Equus Total Return, Inc.: Form 10-Q/A for the period ended Sep 30, 2023

Equus Total Return, Inc. (“we,” “us,” “our,” “Equus,” and the “Fund”), a Delaware corporation, was formed on August 16, 1991. Our shares trade on the New York Stock Exchange under the symbol ‘EQS’. Our investment strategy seeks to provide the highest total return, consisting of capital appreciation and current income.

The information contained in this section should be read in conjunction with our financial statements and notes thereto appearing elsewhere in this Quarterly Report and in conjunction with the financial statements and notes thereto in the Fund’s Form 10-K for the year ended December 31, 2022, as filed with the SEC. In addition, some of the statements in this report constitute forward-looking statements. The matters discussed in this Quarterly Report, as well as in future oral and written statements by management of Equus, that are forward-looking statements are based on current management expectations that involve substantial risks and uncertainties which could cause actual results to differ materially from the results expressed in, or implied by, these forward-looking statements. Forward-looking statements relate to future events or our future financial performance. We generally identify forward-looking statements by terminology such as “may,” “will,” “should,” “expects,” “plans,” “anticipates,” “could,” “intends,” “target,” “projects,” “believes,” “estimates,” “predicts,” “potential” or “continue” or the negative of these terms or other similar words. Important assumptions include our ability to originate new investments, achieve certain margins and levels of profitability, and the availability of additional capital. In light of these and other uncertainties, the inclusion of a forward- looking statement in this Quarterly Report should not be regarded as a representation by us that our plans or objectives will be achieved. The forward- looking statements contained in this Quarterly Report include statements as to:

• our future operating results;
• our business prospects and the prospects of our existing and prospective portfolio companies;
• the return or impact of current and future investments;
• our contractual arrangements and other relationships with third parties;
• the dependence of our future success on the general economy and its impact on the industries in which we invest;
• the financial condition and ability of our existing and prospective portfolio companies to achieve their objectives;
• our expected financings and investments;
• our regulatory structure and tax treatment;
• our ability to qualify and operate as a BDC and a RIC, including the impact of changes in laws or regulations governing our operations, or the operations of our portfolio companies;
• the adequacy of our cash resources and working capital;
• the timing of cash flows, if any, from the operations of our portfolio companies;
• the impact of fluctuations in interest rates on our business;
• the valuation of our investments in portfolio companies, particularly those having no liquid trading market;
• our ability to recover unrealized losses;
• market conditions and our ability to access additional capital, if deemed necessary;
• changes in interest rates and overall investment activity;
• developments in the global economy and resulting demand and supply for oil and natural gas;
• natural or man-made disasters and other external events that may disrupt our operations; and
• continued volatility of oil and natural gas prices.

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There are a number of important risks and uncertainties that could cause our actual results to differ materially from those indicated by such forward-looking statements. For a discussion of factors that could cause our actual results to differ from forward-looking statements contained in this Quarterly Report, please see the discussion in Part II, “Item 1A. Risk Factors”, and in Part I, “Item 1A. Risk Factors” in our Annual Report on Form 10-K for the fiscal year ended December 31, 2022 (“10-K”). In particular, you should carefully consider the risks we have described in the 10-K and elsewhere in this Quarterly Report concerning our efforts to transform Equus into an operating company, as well as the coronavirus pandemic and the economic impact of the coronavirus on the Fund and our sole remaining portfolio company, as well as on oil and gas markets generally. You should not place undue reliance on these forward-looking statements. The forward- looking statements made in this Quarterly Report relate only to events as of the date on which the statements are made. We undertake no obligation to update any forward-looking statement to reflect events or circumstances occurring after the date this Quarterly Report is filed with the SEC.

We attempt to maximize the return to stockholders in the form of current investment income and long-term capital gains by investing in the debt and equity securities of companies with a total enterprise value of between $5.0 million and $75.0 million, although we may engage in transactions with smaller or larger investee companies from time to time. We seek to invest primarily in companies pursuing growth either through acquisition or organically, leveraged buyouts, management buyouts and recapitalizations of existing businesses or special situations. Our income-producing investments consist principally of debt securities including subordinate debt, debt convertible into common or preferred stock, or debt combined with warrants and common and preferred stock. Debt and preferred equity financing may also be used to create long- term capital appreciation through the exercise and sale of warrants received in connection with the financing. To the extent that we remain a BDC, we will seek to achieve capital appreciation by making investments in equity and equity-oriented securities issued by privately-owned companies (and smaller public companies) in transactions negotiated directly with such companies. Given market conditions over the past several years and the performance of our portfolio, our management and Board of Directors believe it is prudent to continue to review alternatives to refine and further clarify the current strategies.

