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EQUUS TOTAL RETURN, INC. - Quarter Report: 2005 March (Form 10-Q)

Form 10-Q
Table of Contents

FORM 10-Q

 


 

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

(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, 2005 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 6,506,692 shares of the registrant’s common stock, $.001 par value, outstanding, as of May 16, 2005. The net asset value of a share at March 31, 2005 was $11.61.

 



Table of Contents

EQUUS II INCORPORATED

(A Delaware Corporation)

 

INDEX

 

         PAGE

PART I. FINANCIAL INFORMATION

    

Item 1.

  Financial Statements     
    Balance Sheets
- March 31, 2005 and December 31, 2004
   1
    Statements of Operations
- For the three months ended March 31, 2005 and 2004
   2
    Statements of Changes in Net Assets
- For the three months ended March 31, 2005 and 2004
   3
    Statements of Cash Flows
- For the three months ended March 31, 2005 and 2004
   4
    Selected Per Share Data and Ratios
- For the three months ended March 31, 2005 and 2004
   6
    Schedule of Portfolio Securities
- March 31, 2005
   7
    Notes to Financial Statements    12

Item 2.

  Management’s Discussion and Analysis of Financial Condition and Results of Operations    20

Item 3.

  Quantitative and Qualitative Disclosure about Market Risk    27

PART II. OTHER INFORMATION

    

Item 4.

  Controls and Procedures    28

Item 6.

  Exhibits    28

SIGNATURE

   30

 

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Table of Contents

EQUUS II INCORPORATED

BALANCE SHEETS

MARCH 31, 2005 AND DECEMBER 31, 2004

(Unaudited)

 

     2005

    2004

 

Assets

                

Investments in portfolio securities at fair value (cost $53,114,390 and $53,194,666, respectively)

   $ 53,592,004     $ 48,621,356  

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

     25,213,577       24,218,234  

Cash

     10,420       12,523  

Temporary cash investments, at cost which approximates fair value

     19,166,199       18,563,525  

Accounts receivable

     87,073       104,964  

Accrued interest and dividends receivable

     280,022       441,644  

Escrowed receivables, at fair value

     3,036,000       2,660,000  
    


 


Total assets

   $ 101,385,295     $ 94,622,246  
    


 


Liabilities and net assets

                

Liabilities:

                

Accounts payable and accrued liabilities

   $ 246,290     $ 99,614  

Accrued compensation

     281,868       12,367  

Dividends payable

     —         1,589,160  

Due to management company

     377,873       342,998  

Borrowing under margin account

     24,963,938       23,978,450  
    


 


Total liabilities

     25,869,969       26,022,589  
    


 


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, 6,506,692 shares outstanding

     6,507       6,507  

Additional paid-in capital

     84,198,238       84,174,979  

Undistributed net investment income (losses)

     (437,935 )     (12,367 )

Undistributed net capital gains (losses)

     (8,729,098 )     (10,996,152 )

Unrealized appreciation (depreciation) of portfolio securities, net

     477,614       (4,573,310 )
    


 


Total net assets

   $ 75,515,326     $ 68,599,657  
    


 


Net assets per share

   $ 11.61     $ 10.54  
    


 


 

The accompanying notes are an integral part of these financial statements.

 

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Table of Contents

EQUUS II INCORPORATED

STATEMENTS OF OPERATIONS

FOR THE THREE MONTHS ENDED MARCH 31, 2005 AND 2004

(Unaudited)

 

     2005

    2004

 

Investment income:

                

Interest income from portfolio securities

   $ 315,825     $ 696,253  

Dividend income from portfolio securities

     156,316       3,572,000  

Interest from temporary cash investments

     89,647       262  

Other income

     3,334       —    
    


 


Total investment income

     565,122       4,268,515  
    


 


Expenses:

                

Management fee

     377,873       348,588  

Director fees and expenses

     104,829       67,657  

Professional fees

     121,172       60,899  

Administrative fees

     12,500       12,500  

Mailing, printing and other expenses

     19,498       21,377  

Interest expense

     38,492       251,356  

Compensation expense (benefit)

     269,501       (300,480 )

Franchise taxes

     46,825       4,200  
    


 


Total expenses

     990,690       466,097  
    


 


Net investment income (loss)

     (425,568 )     3,802,418  
    


 


Realized gain (loss) on dispositions of portfolio securities, net

     2,267,054       (6,119,908 )
    


 


Unrealized appreciation (depreciation) of portfolio securities, net:

                

End of period

     477,614       (6,778,991 )

Beginning of period

     (4,573,310 )     (7,576,155 )
    


 


Increase (decrease) in unrealized appreciation of portfolio securities, net

     5,050,924       797,164  
    


 


Total increase (decrease) in net assets from operations

   $ 6,892,410     $ (1,520,326 )
    


 


Increase (decrease) in net assets from operations per share:

                

Basic

   $ 1.06     $ (0.23 )
    


 


Diluted

   $ 1.05     $ (0.23 )
    


 


Weighted average shares outstanding, in thousands

                

Basic

     6,507       6,615  
    


 


Diluted

     6,542       6,615  
    


 


 

The accompanying notes are an integral part of these financial statements.

