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SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-K
(Mark One)
[X] ANNUAL REPORT UNDER SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF
1934 (FEE REQUIRED)
For the fiscal period ended December 31, 2000
[_] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES
EXCHANGE ACT OF 1934 (NO FEE REQUIRED)
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 (I.R.S. Employer
incorporation or organization) Identification No.)
2929 Allen Parkway, Suite 2500 77019
HOUSTON, TEXAS --------------------
- ---------------------------------- (Zip Code)
Registrant's telephone number, including area code: (713) 529-0900
--------------
Securities registered pursuant to Section 12(b) of the Act:
Title of each class Name of each exchange
on which registered
COMMON STOCK NEW YORK STOCK EXCHANGE
Securities registered pursuant to Section 12(g) of the Act: None
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 if disclosure of delinquent filers pursuant to Item 405
of Regulation S-K is not contained herein, and will not be contained, to the
best of registrant's knowledge, in the definitive proxy or information statement
incorporated by reference in Part III of this 10-K. [ ]
Approximate aggregate market value of common stock held by non-affiliates of the
registrant: $46,669,214, computed on the basis of $9.00 per share, closing price
of the common stock on the New York Stock Exchange on February 28, 2001. For
purposes of calculating this amount only, all directors and executive officers
of the registrant have been treated as affiliates. There were 6,674,577 shares
of the registrant's common stock, $.001 par value, outstanding as of February
28, 2001. The net asset value of a share at December 31, 2000 was $15.40.
Documents incorporated by reference: Proxy Statement for 2001 Annual Meeting of
Stockholders is incorporated by reference in Part III.
TABLE OF CONTENTS
PAGE
PART I
Item 1. Business ....................................................... 1
Item 2. Properties ...................................................... 17
Item 3. Legal Proceedings ............................................... 17
Item 4. Submission of Matters to a Vote of Security Holders ............. 17
PART II
Item 5. Market for Registrant's Common Equity and Related Stockholder
Matters......................................................... 17
Item 6. Selected Financial Data ......................................... 20
Item 7. Management's Discussion and Analysis of Financial
Condition and Results of Operations ............................ 21
Item 7A. Quantitative and Qualitative Disclosure About Market Risk ....... 28
Item 8. Financial Statements and Supplementary Data...................... 30
Item 9. Changes in and Disagreements with Accountants on
Accounting and Financial Disclosure ........................... 53
PART III
Item 10. Directors and Executive Officers of the Registrant .............. 53
Item 11. Executive Compensation........................................... 53
Item 12. Security Ownership of Certain Beneficial Owners and Management .. 53
Item 13. Certain Relationships and Related Transactions .................. 53
Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K.. 53
ii
ITEM 1. BUSINESS.
Equus II Incorporated (the "Fund") is a Delaware corporation that seeks to
achieve capital appreciation principally by making investments in equity and
equity-oriented securities issued by privately-owned companies in transactions
negotiated directly with such companies ("Portfolio Companies"). The Fund seeks
to invest primarily in companies that intend to acquire other businesses,
including through leveraged buyouts. 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 common or preferred
stock or debt combined with warrants, options or other rights to acquire common
or preferred stock. Current income is not a significant factor in the selection
of investments. The Fund has elected to be treated as a business development
company under the Investment Company Act of 1940 (the "Investment Company Act").
The Fund has eight directors. Five of such directors are disinterested
individuals (the "Independent Directors") as defined by the Investment Company
Act. The directors are responsible for providing overall guidance and
supervision of the Fund, approving the valuation of the Fund's investments and
performing various duties imposed on directors of a business development company
by the Investment Company Act. Among other things, the Independent Directors
supervise the management arrangements for the Fund, the custody arrangements
with respect to portfolio securities, the selection of independent public
accountants, fidelity bonding and any transactions with affiliates.
The Fund has engaged Equus Capital Management Corporation, a Delaware
corporation (the "Management Company"), to provide certain investment management
and administrative services to the Fund. Subject to the supervision of the
directors, the Management Company performs, or arranges for third parties to
perform, the management, administrative, certain investment advisory and other
services necessary for the operation of the Fund. The Management Company
identifies, evaluates, structures, monitors and disposes of the Fund's
investments. The Management Company also manages the Fund's cash and short-term,
interest-bearing investments and provides the Fund, at the Management Company's
expense, with the office space, facilities, equipment and personnel (whose
salaries and benefits are paid by the Management Company) necessary to enable
the Fund to conduct its business.
The Management Company, its officers and directors and the officers of the
Fund are collectively referred to herein as "Management". The Fund's principal
office is located at 2929 Allen Parkway, Suite 2500, Houston, Texas 77019-2120,
and the telephone number is (713) 529-0900.
INVESTMENT PRACTICES
Substantially all of the net assets of the Fund are invested or committed
to be invested in securities of Portfolio Companies. Substantially all amounts
not invested in securities of Portfolio Companies are invested in short-term,
highly liquid investments consisting of interest-bearing bank accounts,
certificates of deposit or other short-term, highly liquid investments
providing, in the opinion of the Management Company, appropriate safety of
principal.
The Fund's investments in portfolio securities are usually structured in
private transactions negotiated directly with the owner or issuer of the
securities acquired.
The Fund is concentrating its investment efforts on companies of a type
and size that, in management's view, provide opportunities for significant
capital appreciation, relative ease of acquisition and disposition, reduced
competition for investments and prudent diversification of risk.
1
The enterprise value of a Portfolio Company typically ranges from
$15,000,000 to $75,000,000, at the time of the Fund's initial investment. The
Fund's initial investment in a Portfolio Company typically ranges from
$1,500,000 to $7,500,000, depending on the investment. The balance of the
purchase price of a Portfolio Company is supplied by debt financing and other
equity investors, if necessary.
The Fund is attempting to reduce certain of the risks inherent in private
equity-oriented investments by investing in a portfolio of companies involved in
different industries. The Fund has limited its initial investment (whether in
the form of equity or debt securities, commitments to purchase securities or
debt guaranties) in any Portfolio Company to no more than 15% of the Fund's net
assets. However, if a follow-on investment is available or required, as
discussed below, the Fund's investment in a particular Portfolio Company may
exceed these initial investment limitations. Also, investments in certain
Portfolio Companies may be in excess of the Fund's initial investment
limitations due to increases in the value of such investments.