We elected to be treated as a BDC under the 1940 Act. We currently qualify as a RIC for federal income tax purposes and, therefore, are not required to pay corporate income taxes on any income or gains that we distribute to our stockholders. We have a wholly-owned Taxable Subsidiary which holds one of our portfolio investments listed on our Schedules of Investments. The purpose of this Taxable Subsidiary is to permit us to hold certain income-producing investments or portfolio companies organized as limited liability companies, or LLCs, (or other forms of pass-through entities) and still satisfy the RIC tax requirement that at least 90% of our gross revenue for income tax purposes must consist of investment income. Absent the Taxable Subsidiary, a portion of the gross income of these income- producing investments or of any LLC (or other pass-through entity) portfolio investment, as the case may be, would flow through directly to us for the 90% test. To the extent that such income did not consist of investment income, it could jeopardize our ability to qualify as a RIC and, therefore, cause us to incur significant federal income taxes. The income of the LLCs (or other pass-through entities) owned by Taxable Subsidiary is taxed to the Taxable Subsidiary and does not flow through to us, thereby helping us preserve our RIC status and resultant tax advantages. We do not consolidate the Taxable Subsidiary for income tax purposes and they may generate income tax expense because of the Taxable Subsidiary’s ownership of the portfolio investment. We reflect any such income tax expense on our Statements of Operations.

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Conversion to an Operating Company

Authorization to Withdraw BDC Election. In 2022, holders of a majority of the outstanding common stock of the Fund approved our cessation as a BDC under the 1940 Act and authorized our Board to cause the Fund’s withdrawal of its election to be classified as a BDC, effective as of a date designated by the Board and our Chief Executive Officer. Although this authorization has since expired, we expect to receive a further authorization from our shareholders later in 2023 or 2024 as a consequence of our expressed intent to transform Equus into an operating company. Notwithstanding any such authorization to withdraw our BDC election, we will not submit any such withdrawal unless and until Equus has entered into a definitive agreement to effect a transformative transaction. Further, even if we are again authorized to withdraw our election as a BDC, we will require a subsequent affirmative vote from holders of a majority of our outstanding voting shares to enter into any such definitive agreement or change the nature of our business. While we are presently evaluating various opportunities that could enable us to accomplish this transformation, we cannot assure you that we will be able to do so within any particular time period or at all, and, although we expect that our shareholders will grant a further authorization, we do not expect to cause the Fund to withdraw its election to be classified as BDC prior to December 31, 2023. Moreover, we cannot assure you that the terms of any such transformative transaction would be acceptable to us.

Reduction in Asset Coverage Ratio

On November 14, 2019, our shareholders approved a reduction in our asset coverage ratio from 200% to 150%. Prior to the reduction, we were restricted in the amount that we could borrow to the value of our net assets. The reduction in our asset coverage from 200% to 150% means that we may now borrow up to twice the value of our net assets. Except for a margin loan that we have previously procured each quarter to acquire U.S. Treasury bills as part of the maintenance of our RIC status, we have not incurred any additional borrowings as a consequence of this authorization.

2016 Equity Incentive Plan

On June 13, 2016, our shareholders approved the adoption of our 2016 Equity Incentive Plan (“Incentive Plan”). On January 10, 2017, the SEC issued an order approving the Incentive Plan and certain awards intended to be made thereunder. The Incentive Plan is intended to promote the interests of the Fund by encouraging officers, employees, and directors of the Fund and its affiliates to acquire or increase their equity interest in the Fund and to provide a means whereby they may develop a proprietary interest in the development and financial success of the Fund, to encourage them to remain with and devote their best efforts to the business of the Fund, thereby advancing the interests of the Fund and its stockholders. The Incentive Plan is also intended to enhance the ability of the Fund and its affiliates to attract and retain the services of individuals who are essential for the growth and profitability of the Fund. The Incentive Plan permits the award of restricted stock as well as common stock purchase options. The maximum number of shares of common stock that are subject to awards granted under the Incentive Plan is 2,434,728 shares. The term of the Incentive Plan will expire on June 13, 2026. On March 17, 2017, we granted awards of restricted stock under the Plan to certain of our directors and executive officers in the aggregate amount of 844,500 shares. The awards were each subject to a vesting requirement over a 3-year period unless the recipient thereof was terminated or removed from their position as a director or executive officer without “cause”, or as a result of constructive termination, as such terms are defined in the respective award agreements entered into by each of the recipients and the Fund. As of March 31, 2020, all awards granted under the Incentive Plan were fully vested. We account for share-based compensation using the fair value method, as prescribed by ASC 718. Accordingly, for restricted stock awards, we measure the grant date fair value based upon the market price of our common stock on the date of the grant and amortize the fair value of the awards as share- based compensation expense over the requisite service period, which is generally the vesting term.