 

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EQUUS II INCORPORATED

STATEMENTS OF CHANGES IN NET ASSETS

FOR THE THREE MONTHS ENDED MARCH 31, 2005 AND 2004

(Unaudited)

 

     2005

    2004

 

Operations:

                

Net investment income

   $ (425,568 )   $ 3,802,418  

Realized gain (loss) on dispositions of portfolio securities, net

     2,267,054       (6,119,908 )

Increase in unrealized appreciation of portfolio securities, net

     5,050,924       797,164  
    


 


Increase (decrease) in net assets from operations

     6,892,410       (1,520,326 )
    


 


Capital transactions:

                

Non-cash compensation expense (benefit)

     —         (300,480 )

Increase from officer notes settlement

     23,475       —    

Shares issued in dividend

     (216 )     —    
    


 


Increase (decrease) in net assets from capital share transactions

     23,259       (300,480 )
    


 


Increase (decrease) in net assets

     6,915,669       (1,820,806 )

Net assets, at beginning of period

     68,599,657       71,538,554  
    


 


Net assets, at end of period

   $ 75,515,326     $ 69,717,748  
    


 


 

The accompanying notes are an integral part of these financial statements.

 

3


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EQUUS II INCORPORATED

STATEMENTS OF CASH FLOWS

FOR THE THREE MONTHS ENDED MARCH 31, 2005 AND 2004

(Unaudited)

 

     2005

    2004

 

Cash flows from operating activities:

                

Interest and dividends received

   $ 202,689     $ 3,711,319  

Cash paid to management company, directors, bank and suppliers

     (539,638 )     (867,849 )

Purchase of portfolio securities

     —         (446,800 )

Proceeds from dispositions of portfolio securities

     2,495,113       266,018  

Principal payments from portfolio securities

     18,163       135,000  

Sales (purchases) of restricted temporary cash investments

     (995,343 )     2,045,807  
    


 


Net cash provided by operating activities

     1,180,984       4,843,495  
    


 


Cash flows from financing activities:

                

Advances from bank

     —         3,034,044  

Repayments to bank

     —         (3,925,000 )

Borrowings under margin account

     24,963,938       49,998,800  

Repayments under margin account

     (23,978,450 )     (51,984,089 )

Dividends paid

     (1,589,376 )     (2,287,194 )

Payments received on officer notes

     23,475       —    
    


 


Net cash used by financing activities

     (580,413 )     (5,163,439 )
    


 


Net increase (decrease) in cash and cash equivalents

     600,571       (319,944 )

Cash and cash equivalents at beginning of period

     18,576,048       386,879  
    


 


Cash and cash equivalents at end of period

   $ 19,176,619     $ 66,935  
    


 


 

The accompanying notes are an integral part of these financial statements.

 

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EQUUS II INCORPORATED

STATEMENTS OF CASH FLOWS

FOR THE THREE MONTHS ENDED MARCH 31, 2005 AND 2004

(Unaudited)

(Continued)

 

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

                

Increase (decrease) in net assets from operations

   $ 6,892,410     $ (1,520,326 )

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

                

Realized (gain) loss on dispositions of portfolio securities, net

     (2,267,054 )     6,119,908  

Decrease (increase) in unrealized appreciation, net

     (5,050,924 )     (797,164 )

Decrease (increase) in accrued interest receivable

     161,622       597,240  

Decrease (increase) in accounts receivable

     17,891       (8 )

Accrued interest or dividends exchanged for portfolio securities

     (541,946 )     (1,154,428 )

Non-cash compensation expense (benefit)

     269,501       (300,480 )

Increase (decrease) in accounts payable and accrued liabilities

     146,676       (92,168 )

Increase (decrease) in due to management company

     34,875       (9,104 )

Purchase of portfolio securities

     —         (446,800 )

Proceeds from dispositions of portfolio securities

     2,495,113       266,018  

Principal payments from portfolio securities

     18,163       135,000  

Sales (purchases) of restricted temporary cash investments

     (995,343 )     2,045,807  
    


 


Net cash provided by operating activities

   $ 1,180,984     $ 4,843,495  
    


 


 

The accompanying notes are an integral part of these financial statements.

 

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Table of Contents

EQUUS II INCORPORATED

SUPPLEMENTAL INFORMATION – SELECTED PER SHARE DATA AND RATIOS

FOR THE THREE MONTHS ENDED MARCH 31, 2005 AND 2004

(Unaudited)

 

     2005

    2004

 

Selected per share data:

                

Investment income

   $ 0.09     $ 0.65  

Expenses

     0.15       0.07  
    


 


Net investment income (loss) (1)

     (0.06 )     0.58  

Realized gain (loss) on dispositions of portfolio securities, net

     0.35       (0.93 )

Increase in unrealized appreciation of portfolio securities, net

     0.78       0.12  
    


 


Increase (decrease) in net assets from operations

     1.07       (0.23 )
    


 


Capital transactions:

                

Non-cash compensation expense

     —         (0.04 )
    


 


Net decrease in assets from capital transactions

     —         (0.04 )
    


 


Net increase (decrease) in net assets

     1.07       (0.27 )

Net asset value at beginning of period

     10.54       10.81  
    


 


Net asset value at end of period

   $ 11.61     $ 10.54  
    


 


Weighted average number of shares outstanding during period, in thousands

     6,507       6,615  
    


 


Market value per share at end of period

   $ 8.09     $ 7.79  
    


 


Selected ratios:

                

Ratio of total expenses to average net assets

     1.37 %     0.66 %

Ratio of net investment income (loss) to average net assets

     (0.59 )%     5.38 %

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

     9.57 %     (2.15 )%

Total shareholder return

     4.93 %     (3.23 )%

(1) Net investment income (loss) is calculated as the net investment income (loss) divided by the weighted average number of shares outstanding during the period.

 

The accompanying notes are an integral part of these financial statements.