The Fund may make investments as a sole investor, with other professional
investors or with other persons. The Fund ordinarily will not be the sole
investor in a Portfolio Company. Joint equity participants may include
management of the Portfolio Company, other business development companies, small
business investment companies, other institutional or individual investors or
venture capital groups. The investment position of the Fund and its
co-investors, if any, in Portfolio Companies will typically involve a
substantial, and may constitute a controlling, interest in such companies.
The Fund may borrow funds to make new or follow-on investments, to
maintain its pass through tax status, or to pay contingencies and expenses. See
"Borrowing" and "Loss of Conduit Tax Treatment" under "Factors that May Affect
Future Results, the Market Price of Common Stock, and the Accuracy of Forward
Looking Statements."
INVESTMENT CRITERIA
Prospective investments are evaluated by Management based upon criteria
that may be modified from time to time. The criteria currently being used by
Management in determining whether to make an investment in a prospective
Portfolio Company include:
1. The presence or availability of competent management;
2. The existence of a substantial market for the products or services
of the company characterized by favorable growth potential, or a
substantial market position in a stable industry;
3. The existence of a history of profitable operations or a reasonable
expectation that operations can be conducted at a level of
profitability acceptable in relation to the proposed investment; and
4. The willingness of the company to permit the Fund and its
co-investors, if any, to take a substantial position in the company
and have representation on its board of directors, so as to enable
the Fund to influence the selection of management and basic policies
of the company.
CO-INVESTMENTS
The Fund has coinvested in certain Portfolio Companies with Equus Capital
Partners, L.P., a
2
Delaware limited partnership and an affiliate of the Fund ("ECP"). The Fund and
Management obtained an order from the Securities and Exchange Commission (the
"SEC") exempting the Fund from certain prohibitions contained in the Investment
Company Act relating to coinvestments by the Fund and ECP. Under the terms of
the order, Portfolio Securities purchased by the Fund and ECP were required to
meet certain guidelines or be approved in advance by the Independent Directors
and were required to satisfy certain conditions established by the SEC.
INVESTMENT OPERATIONS
The investment operations of the Fund consist principally of the following
basic activities:
IDENTIFYING INVESTMENTS. Investment opportunities are identified for the
Fund by the Management Company and its officers and directors. Investment
proposals may, however, come to the Fund from many other sources, and may
include unsolicited proposals from the public and referrals from banks, lawyers,
accountants and members of the financial community. Subject to the approval of
the Board of Directors, the Fund may pay such persons (including affiliates of
Management other than directors, officers and employees of the Management
Company) finder's fees to the extent permissible under applicable law and
consistent with industry practice.
EVALUATING INVESTMENT OPPORTUNITIES. Prior to committing funds to an
investment opportunity, due diligence is conducted to assess the prospects and
risks of the potential investment. See "Investment Criteria" above.
STRUCTURING INVESTMENTS. Portfolio Company investments typically are
negotiated directly with the prospective Portfolio Company or its affiliates.
The Management Company structures the terms of a proposed investment, including
the purchase price, the type of security to be purchased and the future
involvement of the Fund and affiliates in the Portfolio Company's business
(including representation on its board of directors). The Management Company
seeks to structure the terms of the investment so as to provide for the capital
needs of the Portfolio Company and at the same time maximize the Fund's
opportunities for capital appreciation in its investment.
PROVIDING MANAGEMENT ASSISTANCE AND MONITORING OF INVESTMENTS. Successful
private equity investments typically require active monitoring of, and
significant participation in, major business decisions of Portfolio Companies.
In most cases, officers of the Fund serve as members of the boards of directors
of Portfolio Companies. Such management assistance is required of a business
development company under the Investment Company Act and is intended to enable
the Fund to provide guidance and management assistance with respect to such
matters as capital structure, budgets, profit goals, diversification strategy,
financing requirements, management additions or replacements and development of
a public or private market for the securities of the Portfolio Company. In
connection with their service as directors of Portfolio Companies, officers and
directors of Management may receive and retain directors' fees or reimbursement
for expenses incurred, and may participate in incentive stock option plans for
non-employee directors, if any. When necessary, the Management Company, on
behalf of the Fund, may also assign staff professionals with financial or
management expertise to assist Portfolio Company management on specific
problems.
CURRENT PORTFOLIO COMPANIES
The following is a description of the Fund's investments in its 27
Portfolio Companies at December 31, 2000.
3
A. C. LIQUIDATING CORPORATION
A. C. Liquidating Corporation ("ACL"), Houston, Texas, has disposed of its
operating businesses and real estate. ACL intends to liquidate in 2001 and will
distribute its remaining cash, if any, to its shareholders as soon as possible.
At December 31, 2000, the Fund's investment in ACL consisted of $188,014 in 10%
secured promissory notes, which was recorded at no value. Nolan Lehmann,
President of the Fund, serves as a director of ACL.
THE BRADSHAW GROUP
The Bradshaw Group ("TBG"), Dallas, Texas, provides innovative printing
solutions primarily for customers in need of high-speed mass printings. TBG
maintains a web site at www.bradshawgroup.com. At December 31, 2000, TBG was
valued at its cost of $1,335,001. The Fund's investment consisted of 1,335,000
shares of preferred stock and a warrant to buy 2,229,450 shares of common stock
at $0.01 through May 2008, representing an approximate 22.3% fully-diluted
equity interest. Gary L. Forbes, a Vice President of the Fund, serves on TBG's
Board of Directors.
CHAMPION WINDOW, INC.
Champion Window, Inc. ("Champion"), Houston, Texas, manufactures and sells
aluminum windows for single and multi-family residential purposes, primarily in
Houston, San Antonio and Austin, Texas. Champion maintains a web site at
www.championwindow.net. At December 31, 2000, the Fund's investment in Champion,
valued at $7,542,500 with a cost of $3,400,000, consisted of 1,400,000 shares of
common stock and 20,000 shares of preferred stock. The Fund's investment in
Champion represents a 32.4% fully-diluted equity interest. Mr. Lehmann and
Patrick M. Cahill, a Vice President of the Fund, serve as directors of Champion.
CONTAINER ACQUISITION, INC.
Container Acquisition, Inc. ("Container"), Houston, Texas, is a logistics
and maintenance services company serving owners of international shipping
containers. Container maintains a web site at www.containercare.com. At December
31, 2000, the Fund's investment in Container, valued at $9,299,300 with a cost
of $7,799,300, consisted of 1,370,000 shares of common stock, 64,283 shares of
preferred stock and a warrant, exercisable under certain conditions, to buy
370,588 shares of common stock at $0.01 per share through June 2003. The Fund's
investment in Container represents a 65% fully-diluted equity interest. The Fund
has committed to invest up to an additional $2,000,000 in Container under
certain circumstances. Mr. Lehmann and Randall B. Hale, a Vice President of the
Fund, serve on Container's Board of Directors.
