EQS

Business Context and Reporting Period

Company: Equus II Incorporated (a Delaware corporation, trading as EQUUS TOTAL RETURN, INC. on the American Stock Exchange under symbol EQS).

Reporting Period: Quarterly period ended March 31, 1998.

Business Purpose: A Business Development Company (BDC) seeking capital appreciation through investments in equity and equity-oriented securities of privately owned companies, including leveraged buyouts and recapitalizations. The Fund provides significant managerial assistance to 87% of its portfolio value.

Key Financial Metrics

Material Changes vs. Prior Period

• Profitability: The Fund reported a significant improvement in total increase in net assets from operations ($8.24M vs $1.59M). This was driven by a reversal from a large realized loss in 1997 to a realized gain in 1998, and a reduction in net investment loss.
• Expense Structure: Total expenses decreased by approximately $103,000. This reduction is primarily due to the elimination of management incentive fees (both current and deferred) following a stockholder vote in April 1997. In Q1 1997, the Fund accrued $482,325 in incentive fees; none were accrued in Q1 1998.
• Investment Income: Income from portfolio securities more than doubled to $1.18M from $514K, attributed to increased investments in interest-bearing securities and dividend conversions.
• Debt Levels: Notes payable increased by $6.7M to $88.6M, reflecting higher average daily balances on lines of credit ($13.4M in 1998 vs $3.3M in 1997), which also drove a four-fold increase in interest expense.
• Portfolio Valuation: Unrealized appreciation increased by $8.05M, compared to $6.35M in the prior year. The portfolio fair value grew to $165.7M from a cost basis of $91.7M.

Outlook, Risks, and Unusual Items

• Management Commentary: Management believes current cash, anticipated income, and borrowing capacity are sufficient to finance committed investments of approximately $8.3M ($5.8M follow-on, $2.5M new).
• Dividend Policy: No dividends were declared for the quarter. The Fund targets a minimum annual distribution of $0.50 per share. Distributions may be made in cash or stock.
• Subsequent Events (Post-March 31, 1998):
  • Repaid $75M of bank notes in April 1998.
  • Sold 65,000 shares of Coach USA, Inc. in April 1998 for a realized gain of $2.26M.
  • Filed to list common stock on the New York Stock Exchange (expected trading start May 20, 1998).
  • Significant activity in Triad Medical, Inc., including a reverse stock split and a $7.8M follow-on investment.
• Risks and Contingencies:
  • Valuation Uncertainty: A significant portion of the portfolio ($147.9M) lacks readily ascertainable market values and relies on appraisals. Publicly traded securities are discounted by $16.4M to reflect sale restrictions.
  • Commitments: The Fund has committed to invest up to $5.8M in existing portfolio companies and $2.5M in a new company.
  • Liquidity: The Fund relies on a $40M revolving line of credit (increased from $30M in April 1998) and a $150M line of credit to maintain diversification and tax status.

Investor Verification Checklist

• Valuation Discounts: Verify the methodology and magnitude of the $16.4M discount applied to publicly traded securities due to sale restrictions.
• Debt Utilization: Confirm the repayment of the $75M bank note mentioned in subsequent events and its impact on future interest expense.
• Concentration Risk: Review the top 5 portfolio holdings (Allied Waste, Drypers, Garden Ridge, Brazos Sportswear, American Residential Services) which represent a significant portion of the $165.7M portfolio.
• Dividend Sustainability: Assess the Fund's ability to meet its $0.50/share annual dividend policy given the net investment loss and reliance on capital gains for distributions.
• Stock Exchange Listing: Monitor the transition from the American Stock Exchange to the New York Stock Exchange and potential liquidity implications.