 

6


Table of Contents

EQUUS II INCORPORATED

SCHEDULE OF PORTFOLIO SECURITIES

MARCH 31, 2005

(Unaudited)

 

Portfolio Company


  

Date of

Initial Investment


   Cost

   Fair Value

Alenco Window Holdings, LLC

   February 2001              

Holds cash and escrowed receivables

                  

- 32.25% membership interest

        $ —      $ 450,000

The Bradshaw Group

   May 2000              

Sells and services mid-range and high-speed printing equipment

                  

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

          —        250,000

- 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      22,000,000

- Warrant to purchase 10,000 shares of common stock for $12.50 per share through June 2009

          —        32,000

ConGlobal Industries, Inc. (Formerly Container Acquisition, Inc.)

   February 1997              

Shipping container repair & storage

                  

- 24,397,303 shares of common stock

          1,370,495      —  

- Member interest in CCI-ANI, LLC

          1,926,942      570,000

- Promissory note (3)

          2,758,861      680,000

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, 2005

(Unaudited)

(Continued)

 

Portfolio Company


  

Date of

Initial Investment


   Cost

   Fair Value

Doane PetCare Enterprises, Inc.

   October 1995              

Manufacturer of private label pet food

                  

- 1,943,598 shares of common stock

        $ 3,936,643    $ —  

The Drilltec Corporation

   August 1998              

Provides protection & packaging for pipe & tubing

                  

- Prime + 9.75% promissory note (2)

          1,000,000      —  

ENGlobal Corporation (AMEX: ENG)

   December 2001              

Engineering and consulting services

                  

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

          —        —  

Equicom, Inc.

   July 1997              

Radio stations

                  

- 452,000 shares of common stock

          141,250      —  

- 657,611 shares of preferred stock

          6,576,110      —  

- 10% subordinated promissory note

          4,614,824      1,994,201

- 10% senior subordinated promissory note (1)(3)

          927,612      927,612

- 8.81% promissory note (1)

          1,013,187      1,013,187

PalletOne, Inc.

   October 2001              

Wooden pallet manufacturer

                  

- 4,192,650 shares of preferred stock (1)

          4,192,650      4,192,650

- 350,000 shares of common stock

          350,000      650,000

Sovereign Business Forms, Inc.

   August 1996              

Business forms manufacturer

                  

- 22,858 shares of preferred stock (1)(3)

          2,337,300      1,889,455

- 15% promissory notes (1)(3)

          4,860,545      4,860,544

- 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

          —        —  

 

The accompanying notes are an integral part of these financial statements.

 

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Table of Contents

EQUUS II INCORPORATED

SCHEDULE OF PORTFOLIO SECURITIES

MARCH 31, 2005

(Unaudited)

(Continued)

 

Portfolio Company


  

Date of

Initial Investment


  

Cost


  

Fair Value


        

Spectrum Management, LLC

   December 1999              

Business & personal property protection

                  

-  285,000 units of Class A equity interest

        $ 2,850,000    $ 7,000,000

-  16% subordinated promissory note (1)

          1,303,698      1,303,698

-  12.75% subordinated promissory note (1)

          223,657      223,657

Sternhill Partners I, L.P.

   March 2000              

Venture capital fund

                  

-  3% limited partnership interest

          2,431,604      740,000

Turf Grass Holdings, Inc.

   May 1999              

Grows, sells & installs warm season turfgrasses

                  

-  1,000 shares of common stock

          959,632      —  

Jones Industrial Holdings, Inc.

   July 1998              

Field service for petrochemical & power generation industries

                  

-  35,000 preferred stock

          3,500,000      3,700,000

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

          100      —  

Vanguard Ventures VII, L.P.

   June 2000              

Venture capital fund

                  

-  1.3% limited partnership interest

          2,047,934      1,050,000
         

  

Total

        $ 53,114,390    $ 53,592,004
         

  


(1) Income-producing. All other securities are considered non-income producing.
(2) As of March 31, 2005, the Fund 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.

 

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EQUUS II INCORPORATED

SCHEDULE OF PORTFOLIO SECURITIES

MARCH 31, 2005

(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 Champion Window Holdings, Inc., The Drilltec Corporation, Jones Industrial Services, Inc. and Sovereign Business Forms, 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, 2005, the Fund was considered to have a controlling interest in Champion Window Holdings, Inc., ConGlobal Industries, Inc., The Drilltec Corporation, Equicom, Inc. (“Equicom”), PalletOne, Inc., Sovereign Business Forms, Inc., and Spectrum Management LLC.

 

Income was earned in the amount of $472,141 and $4,213,288 for the three months ended March 31, 2005 and 2004, respectively, on portfolio securities of companies in which the Fund has a controlling interest. Income was earned in the amount of $0 and $54,965 for the three months ended March 31, 2005 and 2004, 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”), ENGlobal Corporation, Sternhill Partners I, L.P., and Vanguard VII, L.P. The Fund provides significant managerial assistance to portfolio companies that comprise 97% of the total value of the investments in portfolio companies at March 31, 2005.

 

The accompanying notes are an integral part of these financial statements.

 

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EQUUS II INCORPORATED

SCHEDULE OF PORTFOLIO SECURITIES

MARCH 31, 2005

(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, 2005:

 

Type of Securities


   Cost

   Fair Value

   Fair Value as
Percentage
of Net Assets


 

Common stock

   $ 8,229,820    $ 22,650,000    30.0 %

Secured and subordinated debt

     17,161,929      11,252,899    14.9 %

Preferred stock

     17,941,060      9,782,105    13.0 %

Limited liability company investments

     5,301,942      8,085,000    10.7 %

Limited partnership investments

     4,479,538      1,790,000    2.4 %

Options and warrants

     101      32,000    0.0 %
    

  

  

Total

   $ 53,114,390    $ 53,592,004    71.0 %
    

  

  

 

The following is a summary by industry of the Fund’s investments as of March 31, 2005:

 

Industry


  

Fair Value


  

Fair Value as

Percentage

of Net Assets


 

Business Products and Services

   $ 15,527,354    20.6 %

Industrial Products and Services

     3,700,000    4.9 %

Media

     3,935,000    5.2 %

Residential Building Products

     22,482,000    29.8 %

Shipping Products and Services

     6,092,650    8.1 %

Venture Funds and Other

     1,855,000    2.4 %
    

  

Total

   $ 53,592,004    71.0 %
    

  

 

The accompanying notes are an integral part of these financial statements.