CRC HOLDINGS, CORP.
CRC Holdings, Corp. ("CRC"), Houston, Texas, was formed to acquire CRC
Evans Pipeline International, Inc., which designs, manufactures, and services
specialized pipeline construction and automatic welding equipment which it rents
and sells worldwide. In July 1999, the Fund sold its interest in CRC to LG&E
Energy Corp ("LGE"). The Fund is entitled to additional consideration of up to
$10.3 million pursuant to an earn-out agreement that is based on the performance
of CRC over its last two and the next two fiscal years. The remaining earnout
receivable at December 31, 2000, with a cost of $1,192,114, is valued at zero.
4
THE DRILLTEC CORPORATION
The Drilltec Corporation ("Drilltec"), Houston, Texas, provides protection
and packaging for premium oil tubular goods, drill pipe and line pipe, and
manufactures thread protectors for customers worldwide. Drilltec maintains a web
site at www.drilltec.com. At December 31, 2000, the Fund's investment in
Drilltec, valued at its cost of $1,000,000, consisted of a warrant to purchase
10% of the common equity for $100 through September 2002 and a prime + 9.75%
promissory note in the amount of $1,000,000. The Fund recognized a loss on its
investment in the preferred stock and common stock of Drilltec of $7,645,000 in
October 2000. The Fund's investment in Drilltec represents a 70% fully-diluted
equity interest. Mr. Forbes and Mr. Cahill serve on Drilltec's Board of
Directors.
EQUICOM, INC. (FORMERLY TEXROCK RADIO, INC.)
Equicom, Inc. ("Equicom"), Bryan, Texas, was formed to acquire radio
stations in small to medium-sized cities in Texas. At December 31, 2000, Equicom
owned and operated 21 radio stations. At December 31, 2000, the Fund's
investment in Equicom, valued at $4,562,250 with a cost of $9,279,610, consisted
of 452,000 shares of common stock, 657,611 shares of preferred stock and
$2,562,250 in a 10% promissory note. The Fund's investment in Equicom represents
a 56.4% fully-diluted equity interest at December 31, 2000. The Fund has
committed to invest up to an additional $93,500 in Equicom under certain
circumstances. Mr. Hale and Tracy H. Cohen, a Vice President of the Fund, serve
on Equicom's Board of Directors.
EQUIPMENT SUPPORT SERVICES, INC.
Equipment Support Services, Inc. ("ESS"), Houston, Texas, was formed to
buy various companies in the equipment rental business including Carruth-Doggett
Industries, Inc. and CDI Rental Services, Inc., in which the Fund had an
investment. At December 31, 2000, the Fund's investment in ESS, valued at
$2,500,000 with a cost of $3,168,500, consisted of 35,000 shares of common
stock, 35,000 shares of preferred stock and $1,138,000 in an 8% promissory note.
The Fund's investment in ESS represents a 3.5% fully diluted equity interest at
December 31, 2000.
FS STRATEGIES, INC.
FS Strategies, Inc. ("FSS"), Houston, Texas, was formed to acquire Talent
Tree Acquisition Corporation ("Talent Tree", formerly Initial Staffing Service)
and EESIS, Inc ("EESIS"). Talent Tree and EESIS maintain web sites at
www.talenttree.com and www.eesis.com, respectively. Talent Tree operates a
network of over 140 branch offices providing temporary staffing and permanent
placement services in 46 market areas in thirty states, including eighteen
franchises. EESIS is a web-based human resources solution provider based in
Houston. At December 31, 2000, FSS was valued at its cost of $5,500,000. The
Fund's investment consisted of 110,000 shares of common stock. The Fund's
investment in FSS represents an approximate 23% fully-diluted equity interest.
The Fund has committed to invest up to an additional $750,000 in FSS under
certain circumstances. Mr. Lehmann serves on FSS's Board of Directors.
GCS RE, INC.
GCS RE, Inc. ("GCS"), Houston, Texas, was formed to be a general partner
of a real estate partnership, which owns a warehouse that is leased to a former
subsidiary of a previously owned portfolio company. At December 31, 2000, the
Fund's investment in GCS consisted of 1,000 shares of common stock that was
valued at $600,000, with a cost of $132,910. The Fund owns 100% of the stock of
GCS, and GCS owns 50% of the real estate partnership. Sam P. Douglass, Chairman
and CEO of the
5
Fund, and Mr. Lehmann serve on the Board of Directors of GCS.
HOT & COOL HOLDINGS, INC.
Hot & Cool Holdings, Inc. ("Hot & Cool"), Laredo, Texas, is a manufacturer
and distributor of automotive radiators and other heat transfer products. At
December 31, 2000, the Fund's investment in Hot & Cool, valued at zero with a
cost of $5,775,000, consisted of $1,075,000 in a 9% increasing rate subordinated
promissory note, $2,200,000 in 10% subordinated notes, $2,500,000 in a 12%
senior unsecured promissory note, and warrants to buy up to 14,942 and 10,000
shares of common stock at $0.01 per share through March 2006 and February 2003,
respectively. The Fund's investment represents an approximate 25.8%
fully-diluted equity interest in Hot & Cool. Mr. Lehmann serves on Hot & Cool's
Board of Directors.
NCI BUILDING SYSTEMS, INC. (NYSE: NCS)
NCI Building Systems, Inc. ("NCS"), Houston, Texas, manufactures and
markets metal building systems, components and roll up doors for non-residential
users from operating facilities located throughout the U.S. and Mexico. NCS
maintains a web site at www.ncilp.com. The December 31, 2000 closing price of
NCS's common stock on the New York Stock Exchange was $18.8125 per share. At
December 31, 2000, the Fund's investment in NCS consisted of 200,000 shares of
common stock valued at $3,762,500 with a cost of $159,784, which represents an
approximate 1% fully-diluted equity interest in NCS. Mr. Forbes serves as a
director of NCS.
