies and a venture fund, including $254,428 in accrued interest and dividends received in the form of additional portfolio securities and $949,632 recorded as the cost of securities of a former portfolio company exchanged for securities of a new company that acquired the business and the assets of the portfolio company.

 

For the quarter ended March 31, 2004, we received an additional 470 shares of preferred stock of Sovereign Business Forms, Inc. (“Sovereign”) in dividends. In addition, Sovereign elected to convert $207,428 of accrued interest into the balance of the 15% promissory notes due to us.

 

On January 12, 2004, we advanced $75,000 to Equicom pursuant to a 10% promissory note, thereby reducing the guarantee commitment to Equicom’s lender by a like amount.

 

On February 19, 2004, ENG made a principal payment on its 9.5% promissory note of $110,000, reducing the note balance to $2,230,000.

 

On February 24, 2004, we exercised warrants in Champion Window Holdings, Inc. for $71,800 in exchange for 10,000 shares of common stock.

 

On March 3, 2004, we invested an additional $300,000 in Vanguard VII, L.P. pursuant to a $3,000,000 commitment made in June 2000. $1,800,000 of such commitment has been funded through March 31, 2004.

 

On March 16, 2004, we exchanged our existing investment in TAI, including accrued interest, notes receivable and preferred stock with costs aggregating $6,049,696, for 1,000 shares of common stock of a newly formed company which acquired substantially all of the assets of TAI. The newly formed company is controlled by a new investor. Our investment in the newly formed company has a cost basis of $949,632 and we recorded a realized loss of $6,049,696 in conjunction with this transaction. The loss had been recorded as an unrealized loss at December 31, 2003, and had no effect on net assets during the quarter ended March 31, 2004.

 

Subsequent Events

 

On April 1, 2004, we sold U.S. Treasury bills for $50,000,000 and repaid our margin loan.

 

Subsequent to March 31, 2004, we sold 866,989 shares of ENGlobal Corporation common stock for $1,991,794, realizing a capital gain of $71,639.

 

On April 8, 2004, the Fund sold its interest in Strategic Holdings, Inc. and SMIP, Inc. (“Strategic”). The Fund received $12.5 million in cash (including $1.8 million in interest), and could

 

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receive up to $4.1 million more from amounts being held in escrow to support representations and warranties made by the Fund and other shareholders of Strategic in conjunction with the sale. The Fund realized a capital gain of approximately $140,000 on this transaction, which would increase by approximately $600,000 if all escrowed amounts are received.

 

On April 9, 2004, the Fund paid the total outstanding balance on the revolving line of credit at Frost National Bank. On April 15, 2004, the Fund paid in full the $1.5 million promissory note from an individual.

 

Item 3. Quantitative and Qualitative Disclosure about Market Risk

 

We are subject to financial market risks, including changes in interest rates with respect to our investments in debt securities and our outstanding debt payable, as well as changes in marketable equity security prices. We do not use derivative financial instruments to mitigate any of these risks. The return on our investments is generally not affected by foreign currency fluctuations.

 

Our investments in portfolio securities consist of some fixed rate debt securities. Since the debt securities are generally priced at a fixed rate, changes in interest rates do not directly impact interest income. In addition, changes in market interest rates are not typically a significant factor in our determination of fair value of these debt securities, since the securities are generally held to maturity. Their fair values are determined on the basis of the terms of the debt security and the financial condition of the issuer.

 

Borrowings under our lines of credit expose the Fund to certain market risks. Based on the average outstanding borrowings under our lines of credit for the three months ended March 31, 2004 and 2003, respectively, of approximately $6,590,520 and $12,076,389, a change of one percent in the interest rate would have caused a change in interest expense of approximately $65,905 and $120,764. This change would have resulted in a change of $0.01 and $0.02 in the net asset value per share at December 31, 2004 and 2003, respectively. We did not enter into our credit facility for trading purposes and the line of credit carries interest at a pre-agreed upon percentage point spread from the prime rate. We obtained a new line of credit effective March 15, 2004, which expires on March 31, 2005. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations” regarding our liquidity and capital resources.

 

A major portion of our investment portfolio consists of debt and equity investments in private companies. Modest changes in public market equity prices generally do not significantly impact the estimated fair value of these investments. However, significant changes in market equity prices can have a longer-term effect on valuations of private companies, which could affect the carrying value and the amount and timing of gains or losses realized on these investments. A portion of our investment portfolio also consists of common stocks in publicly traded companies. These investments are directly exposed to equity price risk, in that a hypothetical ten percent change in these equity prices would result in a similar percentage change in the fair value of these securities.

 

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Part II. Other Information

 

Item 4. Controls and Procedures

 

The Fund maintains disclosure controls and other procedures that are designed to ensure that information required to be disclosed by the Fund in the reports that it files or submits under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms, and that such information is accumulated and communicated to the Fund’s management, including its Chairman and Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure.

 

The Fund’s management, with the participation of the Fund’s Chairman and Chief Executive Officer and Chief Financial Officer, have evaluated the effectiveness of the design and operations of the Fund’s “disclosure controls and procedures” (as defined in Rule 13a-15(e) under the Securities Exchange Act of 1934) as of March 31, 2004. Based on their evaluation, the Fund’s Chairman and Chief Executive Officer and Chief Financial Officer concluded that the Fund’s disclosure controls and procedures are effective in timely making known to them material information relating to the Fund required to be disclosed in the Fund’s reports file or submitted under the Exchange Act. There has been no change in the Fund’s internal control over financial reporting during the quarter ended March 31, 2004, that has materially affected, or is reasonably likely to materially affect, the Fund’s internal control over financial reporting.

 

Item 6. Exhibits and Reports on Form 8-K.

 

  (a) Exhibits

 

  31. Form of Quarterly Certification Required by Rules 13a-14 and 15d-14 under the Securities Exchange Act of 1934

 

  (1) Certification by Chairman and Chief Executive Officer

 

  (2) Certification by Chief Financial Officer

 

  32. Certification Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

 

  (1) Certification by Chairman and Chief Executive Officer

 

  (2) Certification by Chief Financial Officer

 

  (b) Reports on Form 8-K filed subsequent to quarter ended March 31, 2004

 

On May 13, 2004, we furnished a Form 8-K pursuant to Item 12 reporting the issuance of a press release announcing our financial results for the quarter ended March 31, 2004.

 

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SIGNATURE

 

Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has caused this report to be signed by the undersigned, thereunto duly authorized.

 

Date: May 17, 2004

     

EQUUS II INCORPORATED

         /S/    HARRY O. NICODEMUS IV
       
       

Harry O. Nicodemus IV

Chief Financial Officer

 

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