 

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EQUUS II INCORPORATED

NOTES TO FINANCIAL STATEMENTS

MARCH 31, 2005 AND 2004

(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” or “ECMC”).

 

Pursuant to the rules and regulations of the Securities and Exchange Commission (“SEC”), certain information and footnote disclosures normally included in the annual financial statements prepared in accordance with accounting principles generally accepted in the United States of America 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, 2004 filed with the SEC 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 – At March 31, 2005, we had cash and unrestricted temporary investments of approximately $19.2 million. We had $53,592,004 of our total assets of $101,385,295 invested in portfolio securities of sixteen entities, including twelve portfolio companies, two venture capital funds, and two entities which have disposed of substantially all of their assets and are awaiting liquidation. $24,963,938 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 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 4, 2005.

 

We had a $10,000,000 revolving line of credit with Bank of America, N.A. that expired on January 31, 2004. The line of credit was extended through March 15, 2004 at the reduced maximum borrowing amount of $6,600,000. We used our revolving line of credit to pay operating expenses and for new and follow-on investments in portfolio securities.

 

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Effective March 15, 2004, we entered into a new $6,500,000 revolving line of credit loan with The Frost National Bank, which extended through March 31, 2005. The proceeds of the new loan were utilized to pay off the previous line of credit. In March 2005, we extended our revolving line of credit with The Frost National Bank through April 2006. We paid a commitment fee of $25,000 to extend the line of credit, and reduced the amount that may be borrowed to $5,000,000. There is no outstanding balance as of March 31, 2005, under the new line of credit, and the availability of such line is approximately $5 million.

 

The new loan is collateralized by our investments in portfolio securities. The provisions of the new revolver include a borrowing base that cannot exceed the lesser of 10% of the total value of eligible portfolio securities or $5,000,000. 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. We paid a commitment fee of $65,000 at the closing of the loan in March 2004 and a $25,000 fee in March 2005 to extend the loan through April 2006. Management believes that cash on hand and the new line of credit will provide us with sufficient liquidity to meet our known obligations, including expected follow-on investments, during 2005.

 

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. As of March 31, 2005, we have committed to invest up to an additional $997,500 in the two venture capital funds in our portfolio.

 

At March 31, 2005 and 2004, the Fund was being charged interest at a rate of 6.25% and 4.5%, 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, 2005, and 2004 was $0 and $5,090,520, respectively. During the three months ended March 31, 2005 and 2004, the amount of interest and loan fees paid in cash was $39,115 and $241,512, 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, 2005 and 2004, the Fund borrowed $24,963,938 and $49,998,800, respectively. The Fund collateralized such borrowings with restricted cash and temporary investments of $25,213,577 and $50,649,357 at March 31, 2005 and 2004, respectively. The temporary investments were sold, and the total amounts borrowed were repaid on April 4, 2005 and April 1, 2004. 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

 

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portfolio securities are performed in accordance with accounting principles generally accepted in the United States of America 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.

 

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.

 

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Certain of the promissory notes provide that interest may be paid in kind or that the original issue discount may be accreted over the life of the notes, by adding such amounts to the principal of the notes.

 

Because of the inherent uncertainty of the valuation of portfolio securities which do not have readily ascertainable market values, amounting to $53,592,004 (including no publicly-traded securities) and $48,621,356 (including $2,778,878 in publicly-traded securities, net of a $424,836 valuation discount) at March 31, 2005 and December 31, 2004, 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.

 

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.

 

Escrowed Receivables – In April and May of 2004, we sold our investments in Strategic Holdings, Inc. and Alenco Holding Corporation. A portion of the proceeds from each sale was placed in a cash escrow account to secure the representations and warranties we made to the respective purchasers. We could receive up to an aggregate of $3,371,000 in 2005, 2006 and 2007 from such escrow accounts if no claims are made. At March 31, 2005, we have valued the amounts receivable from the escrows at $3,036,000, because of the uncertainty of collection. We are not aware of any claims against the escrow that have been made as of March 31, 2005.

 

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.

 

 

 

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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, 2005 and 2004, respectively, would have been:

 

     2005

    2004

 

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

   $ 6,892,411     $ (1,520,326 )

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

     269,501       (300,480 )

Stock-based employee compensation expense determined using fair value method

     (23,068 )     (8,543 )
    


 


Pro forma increase (decrease) in net assets from operations

   $ 7,138,844     $ (1,829,349 )
    


 


Net increase (decrease) in net assets from operations per share

                

Basic, as reported

   $ 1.06     $ (0.23 )
    


 


Basic, pro-forma

   $ 1.10     $ (0.28 )
    


 


Diluted, as reported

   $ 1.05     $ (0.23 )
    


 


Diluted, pro-forma

   $ 1.09     $ (0.28 )
    


 


 

In December 2004, the Financial Accounting Standards Board (“FASB”) approved the revision of SFAS 123, Accounting for Stock-Based Compensation, and issued the revised SFAS Statement No. 123R, “Share-Based Payment.” SFAS 123R effectively replaces SFAS 123, and supersedes APB Opinion No. 25, “Accounting for Stock Issued to Employees.” The new standard is effective for awards that are granted, modified or settled in cash for interim or annual periods beginning after January 1, 2006. The adoption of SFAS 123R will require the Fund to begin expensing unvested or newly granted stock options as compensation cost.