PARACELSUS HEALTHCARE CORPORATION (OTCBB:PLHC)
Paracelsus Healthcare Corporation ("PLHC"), Houston, Texas, owns or
operates, directly or through hospital partnerships, ten acute-care hospitals in
six states. In September 2000, PLHC filed for protection under Chapter 11 of the
Federal Bankruptcy Code. PLHC has negotiated a plan of reorganization with its
primary creditors and expects to emerge from bankruptcy in March 2001. The
December 31, 2000 closing price of PLHC's common stock on the over the counter
bulletin board was $0.013 per share. At December 31, 2000, the Fund's investment
in PLHC, valued at $22,549 with a cost of $4,299,449, consisted of 1,844,345
shares of common stock. The common stock of PLHC was valued by the Fund at a
discounted average of $0.01261 per share at December 31, 2000, due to
restrictions on the Fund's ability to sell such stock, which resulted in an
aggregate reduction in value from the market price on such date of $1,518. The
Fund's investment in PLHC represents an approximate 3% fully-diluted equity
interest in PLHC. Mr. Lehmann serves on PLHC's Board of Directors.
PETROCON ENGINEERING, INC.
Petrocon Engineering, Inc. ("Petrocon"), Beaumont, Texas, is an
international engineering, systems and construction management firm, servicing
industrial customers with a primary focus in the process industries - oil,
chemical, petrochemical and forest products. At December 31, 2000, the Fund's
investment, valued at its original cost of $7,323,323, consisted of 887,338
shares of common stock, $2,659,332 in an 8% Series B junior subordinated
promissory note, $4,663,356 in a 12% promissory note and a warrant to buy
1,552,571 shares of common stock for $0.01 through March 2009. The Fund's
investment in Petrocon represents an approximate 30% fully-diluted interest in
Petrocon through March 2009. Mr. Forbes and Ms. Cohen serve on Petrocon's Board
of Directors.
RAYTEL MEDICAL CORPORATION (NASDAQ: RTEL)
Raytel Medical Corporation ("RTEL"), San Mateo, California, is a leading
nationwide provider
6
of alternate-site medical service to physicians, hospitals, patients and managed
care groups. The December 31, 2000 closing price of RTEL's common stock on the
NASDAQ National Market was $0.8125 per share. At December 31, 2000, the Fund's
investment in RTEL, valued at $26,872 with a cost of $330,730, consisted of
33,073 shares of common stock. The Fund's investment in RTEL represents less
than a 1% equity interest.
SOVEREIGN BUSINESS FORMS, INC.
Sovereign Business Forms, Inc. ("Sovereign"), Houston, Texas, is a
manufacturer of wholesale business forms in six states. At December 31, 2000,
the Fund's investment in Sovereign, valued at $6,026,386 with a cost of
$4,394,844, consisted of 16,011 shares of preferred stock, $2,793,744 in 15%
promissory notes and warrants to buy up to 551,894, 25,070 and 273,450 shares of
common stock at $1, $1.25 and $1 per share through August 2006, October 2007 and
October 2009, respectively. The Fund has committed to invest up to an additional
$625,000 under certain circumstances. The Fund's investment represents a 31%
fully-diluted equity interest in Sovereign. Mr. Forbes serves on Sovereign's
Board of Directors.
SPECTRUM MANAGEMENT, LLC
Spectrum Management, LLC ("Spectrum"), Dallas, Texas, was formed to
acquire a business which provides security devices to financial institutions. At
December 31, 2000, the Fund's investment in Spectrum, valued at its original
cost of $2,850,000, consisted of 285,000 units of Class A equity interests. The
Fund's investment in Spectrum represents a 79% fully-diluted equity interest in
Spectrum. Mr. Forbes and Mr. Hale serve on the Board of Directors of Spectrum.
STEPHEN L. LAFRANCE HOLDINGS, INC.
Stephen L. LaFrance Holdings, Inc. ("LaFrance"), Pine Bluff, Arkansas,
owns and operates 98 retail drug stores primarily in Arkansas, Mississippi and
Tennessee. At December 31, 2000, the Fund's investment in LaFrance, valued at
$9,498,452 with a cost of $2,498,452, consisted of 2,498,452 shares of preferred
stock and a warrant to buy 269 shares of common stock at $0.01 per share through
September 2007. The Fund's investment in LaFrance represents an approximate 20%
fully-diluted equity interest. Mr. Forbes serves on the Board of Directors of
LaFrance.
STERNHILL PARTNERS I, L.P.
Sternhill Partners I, L.P. ("Sternhill"), Houston, Texas, is a venture
capital fund which was formed to invest in seed and early stage information,
communication and entertainment technology companies. Sternhill maintains a web
site at www.sternhillpartners.com. The Fund has committed to invest up to
$3,000,000 in Sternhill. At December 31, 2000, the Fund's investment in
Sternhill was valued at $1,000,000 with a cost of $900,000. The Fund's
investment consisted of a 3% limited partnership interest.
STRATEGIC HOLDINGS, INC. AND RELATED ENTITY
Strategic Holdings, Inc. ("SHI"), Houston, Texas, was formed to acquire
Strategic Materials, Inc., formerly known as Allwaste Recycling, Inc., the glass
recycling division of Allwaste, Inc. SHI receives and processes used glass,
which is then sold to the container, fiberglass and bead industries as a raw
material source. At December 31, 2000, the Fund's investment in SHI was valued
at $10,000,000 with an original cost of $13,659,013. The Fund's investment in
SHI consists of 3,089,751 shares of common stock, 3,822,157 shares of Series B
preferred stock, $6,750,000 in a 15% promissory note and
7
warrants to buy 225,000, 100,000 and 2,219,237 shares of SHI common stock at
$0.4643, $1.50 and $0.01 per share through August 2005, August 2005 and November
2005, respectively. Mr. Lehmann and Mr. Hale serve as directors of SHI.
SMIP, Inc. ("SMIP"), Houston, Texas, was formed to be the general partner
of a limited partnership which owns an 18% fully-diluted interest in SHI.
Management personnel of Strategic Materials, Inc. are the limited partners of
the partnership. At December 31, 2000, the Fund's investment in SMIP was valued
at $175,000, with a cost of $325,000. The Fund's investment in SMIP consists of
1,000 shares of common stock and $175,000 in a 15% promissory note. SMIP is
wholly-owned by the Fund. Mr. Lehmann and Mr. Hale serve as directors of SMIP.
The Fund's investments in SHI and SMIP represent an approximate 85%
fully-diluted equity interest in SHI.
SUMMIT/DPC PARTNERS, L. P.