Critical Accounting Policies

See the Fund’s Critical Accounting Policies from the disclosure set forth in the Fund’s Annual Report on Form 10-K for the year ended December 31, 2022.

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Current Market Conditions

Impact of Economic and Geopolitical Events on the Oil and Gas Sector. The substantial volatility in world markets has been prominent in the oil and gas sector, with WTI oil prices reaching a multi-year high of $130.00 per barrel in March 2022, and gas prices also reaching a multi-year high in mid-year, both due in part to increased demand, the reluctance of U.S. producers and OPEC nations to generate additional supply, and the conflict in Ukraine. Beginning in the second and third quarters of 2022, oil and natural gas prices retreated substantially before stabilizing in the second quarter of 2023 and resuming their increase in the third quarter of 2023. During the three months ended September 30, 2023, oil prices increased from $70.64 to $90.79 and gas prices increased from $2.48 to $2.68. Recent oil price stability has been a significant factor in increased consolidation activity in the Permian Basin where Equus Energy holds most of its development rights, as well as in the Williston Basin region in North Dakota where Morgan E&P, LLC holds its development rights. The U.S. Energy Information Administration has modified its 2023 oil and gas price forecasts accordingly, with an August 2023 estimate of $87.00 per barrel for Brent crude by the end of 2023, and $2.62 per MMBTU for gas prices by the end of the year.

Operators of the leasehold interests held by Equus Energy have not yet undertaken significant capital expenditures, which could have a material adverse effect upon the operations and long-term financial condition of Equus Energy. To conserve existing cash resources or create additional cash resources during the next year, Equus Energy intends to either:

(i) attempt to secure equity or debt financing from one or more institutional sources, which sources may include the Fund, a commercial lender, or other investors, (ii) request that its operators shut-in additional wells, (iii) sell certain of its oil and gas holdings, or (iv) undertake a combination of the foregoing. However, we cannot assure you that Equus Energy will be able to implement these plans successfully, or that such plans will generate sufficient liquidity to fund the operating expenses of Equus Energy over the next twelve-months.

Morgan has undertaken significant capital expenditures for oil and gas development during the third quarter of 2023 and is expected to continue to do so during the fourth quarter of 2023. Morgan may secure capital for this purpose from Equus, from one or more institutional and private sources, or a combination of the foregoing.

The U.S. Economy. U.S. GDP increased at an annualized rate of 4.9% in the third quarter of 2023, above consensus estimates of 4.3% for the period. This followed an increase of 2.1% on an annualized basis for the second quarter of 2023. The principal drivers of the increase during the third quarter of 2023 were increased consumer spending, as well as consumption of housing and utilities, health care, financial services and insurance. After decreasing 9.3% during the second quarter of 2023, exports increased 6.2% during the third quarter of 2023. The Conference Board is still projecting a mild recession for the U.S. economy in 2024, with overall GDP growth of 2.2% for all of 2023 and 0.8% growth for all of 2024. (Sources: Bureau of Economic Analysis; The Conference Board).

Employment and Housing. At September 30, 2023, the U.S. unemployment rate has stood at 3.8%, largely unchanged since the first quarter of 2022 and substantially below the high of 14.5% in April 2020 when economic uncertainty associated with Covid-19 was at its peak. With signs of a recession in 2024, economists are projecting a rate of 4.0% to 4.5% during the coming year. Most of the recent employment gains in the first nine months of 2023 were due to gains in nonfarm payrolls, the leisure and hospitality industry, professional and business services, retail trade, transportation, and warehousing (Sources: Bureau of Labor Statistics; Trading Economics).