 

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

 

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of the three months ended March 31, 2005 and 2004. 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 Board of Directors attended in person, a fee of $1,000 for participation in each telephonic meeting of the Board of Directors and a fee of $1,000 for each committee meeting attended, 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 May 9, 2006, 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 of ordinary income for 2004 under income tax regulations. For the year ended December 31, 2004, the Fund had net investment income for book purposes of $3.7 million and $3.5 million for tax purposes. During 2004, the Fund had a net capital loss for book purposes of $5.5 million and a net capital loss for tax purposes of $7.8 million. As of December 31, 2004, the Fund has a capital loss carryforward of $16.0 million, which may be used to offset future taxable capital gains. If not utilized, some of the loss will expire beginning in 2009.

 

(6) Dividends

 

The Fund declared no dividends during the three months ended March 31, 2005 and 2004. On January 16, 2005, the Fund paid $1,589,377 in cash for a dividend that had been declared in 2004 and 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, 2005, the Fund made follow-on investments of $541,946 in four companies, all in the form of interest or dividends paid in kind or original issue discount amortization. In addition, the Fund realized a net capital gain of $2,267,054 during the three months ended March 31, 2005.

 

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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.

 

(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 959,000 and 1,033,800 shares of the Fund’s common stock with a weighted average exercise price of $8.53 and $8.47 per share were outstanding at March 31, 2005 and 2004, respectively. Of these options, 779,527 and 829,338 shares, with a weighted average exercise price per share of $8.72 and $8.65 were exercisable at March 31, 2005 and 2004, respectively. Of the outstanding options at March 31, 2005, 901,800 have exercise prices ranging from $7.43 to $9.03 and the remaining options have exercise prices ranging from $14.14 to $24.95. These options expire in November 2007 through January 2015.

 

On May 7, 2004, options to acquire a total of 15,400 shares at $7.72 per share were issued to the non-officer directors. On January 4, 2005 options to purchase 150,000 shares at $7.69 per share were issued to two of the Fund’s officers. On December 24, 2003, options to purchase 40,000 shares at $7.85 per share were issued to a new officer of the Fund. 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. Because of these rights, the options are accounted for using variable plan accounting. Variable plan accounting resulted in non-cash compensation expense (benefit) of $269,501 during the three months ended March 31, 2005. The fund added $269,501 to its accrued liability related to the non-cash compensation, equivalent to the value of the options at March 31, 2005.

 

On September 30, 1999, options to purchase 719,794 shares of common stock of the Fund were exercised by six officers of the Fund for $15.45 per share. Pursuant to the terms of the options, the Stock Incentive Plan, and the Investment Company Act, the Fund loaned the officers the exercise price of $11,124,086 and the officers issued promissory notes, which were secured by the 719,794 shares, to the Fund. In 2001, the Fund agreed to cancel the remaining principal balance and accrued interest on the promissory notes aggregating $11,040,849 in consideration of the officers surrendering to the Fund 844,133 shares of common stock (the shares originally issued and certain shares received as dividends). Pursuant to the terms of the notes, the cancellation of the principal and accrued interest on the notes was based on the net asset value of the shares at date of surrender. The officers retained 71,235 shares of common stock following the cancellation of the notes. These transactions were recorded as decreases in common stock and additional paid in capital. There was no change in total net assets as a result of the note repayment and surrendering of the shares.

 

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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. 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. 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. Based on the ongoing discussion with the SEC, the Fund has not credited any dividends to the outstanding options or recorded any associated compensation expense for the 2004 or 2003 dividends applicable to dividend equivalent rights. If the dividend equivalent rights had been in effect, additional non-cash compensation expense of approximately $387,000 and $650,000 with a credit to accrued compensation, would have been recognized under variable plan accounting in the fourth quarter of 2004 and 2003, respectively.

 

During its review of the exemptive application filed by the Fund in connection with the granting of the dividend equivalent rights as part of the Stock Incentive Plan, the SEC staff raised certain issues with respect to the valuation of the shares held as collateral and the manner in which the notes were settled in 2001. In November 2003, the Fund’s board of directors appointed a special committee of independent directors to address the SEC staff’s issues and retained independent legal counsel with respect to the issues raised by the SEC. The Fund responded to the staff’s questions and supplied additional information, and the special committee and counsel met personally with the SEC staff.

 

In September 2004, the independent directors of the Fund unanimously approved a proposal to resolve the issues surrounding the loan transactions by unwinding the loan transactions and attempting to place the Fund in the position it would have been in had the loan transactions never taken place. In exchange for repayment of the balance of benefits received as a result of the loan transactions, the Fund agreed to formally release each of the Fund’s officers and former officers from any and all claims that the Fund might have with respect to the loan transactions. In connection with the resolution of this matter, the Fund issued a release to one additional former officer in consideration of his payment to the Fund of $23,475 in March 2005.

 

Options to purchase 12,500 shares were exercised by one officer of the Fund during 2004 and the Fund received $96,125 in cash from the exercise of such options.

 

If all outstanding options for which the market price exceeds the exercise price at March 31, 2005 and December 31, 2004, had been exercised, the fund’s net asset value would have been reduced by $0.06 and $0.02 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 February 18, 2005, Champion Window Holdings, Inc. retained an investment banker to explore strategic alternatives for maximizing shareholder value. The company has received several indications of interest from potential acquirers. The Fund has also received an indication of interest from a potential acquirer of Spectrum Management, LLC.

 

On April 4, 2005, the Fund sold U.S. Treasury bills for $25,000,000 and repaid our margin loan.

 

On April 5, 2005, the Fund received a cash dividend payment from PalletOne, Inc. for $104,816. This amount was included in dividends receivable at March 31, 2005.