Summit/DPC Partners, L. P. ("DPC"), Houston, Texas, was formed to invest
in Doane Pet Care Enterprises, Inc., which is believed to be the largest
manufacturer of private label dry pet food in the United States. At December 31,
2000, the Fund's investment in DPC was valued at $10,000,000, with an original
cost of $3,326,565. The Fund's investment consists of an approximate 36.11%
limited partnership interest in DPC, which in turn owns an approximate 16%
fully-diluted interest in Doane Pet Care Enterprises, Inc.
TRAVIS INTERNATIONAL, INC.
Travis International, Inc. ("Travis"), Houston, Texas, distributes
specialty products for industrial and commercial use, including o-rings, gaskets
and sealants and designs and manufactures various other products used in the
concrete construction industry. At December 31, 2000, the Fund's investment in
Travis, valued at $1,500,000 with a cost of $5,398, consisted of 98,761 shares
of common stock, which represents an approximate 6.8% fully-diluted equity
interest in Travis. Mr. Lehmann serves as a director of Travis.
TULSA INDUSTRIES, INC.
Tulsa Industries, Inc. ("Tulsa"), Houston, Texas, manufactures equipment
for the oil and gas industry. At December 31, 2000, the Fund's investment in
Tulsa was valued at $1,713,769 with an original cost of $7,213,769. The Fund's
investment consisted of 209,089 shares of common stock, 1,058 shares of Series B
preferred stock and $655,769 in a junior participation promissory note,
representing an approximate 26.3% fully-diluted equity interest. Mr. Forbes and
Mr. Hale serve on Tulsa's Board of Directors.
TURFGRASS AMERICA, INC.
Turfgrass America, Inc. ("Turfgrass"), Granbury, Texas, was formed for the
purpose of acquiring all the outstanding stock of C&D Turfgrass, Ltd., Crenshaw
& Doguet Turfgrass, Inc., Millberger Turf Farms, Inc., Millberger Turf Sales,
Inc., and 5-T Enterprises, Inc. (the parent of Thomas Bros. Grass, Ltd.). The
combination of these companies has created one of the largest warm season
turfgrass companies in the country. Turfgrass maintains a web site at
www.turfgrassamerica.com. At December 31, 2000, the Fund's investment in
Turfgrass was valued at its cost of $4,195,000. The Fund's investment consisted
of 3,167,756 shares of common stock and $3,595,000 invested in a $4,000,000, 12%
subordinated promissory note, representing an approximate 11% fully-diluted
equity interest in
8
Turfgrass. The Fund has committed to invest up to an additional $1,000,000 under
certain circumstances. Mr. Hale serves as a director of Turfgrass.
UNITED INDUSTRIAL SERVICES, INC.
United Industrial Services, Inc. ("UIS"), Houston, Texas, specializes in
field services for the petrochemical and power generation industries. At
December 31, 2000, the Fund's investment in UIS was valued at $3,085,100 with an
original cost of $4,085,100 and consisted of $585,000 in a 15% promissory note,
35,000 shares of preferred stock and warrants to buy up to 63,637 and 18,887
shares of common stock at $0.01 through June 2008 and March 2011, respectively.
The Fund's investment in UIS represents an approximate 38% fully-diluted equity
interest. Mr. Forbes serves on UIS's Board of Directors.
VANGUARD VII, L.P.
Vanguard VII, L.P. ("Vanguard"), Houston, Texas, is a venture capital fund
which was formed to invest in seed and early stage communications, internet and
life science technology companies. Vanguard maintains a web site at
www.vanguardventures.com. The Fund has committed to invest up to $3,000,000 in
Vanguard. At December 31, 2000, the investment in Vanguard was valued at its
cost of $600,000. The Fund's investment consisted of a 1.3% limited partnership
interest.
TEMPORARY INVESTMENTS
Pending investment in Portfolio Companies, the Fund invests its available
funds in interest-bearing bank accounts, money market mutual funds, U.S.
Treasury securities and/or certificates of deposit with maturities of less than
one year (collectively, "Temporary Investments"). Temporary Investments may also
include commercial paper (rated or unrated) and other short-term securities.
Temporary Investments constituting cash, cash items, securities issued or
guaranteed by the U.S. Treasury or U.S. Government agencies and high quality
debt securities (commercial paper rated in the two highest rating categories by
Moody's Investor Services, Inc. or Standard & Poor's Corporation, or if not
rated, issued by a company having an outstanding debt issue so rated with
maturities of less than one year at the time of investment) will qualify for
determining whether the Fund has 70% of its total assets invested in Managed
Companies (as hereafter defined) or in qualified Temporary Investments for
purposes of the business development company provisions of the Investment
Company Act. See "Regulation" below.
FOLLOW-ON INVESTMENTS
Following its initial investment in a Portfolio Company, the Fund may be
requested to make follow-on investments in the company. Follow-on investments
may be made to take advantage of warrants or other preferential rights granted
to the Fund or otherwise to increase the Fund's position in a successful or
promising Portfolio Company. The Fund may also be called upon to provide
additional equity or loans needed by a Portfolio Company to fully implement its
business plans, to develop a new line of business or to recover from unexpected
business problems. The Fund may make follow-on investments in Portfolio
Companies from funds on hand or may borrow all or a portion of the funds
required to make such follow-on investments.
DISPOSITION OF INVESTMENTS
The method and timing of the disposition of the Fund's portfolio
investments is critical to the realization of capital appreciation and to the
minimization of any capital losses. The Fund expects to
9
dispose of its portfolio securities through a variety of transactions, including
sales of portfolio securities in underwritten public offerings, public sales of
such securities and negotiated private sales of such securities to the Portfolio
Company itself or to other investors. In addition, the Fund may distribute its
portfolio securities in-kind to its shareholders. In structuring investments,
the Fund endeavors to reach such agreements or understandings with a prospective
Portfolio Company as may be appropriate with respect to the method and timing of
the disposition of the Fund's investment and, if appropriate, seeks to obtain
registration rights at the expense of the Portfolio Company. The Fund bears the
costs of disposing of investments to the extent not paid by the Portfolio
Company.
OPERATING EXPENSES
The Management Company, at its expense, provides the Fund with office
space, facilities, equipment and personnel (whose salaries and benefits are paid
by the Management Company) necessary for the conduct of the Fund's business and
pays all costs related to proposed acquisitions of portfolio securities that are
not completed, unless such proposed acquisitions have been previously approved
by the Board of Directors of the Fund.