Consumer Prices. Consumer prices, which had largely been held in check during the pandemic, began to rise steadily in 2021 and into 2022, reaching an annualized rate of 9.1% during 2022, before retreating to an overall rate of 8.0% for the year. In October 2023, the Bureau of Labor Statistics reported an annualized inflation rate of 3.7%, an increase from the trailing twelve month rate of 2.6% at the end of the second quarter of 2023. Energy prices remained a principal driver of inflation, but even the core inflation rate, which excludes energy and food prices, was 4.3%. Largely as a result of Fed monetary responses and a slowing of economic growth, most commentators are forecasting a decrease in the rate of inflation throughout the remainder of 2023 and into 2024. (Sources: Bureau of Economic Analysis; Kiplinger; Bureau of Labor Statistics; Trading Economics).

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Interest Rates. Principally as a response to rising prices, the Federal Reserve began a series of federal funds rate increases in May 2022 which continued for ten consecutive meetings of the Federal Open Market Committee until July 2023, which set the rate at 5.5%, the highest in 22 years. No further increases are expected for the remainder of 2023, but the effect of such rate increases and inflationary pressures has been substantially increased borrowing costs, particularly for homebuyers and small businesses, as well as heightened recession risks. Moreover, credit providers have also begun to require higher collateralization rates, with shorter maturities and higher fees than in the recent past. (Source: Forbes; The Wall Street Journal).

Mergers and Acquisitions. Despite inflationary pressures and Fed tightening, global merger and acquisition activity in the first nine months of 2023 began to recover from its 2022 year-end slowdown, which was largely as a result of increased costs of capital, reduced financial sponsor activity, and increased regulatory scrutiny. Some industry commentators are predicting that consolidations will continue to increase in the remainder of 2023 and into 2024, particularly in the areas of healthcare, technology, and energy. Higher interest rates and lower deal volumes have kept valuation multiples at levels consistent with 2022, which is expected to facilitate increased transaction activity through the remainder of the year. (Sources: Morgan Stanley; Washington Technology).

Private Equity. After experiencing a record year in 2021, private equity activity slowed in 2022, particularly during the second half of the year. With the increase in M&A dealmaking in the nine months of 2023, private equity analysts are also expecting an increase in investment opportunities, particularly in view of comparably lower valuation multiples and, in the face of a predicted recession, increased motivation from sellers. (Sources: The Wall Street Journal; CNBC; Washington Technology).

During the nine months ended September 30, 2023, our net asset value increased from $2.61 per share to $3.49 per share, an increase of 33.7%. As of September 30, 2023, our common stock is trading at a 57.6% discount to our net asset value as compared to 45.2% as of December 31, 2022.

Over the past several years, we have executed certain initiatives to enhance liquidity, achieve a lower operational cost structure, provide more assistance to portfolio companies and realize certain of our portfolio investments. Specifically, we changed the composition of our Board of Directors and Management, terminated certain of our follow- on investments, internalized the management of the Fund, suspended our managed distribution policy, modified our investment strategy to pursue shorter term liquidation opportunities, pursued non-cash investment opportunities, and sold certain of our legacy and underperforming investment holdings. We believe these actions continue to be necessary to protect capital and liquidity in order to preserve and enhance shareholder value. Because our Management is internalized, certain of our expenses should not increase commensurate with an increase in the size of the Fund and, therefore, to the extent we remain a BDC, we expect to achieve efficiencies in our cost structure if we are able to grow the Fund.

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Liquidity and Capital Resources

We generate cash primarily from maturities, sales of securities and borrowings, as well as capital gains realized upon the sale of portfolio investments. We use cash primarily to make additional investments, either in new companies or as follow-on investments in the existing portfolio companies and to pay the dividends to our stockholders.

Because of the nature and size of the portfolio investments, we may periodically borrow funds to make qualifying investments to maintain our tax status as a RIC. We often borrow 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, Equus may no longer qualify as a RIC. The Fund would then be subject to corporate income tax on its net investment income and realized capital gains, and distributions to stockholders would be subject to income tax as ordinary dividends.

The Fund has 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.

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 the Fund as long-term capital gains and stockholders will be able to claim their proportionate share of the federal income taxes paid 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.