 

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On April 12, 2005, the Fund received a cash payment of $898,667 from the Strategic Holdings, Inc. escrow account to be applied against the escrow receivable.

 

In January 2005, Equus Corporation International (“ECI”), the majority owner of Equus Capital Management Corporation, the investment adviser to the Fund, and Moore, Clayton & Co., Inc. (“Moore, Clayton”) entered into an agreement for Moore, Clayton to acquire ECI’s ownership interest in ECMC. As part of the overall transaction a proposal was also made for the Fund to enter into a new management agreement with Moore, Clayton Capital Advisors, Inc. (“MCCA”), a newly formed subsidiary of Moore, Clayton, and a new administration agreement with Equus Capital Administration Company, Inc., also a newly formed subsidiary of Moore, Clayton. Since under the Investment Company Act the change in ownership of ECMC would result in the automatic termination of the Fund’s current management agreement, the Fund’s Board of Directors appointed a special committee (the “Special Committee”) to review strategic alternatives for the Fund. The Special Committee and the Board considered a number of alternatives, including (1) entering into the proposed management agreement with MCCA; (2) retaining an investment adviser other than MCCA; (3) merging the Fund with another business development company; and (4) liquidating the Fund. On April 6, 2005, the Fund’s Board, including a majority of the independent directors, reviewed and approved the proposed management agreement with MCCA and voted to recommend the proposed management agreement to the Fund’s stockholders for their approval at the 2005 annual meeting of stockholders. One director abstained from such vote.

 

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 sixteen entities, including twelve portfolio companies, two venture capital funds and two entities which have disposed of substantially all of their assets and are awaiting liquidation at March 31, 2005. We had investments in sixteen portfolio companies and two venture capital funds at March 31, 2004. We did not make any new investments during the three months ended March 31, 2005 or 2004.

 

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 borrowings. We also spend our cash on

 

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new investments, or follow-on investments which may be required by certain portfolio companies. Prior to 2004, our cash flow from interest and dividends was not sufficient to cover our expenses and follow-on investments. Because our investments are illiquid, we utilized leverage to provide the required funds, and the leverage was then repaid from the sale of portfolio securities. In April and May of 2004, we sold securities of two portfolio companies and paid off our loans. We have maintained substantial amounts of cash and cash equivalents since May 2004.

 

We have distributed to our stockholders any net taxable investment income or realized capital gains on an annual basis. We declared a net investment income dividend of $0.57 per share in 2004, all of which was qualifying dividend income.

 

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 continue to 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

 

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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.

 

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 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 our financial statements. As of December 31, 2004, the Fund had a capital loss carryforward of approximately $16,000,000, which may be used to offset future taxable capital gains. We borrow money from time to time to maintain our tax status under the Internal Revenue Code as a regulated investment company (“RIC”).

 

Liquidity and Capital Resources

 

At March 31, 2005, we had cash and unrestricted temporary investments of approximately $19.2 million. We had $53,592,004 of our total assets of $101,385,295 invested in portfolio securities of sixteen entities, including twelve portfolio companies, two venture capital funds, and two entities which have disposed of substantially all of their assets and are awaiting liquidation. $24,963,938 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 4, 2005.

 

Effective March 15, 2004, we entered into a new $6,500,000 revolving line of credit loan with The Frost National Bank, which extended through March 31, 2005. The proceeds of the new loan were utilized to pay off the previous line of credit. In March 2005, the Fund extended our revolving line of credit with The Frost National Bank through April 2006. We paid a commitment fee of $25,000 to

 

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extend the line of credit, and reduced the amount that may be borrowed to $5,000,000. There is no outstanding balance as of March 31, 2005, under the new line of credit, and the availability of such line is approximately $5 million.

 

The new loan is collateralized by our investments in portfolio securities. The provisions of the new revolver include a borrowing base that cannot exceed the lesser of 10% of the total value of eligible portfolio securities or $5,000,000. 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. We paid a commitment fee of $65,000 at the closing of the loan in March 2004 and a $25,000 fee in March 2005 to extend the loan through April 2006. Management believes that cash on hand and the new line of credit will provide us with sufficient liquidity to meet our known obligations, including expected follow-on investments, during 2005.

 

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 net investment income dividend of $0.57 per share for 2004, or $3,560,205. We paid $1,589,376 in cash and issued 260,719 additional shares of common stock at $7.56 per share on January 16, 2005.

 

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. As of March 31, 2005, we have committed to invest up to an additional $997,500 in the two venture capital funds in our portfolio.

 

Net cash provided by operating activities was $1,180,984 and $4,843,495 for the three months ended March 31, 2005 and 2004, respectively. Approximately $11.2 million in estimated value of our investments are in the form of notes receivable from portfolio companies. However, only three of the portfolio companies are currently paying cash interest to us in accordance with their respective notes receivable, which aggregate $2,821,673 in fair value. Certain of the promissory notes provide that interest may be paid in kind or that the original issue discount may be accreted over the life of the notes, by adding such amounts 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, 2005 and 2004, 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.

 

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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.

 

Results of Operations

 

Investment Income and Expense

 

Net investment (loss) income after all expenses amounted to ($425,568) and $3,802,418 for the three months ended March 31, 2005 and 2004, respectively. Income from portfolio securities was $472,141 for the three months ended March 31, 2005 and $4,268,253 for the comparable period in 2004. The decrease from 2004 to 2005 is due to a cash dividend of $3,525,000 received in 2004 from Champion Window Holdings, Inc. Director fees and expenses increased to $104,829 at March 31, 2005 from $67,657 in 2004. Professional fees increased to $121,172 at March 31, 2005, from $60,899 in 2004.