The Fund is responsible for paying certain expenses relating to its
operations, including: management fees to the Management Company; fees and
expenses of the Independent Directors; finder's fees; direct costs of proposed
investments in Portfolio Companies, whether or not completed, if such proposed
investments have been approved for acquisition by the Board of Directors of the
Fund; depositary fees of unaffiliated depositaries; fees of unaffiliated
transfer agents, registrars and disbursing agents; the administrative fee to the
Management Company; portfolio transaction expenses; interest; legal and
accounting expenses; costs of printing and mailing proxy materials and reports
to shareholders; New York Stock Exchange fees; custodian fees; litigation costs;
costs of disposing of investments including brokerage fees and commissions; and
other extraordinary or nonrecurring expenses and other expenses properly payable
by the Fund. The Fund has the ability to pay bonuses to its officers, however to
date the Fund has not paid any bonuses.
VALUATION
On a quarterly basis, the Management Company performs a valuation of the
investments in portfolio securities of the Fund, subject to the approval of the
Board of Directors of the Fund. Valuations of portfolio securities are done in
accordance with generally accepted accounting principles and the financial
reporting policies of the SEC. The applicable methods prescribed by such
principles and policies are described below.
The fair value of investments for which no market exists (including most
investments made by the Fund) 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 being valued by the
directors would be the amount the Fund might reasonably expect to receive for it
upon its current sale. There is a range of values that are reasonable for such
investments at any particular time. 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.
Appraisal valuations are based upon such factors as the Portfolio
Company's earnings, cash flow and net worth, the market prices for similar
securities of comparable companies and an assessment of the company's future
financial prospects. In the case of unsuccessful operations, the appraisal may
be based upon liquidation value. Appraisal valuations are necessarily
subjective.
10
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.
Securities with legal, contractual or practical restrictions on transfer may be
valued at a discount from their value determined by the foregoing method to
reflect such restrictions.
Fund investments for which market quotations are readily available and
which are freely transferable are valued as follows: (i) securities traded on a
securities exchange or the NASDAQ National Market are valued at the closing
price on the date of valuation and (ii) securities traded in the
over-the-counter market are valued at the average of the closing bid and asked
prices on the date of valuation. For securities which are in a class of public
securities but are restricted from free trading (such as Rule 144 stock),
valuation is set by discounting the closing sales or bid price to reflect the
estimated effects of the illiquidity caused by such restrictions. 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.
The directors review the valuation policies on a quarterly basis to
determine their appropriateness and may also hire independent firms to review
the Management Company's methodology of valuation or to conduct an independent
valuation.
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 and on the Fund's website at
www.equuscap.com.
CUSTODIAN
The Fund acts as the custodian of its securities to the extent permitted
under the Investment Company Act and is subject to the restrictions imposed on
self-custodians by the Investment Company Act and the rules and regulations
thereunder. The Fund has entered into an agreement with Bank of America, N.A.
with respect to the safekeeping of such securities. The principal business
office of the custodian is 700 Louisiana Street, 6th Floor, Houston, Texas
77002.
TRANSFER AND DISBURSING AGENT
The Fund employs American Stock Transfer & Trust Company as its transfer
agent to record transfers of the shares, maintain proxy records and to process
distributions. The principal business office of such company is 40 Wall Street,
New York, NY, 10005.
FACTORS THAT MAY AFFECT FUTURE RESULTS, THE MARKET PRICE OF COMMON STOCK, AND
THE ACCURACY OF FORWARD-LOOKING STATEMENTS
In the normal course of its business, the Fund, in an effort to keep its
stockholders and the public informed about the Fund's operations and portfolio
of investments, may from time-to-time issue certain statements, either in
writing or orally, that contain or may contain forward-looking information.
Generally, these statements relate to business plans or strategies of the Fund
or Portfolio Companies in which it invests, projected or anticipated benefits or
consequences of such plans or strategies, projected or anticipated benefits of
new or follow-on investments made by or to be made by the Fund, or projections
involving anticipated purchases or sales of securities or other aspects of the
Fund's operating results. Forward-looking statements are not guarantees of
future performance and are subject to risks and
11
uncertainties that could cause actual results to differ materially. As noted
elsewhere in this report, the Fund's operations and portfolio of investments are
subject to a number of uncertainties, risks, and other influences, many of which
are outside the control of the Fund, and any one of which, or a combination of
which, could materially affect the results of the Fund's operations or net asset
value, the market price of its common stock, and whether forward-looking
statements made by the Fund ultimately prove to be accurate.
The following discussion outlines certain factors that in the future could
affect the Fund's results for 2001 and beyond and cause them to differ
materially from those that may be set forth in any forward-looking statement
made by or on behalf of the Fund:
LONG-TERM OBJECTIVE. The Fund is intended for investors seeking long-term
capital growth. The Fund is not meant to provide a vehicle for those who wish to
play short-term swings in the stock market. The portfolio securities acquired by
the Fund generally require four to seven years to reach maturity and generally
are illiquid. An investment in shares of the Fund should not be considered a
complete investment program. Each prospective purchaser should take into account
his investment objectives as well as his other investments when considering the
purchase of shares of the Fund.
NON-DIVERSIFIED STATUS; NUMBER OF INVESTMENTS. The Fund is classified as a
"non-diversified" investment company under the Investment Company Act, which
means the Fund is not limited in the proportion of its assets that may be
invested in the securities of a single issuer. Generally, the Fund does not
intend to initially invest more than 15% of the value of its net assets in a
single portfolio company. However, follow-on investments or a disproportionate
increase in the value of one portfolio company may result in greater than 15% of
the Fund's net assets being invested in a single portfolio company. While these
restrictions limit the exposure of the capital of the Fund in any single
investment, to the extent the Fund takes large positions in the securities of a
small number of issuers, the Fund will be exposed to a greater risk of loss and
the Fund's net asset value and the market price of its common stock may
fluctuate as a result of changes in the financial condition, the stock price of,
or in the market's assessment of any single Portfolio Company to a greater
extent than would be the case if it were a "diversified" company holding
numerous investments. The Fund currently has investments in 27 Portfolio
Companies, of which none exceed 15% of the value of its net assets and four of
the remaining investments exceed 10%.
