EQS

Business Context and Reporting Period

Company: Equus II Incorporated (a Delaware corporation and Business Development Company)

Reporting Period: Fiscal year ended December 31, 2000

Business Model: The Fund seeks capital appreciation by investing in equity and equity-oriented securities of privately-owned companies, primarily through leveraged buyouts and recapitalizations. It provides significant managerial assistance to portfolio companies. As of December 31, 2000, the Fund held investments in 27 portfolio companies.

Key Financial Metrics

Liquidity: The Fund maintained $77 million in temporary cash investments, largely funded by a $77 million note payable to a bank to maintain diversification requirements for tax status. This specific note was repaid on January 2, 2001. The Fund also had $7.3 million outstanding on a $32.5 million revolving line of credit.

Material Changes vs. Prior Period

• Net Asset Value Decline: NAV per share decreased from $16.61 in 1999 to $15.40 in 2000, a decline of approximately 7.3%.
• Realized Losses: The Fund shifted from a net realized gain of $40.35 million in 1999 to a net realized loss of $6.16 million in 2000. Significant losses included write-offs of The Drilltec Corporation ($7.65 million) and Drypers Corporation ($1.97 million), partially offset by gains from the sale of Allied Waste Industries ($8.53 million).
• Operating Income Improvement: Net investment income turned positive ($549k) in 2000 compared to a loss of $2.18 million in 1999. This was driven by reduced interest expense and lower non-cash compensation expenses related to officer stock options.
• Dividend Policy: Dividends dropped significantly from $4.25 per share in 1999 to $0.60 per share in 2000. The 2000 dividend was primarily a return of capital and ordinary income, whereas 1999 was largely long-term capital gains.
• Portfolio Composition: Approximately 96% of the fair value of portfolio securities at year-end lacked readily available market quotations, requiring fair value estimates by management.

Guidance, Outlook, Risks, and Unusual Items

• Outlook: Management believes current cash, anticipated income, and borrowing capacity are sufficient to fund committed investments of approximately $15 million in existing and new companies.
• Stock Repurchases: The Fund actively repurchased shares to reduce the market discount to NAV. In 2000, it repurchased 432,927 shares at an average discount of roughly 35% from NAV. A new program to repurchase up to 5% of outstanding stock was authorized in February 2001.
• Key Risks:
  • Liquidity Risk: Portfolio investments are largely illiquid private securities.
  • Valuation Risk: Significant reliance on management estimates for fair value of private holdings.
  • Leverage Risk: Portfolio companies are highly leveraged (66-90% debt), increasing the risk of foreclosure or bankruptcy.
  • Tax Status: The Fund must maintain specific diversification ratios to retain pass-through tax status; failure could subject the Fund to corporate income tax.
• Unusual Items:
  • Non-Cash Compensation: $388,663 recorded in 2000 related to dividends paid on officer stock securing limited recourse notes.
  • Bankruptcy: Portfolio company Paracelsus Healthcare Corporation filed for Chapter 11 protection in September 2000; the Fund's investment was written down significantly.

Investor Verification Checklist

• Valuation Methodology: Verify the assumptions used by management to value the 96% of the portfolio lacking public market quotes, particularly for distressed assets like Paracelsus and Hot & Cool Holdings.
• Debt Covenants: Confirm the Fund's compliance with the 200% asset coverage ratio required by the Investment Company Act for its borrowings.
• Officer Notes: Review the status of the $10.1 million in limited recourse notes receivable from officers, which are excluded from the reported NAV but secured by pledged shares.
• Follow-on Commitments: Assess the Fund's ability to meet its $15 million in unfunded commitments to portfolio companies without further dilution or excessive borrowing.
• Subsequent Events: Note the February 2001 sale of Stephen L. LaFrance Holdings for a $7.5 million gain, which occurred after the reporting period.