 

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 $377,873 and $348,588 during the three months ended March 31, 2005 and 2004, respectively. The increase in management fees during the three months ended March 31, 2005, was due to an increase in net assets between the two periods which was primarily from the $5.9 million valuation increase at Champion Window Holdings, Inc.

 

Director fees and expenses increased by $37,172 at March 31, 2005, from the same period in 2004 due primarily to eight Special Committee meetings in 2005 and three full board meetings for 2005 compared to one full board meeting in 2004.

 

Professional Fees increased by $60,273 for the three months ended March 31, 2005 over the comparable period in 2004. These increases are primarily due to legal fees incurred in connection with the SEC matter, annual report, proxy and the consideration of strategic alternatives for the benefit of the Fund’s shareholders.

 

Interest expense decreased to $38,492 in 2005 from $251,356 in 2004 due to the fact that fees paid to extend the line of credit at Bank of America, NA were higher than fees related to acquiring and extending the new line of credit with Frost National Bank. Also, the average balance of borrowings was lower in 2005.

 

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 $269,501 and $(300,480) during the quarters ended March 31, 2005 and March 31, 2004, respectively. The large change is due to the fluctuation in the Fund’s closing stock market price from the beginning of the quarter to the price at the end of the quarter in relation to the exercise price of the stock options (the majority of the options have an exercise price of $7.69). In 2005, the market price increased from a January 1, 2005 market price of $7.71 to an ending market price at March 31, 2005 of $8.09. In 2004, the market price decreased from a market price at January 1, 2004 of $8.05 to an ending market price at March 31, 2004 of $7.79.

 

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Realized Gains and Losses on Sales of Portfolio Securities

 

During the three months ended March 31, 2005, we realized net capital gains of $2,267,054 from the disposition of securities in one portfolio company and a reduction in the discounts on the escrow receivable related to the sales of two former portfolio companies. We sold 1,033,457 shares of ENGlobal Corporation (“ENG”) common stock, realizing a capital gain of $1,890,142. We increased the value of the escrow account of Strategic Holdings, Inc. for a capital gain of $331,000 and increased the value of the escrow account of Alenco Holding Corp. for a capital gain of $45,000. In addition, we realized a short-term capital gain of $912 on our U.S. Treasury bills.

 

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 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 on our U.S. Treasury bills.

 

Changes in Unrealized Appreciation/Depreciation of Portfolio Securities

 

Net unrealized appreciation on investments increased by $5,050,924 during the three months ended March 31, 2005, from a net unrealized depreciation of ($4,573,310) to a net unrealized appreciation of $477,614. The increase in appreciation resulted from increases in the estimated fair values of six of our portfolio companies aggregating $8,432,000, of which Champion Window Holdings, Inc. accounted for $6,632,000. The Fund had decreases in the estimated fair values of six of our portfolio companies aggregating ($1,490,934), with Sovereign Business Forms, Inc. accounting for ($747,845). The Fund also transferred ($1,890,142) in unrealized appreciation to realized capital gains from the sale of all its common stock of ENG.

 

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.

 

Dividends

 

We declared no dividends for the three months ended March 31, 2005 and 2004. On January 16, 2005 we paid cash dividends of $1,589,376 for dividends declared in 2004. 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, 2005, we made follow-on investments of $541,946 in four portfolio companies, all of which were in the form of accrued interest, dividends, and original issue discount received in the form of additional portfolio securities.

 

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For the quarter ended March 31, 2005, we received an additional 515 shares of preferred stock of Sovereign Business Forms, Inc. (“Sovereign”) in dividends. In addition, Sovereign elected to convert $196,565 of accrued interest into the balance of the 15% promissory notes due to us.

 

For the quarter ended March 31, 2005 Spectrum Management, LLC elected to convert $223,657 of accrued interest into a new 12.75% promissory note with interest and principal due at maturity on January 31, 2006.

 

During the quarter ended March 31, 2005, all 1,033,457 shares of ENG common stock were sold, realizing a capital gain of $1,890,142.

 

During the quarter ended March 31,2005, Equicom, Inc. made three principal payments on its 8.81% promissory note of $18,163, reducing the note balance to $1,013,187. Equicom also elected to convert $22,502 of accrued interest into the balance of the 10% promissory note due to us.

 

For the quarter ended March 31, 2005, we recorded $47,722 as amortization of original issue discount on our non-interest bearing note receivable from ConGlobal Industries, Inc.

 

Subsequent Events

 

On February 18, 2005, Champion Window Holdings, Inc. retained an investment banker to explore strategic alternatives for maximizing shareholder value. The company has received several indications of interest from potential acquirers. The Fund has also received an indication of interest from a potential acquirer of Spectrum Management, LLC.

 

On April 4, 2005, the Fund sold U.S. Treasury bills for $25,000,000 and repaid our margin loan.

 

On April 5, 2005, the Fund received a cash dividend payment from PalletOne, Inc. for $104,816. This amount was included in dividends receivable at March 31, 2005.

 

On April 12, 2005, the Fund received a cash payment of $898,667 from the Strategic Holdings, Inc. escrow account to be applied against the escrow receivable.