LEVERAGED PORTFOLIO INVESTMENTS. While leveraged buyout investments and
investments in highly leveraged companies offer the opportunity for significant
capital gains and current income, such investments involve a high degree of
business and financial risk and can result in substantial losses. The Fund's
Portfolio Companies incur substantial indebtedness in connection with leveraged
buyout or other highly leveraged transactions. Such indebtedness generally
represents from 66% to 90% of the capitalization of a Portfolio Company. In the
event a Portfolio Company cannot generate adequate cash flow to meet the
principal and interest payments on such indebtedness, the Fund's equity
investment could be reduced or eliminated through foreclosure on the Portfolio
Company's assets or the Portfolio Company's reorganization or bankruptcy. A
substantial portion of the indebtedness incurred by Portfolio Companies may bear
interest at rates that will fluctuate in accordance with a stated interest rate
index or the prime lending rate. The cash flow of a Portfolio Company may not be
sufficient to meet increases in interest payments on its indebtedness.
Accordingly, the profitability of the Fund's Portfolio Companies, as well as
appreciation of the investments in such companies, will depend in a significant
part upon prevailing interest rates.
LACK OF LIQUIDITY OF PORTFOLIO INVESTMENTS. The portfolio investments of
the Fund consist principally of securities that are subject to restrictions on
sale because they were acquired from the issuer in "private placement"
transactions or because the Fund is deemed to be an affiliate of the issuer.
Generally,
12
the Fund will not be able to sell these securities publicly without the expense
and time required to register the securities under the Securities Act and
applicable state securities law unless an exemption from such registration
requirements is available. In addition, contractual or practical limitations may
restrict the Fund's ability to liquidate its securities in Portfolio Companies
since in many cases the securities of such companies will be privately held and
the Fund may own a relatively large percentage of the issuer's outstanding
securities. Sales may also be limited by securities market conditions, which may
be unfavorable for sales of securities of particular issuers or issuers in
particular industries. The above limitations on liquidity of the Fund's
securities could preclude or delay any disposition of such securities or reduce
the amount of proceeds that might otherwise be realized.
NEED FOR FOLLOW-ON INVESTMENTS IN PORTFOLIO COMPANIES. After its initial
investment in a Portfolio Company, the Fund may be called upon from time to time
to provide additional funds to such company or have the opportunity to increase
its investment in a successful situation, e.g., the exercise of a warrant to
purchase common stock. There is no assurance that the Fund will make, or have
sufficient funds to make, follow-on investments. Any decision by the Fund not to
make a follow-on investment or any inability on its part to make such an
investment may have a negative impact on a Portfolio Company in need of such an
investment or may result in a missed opportunity for the Fund to increase its
participation in a successful operation and may dilute the Fund's equity
interest in or reduce the expected yield on its investment.
COMPETITION FOR INVESTMENTS. The Fund encounters competition from other
persons or entities with similar investment objectives. These competitors
include leveraged buyout partnerships, other business development companies,
investment partnerships and corporations, small business investment companies,
large industrial and financial companies investing directly or through
affiliates, foreign investors of various types and individuals. Many of these
competitors have greater financial resources and more personnel than the Fund
and may be subject to different and frequently less stringent regulation.
BORROWING. The Fund may borrow funds to make new or follow-on investments,
to maintain its pass-through tax status as a regulated investment company under
Subchapter M of the Code or to pay contingencies and expenses. The Fund is
permitted under the Investment Company Act to borrow funds if, immediately after
the borrowing, it will have an asset coverage of at least 200%. That is, the
Fund may borrow funds in an amount up to 50% of the value of its assets
(including investments made with borrowed funds). The amount and nature of any
Fund borrowings will depend upon a number of factors over which the Fund has no
control, including general economic conditions, conditions in the financial
markets and the impact of the financing on the tax treatment of the
stockholders. The use of leverage, even on a short-term basis, could have the
effect of magnifying increases or decreases in the Fund's net asset value. While
the "spread" between the current yield on the Fund's investments and the cost of
any loan would augment the stockholders' return from the Fund, if the spread
narrows (because of an increase in the cost of debt or insufficient income on
the Fund's investments), distributions to the stockholders would be adversely
affected. If the spread were reversed, the Fund might be unable to meet its
obligations to its lenders, which might then seek to cause the Fund to liquidate
some or all of its investments. There can be no assurance that the Fund would
realize full value for its investments or recoup all of its capital if its
portfolio investments were involuntarily liquidated.
The costs of borrowing money may exceed the income from the portfolio
securities purchased by the Fund with the borrowed money. The Fund will suffer a
decline in net asset value if the investment performance of the additional
securities purchased with borrowed money fails to cover their cost to the Fund
(including any interest paid on the money borrowed). A decline in net asset
value could affect the ability of the Fund to make distributions on its common
stock. Failure by the Fund to distribute a sufficient portion of its net
investment income and net realized capital gains could result in a loss of
pass-
13
through tax status or subject the Fund to a 4% excise tax. See "Tax Matters." If
the asset coverage for debt securities issued by the Fund declines to less than
200% (as a result of market fluctuations or otherwise), the Fund may be required
to sell a portion of its investments when it may be disadvantageous to do so.
Because of the nature and size of its portfolio investments, the Fund
borrows money from time to time to make qualifying investments to maintain its
tax status under the Code. There can be no assurance that debt financing will be
available on terms that the Fund considers to be acceptable and in the best
interests of the Fund. If borrowing is unavailable, the Fund may be required to
make an untimely disposition of an investment or lose its pass-through tax
status. See "Loss of Conduit Tax Treatment" below.
LOSS OF CONDUIT TAX TREATMENT. The Fund may cease to qualify for conduit
tax treatment if it is unable to comply with the diversification requirements
contained in Subchapter M of the Internal Revenue Code. Subchapter M requires
that at the end of each quarter (i) at least 50% of the value of the Fund's
assets must consist of cash, government securities and other securities of any
one issuer that do not represent more than 5% of the value of the Fund's total
assets and 10% of the outstanding voting securities of such issuer, and (ii) no
more than 25% of the value of the Fund's assets may be invested in the
securities of any one issuer (other than United States government securities),
or of two or more issuers that are controlled by the Fund and are engaged in the
same or similar or related trades or businesses. The Fund will borrow funds if
necessary to make qualifying investments to satisfy the foregoing
diversification requirements. If the Fund fails to satisfy such diversification
requirements and ceases to qualify for conduit tax treatment, the Fund will be
subject to income tax on its income and gains and stockholders will be subject
to income tax on distributions. The Fund may also cease to qualify for conduit
tax treatment, or be subject to a 4% excise tax, if it fails to distribute a
sufficient portion of its net investment income and net realized capital gains.