We are evaluating the impact of current market conditions on our portfolio company valuations and their ability to provide current income. We believe we have followed valuation techniques in a reasonably consistent manner; however, we are cognizant of current market conditions that might affect future valuations of portfolio securities. In view of our present status as a BDC and our anticipated transformation into an operating company, we believe that our operating cash flow and cash on hand will be sufficient to meet operating requirements and to finance routine capital expenditures through the next twelve months.

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Results of Operations Investment Income and Expense

Net investment loss was $1.2 million for the three months ended September 30, 2023 and $0.9 million for the three months ended September 30, 2022, respectively. Net investment loss was $3.2 million for the nine months ended September 30, 2023 and $2.6 million for the nine months ended September 30, 2022, respectively.

Investment income was $0.04 million and $0.06 million for the three and nine months ended September 30, 2023 due to the interest earned on portfolio investments and short-term investments.

Compensation expense was $1.5 million for the nine months ended September 30, 2023 and $1.1 million for the nine months ended September 30, 2022, as a result of bonuses paid in 2023.

Professional fees were comparable for the nine months ended September 30, 2023 and 2022, and were $0.7 million and $0.6 million, respectively.

General and administrative expenses were comparable for the nine months ended September 30, 2023 and 2022, and were $0.1 million and $0.09 million, respectively.

Changes in Unrealized Appreciation/Depreciation of Portfolio Securities

During the nine months ended September 30, 2023, we made a $2.4 million debt investment in Morgan E&P, LLC (“Morgan”) and also invested $1.00 in the equity of Morgan. We recorded a change in fair value of the equity of Morgan of $15.0 million. The increase was principally due to a significant increase in Morgan’s acreage rights and associated reserves, an increase in oil and gas prices, and our expectation of Morgan generating operating cash flow from recent drilling activity in the near future in the Bakken shale region where it holds leasehold acreage rights.

During the nine months ended September 30, 2023, with respect to our holding in Equus Energy, LLC, we recorded no change in the fair value of this investment.

During the nine months ended September 30, 2022, with respect to our holding in Equus Energy, LLC, we recorded an increase in the fair value of this investment by $2.5 million. Such change in fair value was principally due to increases in mineral acreage prices and an increase in short-and long-term prices for crude oil and natural gas.

Dividends

We will pay out net investment income and/or realized capital gains, if any, on an annual basis as required under the Investment Company Act of 1940.

Subsequent Events

Management performed an evaluation of the Fund’s activity through the date the financial statements were issued, noting the following subsequent events:

On October 3, 2023, our holding in $18.0 million in U.S. Treasury Bills matured and we repaid our margin loan.

During October and November 2023, we advanced Morgan an additional $3.9 million under its existing credit facility with the Fund.

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We are subject to financial market risks, including changes in interest rates with respect to investments in debt securities and outstanding debt payable, as well as changes in marketable equity security prices. In the future, we may invest in companies outside the United States, including in Europe and Asia, which would give rise to exposure to foreign currency value fluctuations. We do not use derivative financial instruments to mitigate any of these risks. The return on 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 affect interest income. In addition, changes in market interest rates are not typically a significant factor in the determination of fair value of these debt securities, since the securities are generally held to maturity. We determine their fair values based on the terms of the relevant debt security and the financial condition of the issuer.

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 small portion of the investment portfolio could also consist of common stock 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.

We maintain disclosure controls and other procedures that are designed to ensure that information required to be disclosed by the Fund in the reports that we file or submit 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 our management, including our Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure.

Our management, with the participation of our Fund’s 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 September 30, 2023. Based on their evaluation, our Chief Executive Officer and Chief Financial Officer concluded that the Fund’s disclosure controls and procedures were effective at a reasonable assurance level. There has been no change in our internal control over financial reporting during the quarter ended September 30, 2023, that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

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In connection with our efforts to convert Equus into an operating company in furtherance of our plan to convert the Fund into an operating company, we may be subject to a number of risks associated with this process, the transactions that would embody a consolidation of Equus with another company, as well as specific risks associated with the commercial enterprise with which Equus may seek to combine itself. We intend to identify, as will be reasonably possible, such risks and include the same in our subsequent filings and reports with the SEC.

Readers should carefully consider these risks and all other information contained in our annual report on Form 10-K (“10-K”) for the year ended December 31, 2022, including the Fund’s financial statements and the related notes thereto. The risks and uncertainties described in our 10-K and throughout this 10-Q are not the only ones facing the Fund.

Additional risks and uncertainties not presently known to us, or not presently deemed material by us, may also impair our operations and performance.

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