 

In January 2005, Equus Corporation International (“ECI”), the majority owner of Equus Capital Management Corporation, the investment adviser to the Fund, and Moore, Clayton & Co., Inc. (“Moore, Clayton”) entered into an agreement for Moore, Clayton to acquire ECI’s ownership interest in ECMC. As part of the overall transaction a proposal was also made for the Fund to enter into a new management agreement with Moore, Clayton Capital Advisors, Inc. (“MCCA”), a newly formed subsidiary of Moore, Clayton, and a new administration agreement with Equus Capital Administration Company, Inc., also a newly formed subsidiary of Moore, Clayton. Since under the Investment Company Act the change in ownership of ECMC would result in the automatic termination of the Fund’s current management agreement, the Fund’s Board of Directors appointed a special committee (the “Special Committee”) to review strategic alternatives for the Fund. The Special Committee and the Board considered a number of alternatives, including (1) entering into the proposed management agreement with MCCA; (2) retaining an investment adviser other than MCCA; (3) merging the Fund with another business development company; and (4) liquidating the Fund. On April 6, 2005, the Fund’s Board, including a majority of the independent directors, reviewed and approved the proposed management agreement with MCCA and voted to recommend the proposed management agreement to the Fund’s stockholders for their approval at the 2005 annual meeting of stockholders. One director abstained from such vote.

 

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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, 2005 and 2004, respectively, of approximately $0 and $6,590,520, a change of one percent in the interest rate would have caused a change in interest expense of approximately $0 and $65,905. This change would have resulted in a change of $0.00 and $0.01 in the net asset value per share at March 31, 2005 and 2004, 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. In March 2005, the Fund extended our revolving line of credit with The Frost National Bank through April 2006. 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.

 

The Fund is classified as a “non-diversified” investment company under the Investment Company Act, which means we are not limited in the proportion of our assets that may be invested in the securities of a single user. At March 31, 2005, we had investments in twelve portfolio companies, two venture capital funds and and two entities which have disposed of substantially all of their assets and are awaiting liquidation. The value of one of our investments, in a business which manufactures residential windows primarily for new construction, was 29% of our net asset value and 41% of our investments in portfolio company securities (at fair value) at March 31, 2005. Changes in business or industry trends or in the financial condition, results of operations, or the market’s assessment of any single portfolio company will affect our net asset value and the market price of our common stock to a greater extent than would be the case if we were a “diversified” company holding numerous investments.

 

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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, 2005. 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, 2005, that has materially affected, or is reasonably likely to materially affect, the Fund’s internal control over financial reporting.

 

Item 6. Exhibits.

 

  3. Articles of Incorporation and By-laws

 

  (a) Restated Certificate of Incorporation of the Fund dated March 4, 1992. [Incorporated by reference to Exhibit 3(a) to Registrant’s Annual Report on Form 10-K for the year ended December 31, 1991.]

 

  (b) Certificate of Merger dated June 30, 1993, between the Fund and Equus Investments Incorporated [Incorporated by reference to Exhibit 3(c) to Registrant’s Annual Report on Form 10-K for the year ended December 31, 1993.]

 

  (c) Amended and Restated Bylaws of the Fund. [Incorporated by reference to Exhibit 3(c) to Registrant’s Annual Report on Form 10-K for the year ended December 31, 1995.]

 

  10. Material contracts

 

  (a) Form of Management Agreement between the Fund and Equus Capital Management Corporation. [Incorporated by reference to Exhibit A to the Definitive Proxy Statement dated February 24, 1997.]

 

  (b) 1997 Stock Incentive Plan [Incorporated by reference to Exhibit B to the Registrant’s Definitive Proxy Statement dated February 24, 1997.]

 

  (c) Loan Agreement between Equus II Incorporated and The Frost National Bank dated March 15, 2004. [Incorporated by reference to Exhibit 10(n) to Registrant’s Annual Report on Form 10-K for the year ended December 31, 2003.]

 

  (d) Pledge and Security Agreement between Equus II Incorporated and The Frost National Bank dated March 15, 2004. [Incorporated by reference to Exhibit 10(o) to Registrant’s Annual Report on Form 10-K for the year ended December 31, 2003.]

 

  (e) Revolving Promissory Note between Equus II Incorporated and The Frost National Bank dated March 15, 2004. [Incorporated by reference to Exhibit 10(p) to Registrant’s Annual Report on Form 10-K for the year ended December 31, 2003.]

 

  (f) Second Modification Agreement dated as of March 31, 2005, between The Frost National Bank, a national banking association, and Equus II Incorporated.

 

  (g) Safekeeping Agreement between Equus II Incorporated and The Frost National Bank dated March 15, 2004. [Incorporated by reference to Exhibit (10)f) to the Registrant’s Annual Report of Form 10-K for the year ended December 31, 2004.]

 

  (h) Form of Indemnification Agreement between Equus II Incorporated and its directors and certain officers. [Incorporated by reference to Exhibit 10(g) to the Registrant’s Annual Report of Form 10-K for the year ended December 31, 2004.]

 

  (i) Form of Release Agreement between Equus II Incorporated and certain of its officers and former officers. [Incorporated by reference to Exhibit 10(h) to the Registrant’s Annual Report of Form 10-K for the year ended December 31, 2004.]

 

  (j) Joint Code of Ethics of Equus II Incorporated and Equus Capital Management Corporation (Rule 17j-1). [Incorporated by reference to Exhibit 10(i) to the Registrant’s Annual Report of Form 10-K for the year ended December 31, 2004.]

 

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  14. Code of Business Conduct and Ethics for Members of the Board of Directors, Officers, and Employees. [Incorporated by reference to Exhibit 14 to the Registrant’s Annual Report of Form 10-K for the year ended December 31, 2004.]

 

  31. Rule 13a-14(a)/15d-14(a) Certifications

 

  (a) Certification by Chairman and Chief Executive Officer

 

  (b) Certification by Chief Financial Officer

 

  32. Section 1350 Certification

 

  (a) Certification by Chairman and Chief Executive Officer

 

  (b) Certification by Chief Financial Officer

 

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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 16, 2005   EQUUS II INCORPORATED
   

/s/ Harry O. Nicodemus IV


    Harry O. Nicodemus IV
    Chief Financial Officer

 

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