MARKET VALUE AND NET ASSET VALUE. The shares of the Fund's common stock
are listed on the NYSE. Investors desiring liquidity may trade their shares of
Common Stock on the NYSE at current market value, which may differ from the then
current net asset value. Shares of closed-end investment companies frequently
trade at a discount from net asset value. This characteristic of shares of a
closed-end fund is a risk separate and distinct from the risk that the Fund's
net asset value will decrease. The risk of purchasing shares of a closed-end
fund that might trade at a discount is more pronounced for investors who wish to
sell their shares in a relatively short period of time because for those
investors, realization of a gain or loss on their investments is likely to be
more dependent upon the existence of a premium or discount than upon portfolio
performance. The Fund's shares have traded at a discount to net asset value
since they began trading. For information concerning the trading history of the
Fund's shares see "Market for Registrant's Common Stock and Related Stockholder
Matters."
VALUATION OF INVESTMENTS. The Fund's net asset value is based on the value
assigned to its portfolio investments. Investments in companies whose securities
are publicly traded are valued at their quoted market price, less a discount to
reflect the estimated effects of restrictions on the sale of such securities, if
applicable. The Fund adjusts its net asset value for changes in the value of its
publicly held securities on a daily basis. The value of the Fund's investments
in securities for which market quotations are not available is determined as of
the end of each calendar quarter, unless there is a significant event requiring
a change in valuation in the interim. Cost is used to approximate fair value of
such investments until significant developments affecting an investment provide
a basis for use of an appraisal valuation. Thereafter, such portfolio
investments are carried at appraised values as determined quarterly. Because of
the inherent uncertainty of the valuation of portfolio securities which do not
have readily ascertainable market values, the Fund's estimate of fair value may
significantly differ from the fair value that would have been used had a ready
market existed for the securities. At December 31, 2000, approximately 96%
14
of the Fund's fair value of portfolio securities were invested in securities for
which market quotations were not readily available. See "Valuation".
POSSIBLE VOLATILITY OF STOCK PRICE. The market price of the Fund's common
stock could be subject to significant fluctuations in response to variations in
the net asset value of the Fund, its quarterly operating results, and other
factors. The market price of the common stock may be significantly affected by
such factors as the announcement of new or follow-on investments in portfolio
companies, the sale or proposed sale of a portfolio investment, the results of
operations or fluctuations in the market prices or appraised value of one or
more of the Fund's portfolio companies, changes in earnings estimates by market
analysts, speculation in the press or analyst community and general market
conditions or market conditions specific to particular industries. From time to
time in recent years, the securities markets have experienced significant price
and volume fluctuations that have often been unrelated or disproportionate to
the operating performance of particular companies. These broad fluctuations may
adversely affect the market price of the common stock. In addition, the Fund is
subject to the risk of the securities markets in which the portfolio securities
of the Fund are traded. Securities markets are cyclical and the prices of the
securities traded in such markets rise and fall at various times. These cyclical
periods may extend over significant periods of time.
REGULATION
The Investment Advisers Act generally prohibits investment advisers from
entering into investment advisory contracts with an investment company that
provides for compensation to the investment adviser on the basis of a share of
capital gains or capital appreciation of the portfolio investments or any
portion of the funds of the investment company or pursuant to a stock option
plan. The Investment Advisers Act, however, does permit the payment of
compensation based on capital gains or the issuance of incentive stock options
to management in an investment advisory contract between an investment adviser
and a business development company. The Fund has elected to be treated as a
business development company under the Investment Company Act. Accordingly, it
has provided for incentive compensation to the Management Company based on an
incentive stock option plan established in 1997.
The Fund may not withdraw its election to be treated as a business
development company without first obtaining the approval of a majority in
interest of its shareholders. The following brief description of the Investment
Company Act is qualified in its entirety by reference to the full text of the
Investment Company Act and the rules thereunder.
A business development company must be operated for the purpose of
investing in the securities of certain present and former "eligible portfolio
companies" or certain bankrupt or insolvent companies and must make available
significant managerial assistance to portfolio companies. An eligible portfolio
company generally is a company that (i) is organized under the laws of, and has
its principal place of business in, any state or states, (ii) is not an
investment company and (iii)(a) does not have a class of securities registered
on an exchange or included in the Federal Reserve Board's over-the-counter
margin list, (b) is actively controlled by the business development company
acting either alone or as part of a group acting together and an affiliate of
the business development company is a member of the portfolio company's board of
directors or (c) meets such other criteria as may be established by the SEC.
Control is presumed to exist where the business development company owns more
than 25% of the outstanding voting securities of a portfolio company.
"Making available significant managerial assistance" is defined under the
Investment Company Act to mean (i) any arrangement whereby a business
development company, through its directors, officers or employees, offers to
provide and, if accepted, does provide significant guidance and counsel
15
concerning the management, operations or business objectives or policies of a
portfolio company or (ii) the exercise of a controlling influence over the
management or policies of a portfolio company by the business development
company acting individually or as part of a group of which the business
development company is a member acting together which controls such company
("Managed Company"). A business development company may satisfy the requirements
of clause (i) with respect to a portfolio company by purchasing securities of
such a company as part of a group of investors acting together if one person in
such group provides the type of assistance described in such clause. However,
the business development company will not satisfy the general requirement of
making available significant managerial assistance if it only provides such
assistance indirectly through an investor group. A business development company
need only extend significant managerial assistance with respect to portfolio
companies which are treated as Qualifying Assets (as defined below) for the
purpose of satisfying the 70% test discussed below.
The Investment Company Act prohibits or restricts the Fund from investing
in certain types of companies, such as brokerage firms, insurance companies,
investment banking firms and investment companies. Moreover, the Investment
Company Act limits the type of assets that the Fund may acquire to "Qualifying
Assets" and certain assets necessary for its operations (such as office
furniture, equipment and facilities) if, at the time of the acquisition, less
than 70% of the value of the Fund's total assets consists of qualifying assets.
Qualifying Assets include (i) securities of companies that were eligible
portfolio companies at the time that the Fund acquired their securities; (ii)
securities of companies that are actively controlled by the Fund; (iii)
securities of bankrupt or insolvent companies that are not otherwise eligible
portfolio companies; (iv) securities acquired as follow-on investments in
companies that were eligible portfolio companies at the time of the Fund's
initial acquisition of their securities but are no longer eligible portfolio
companies, provided that the Fund has maintained a substantial portion of its
initial investment in such companies; (v) securities received in exchange for or
distributed on or with respect to any of the foregoing; and (vi) cash items,
government securities and high-quality, short-term debt. The Investment Company
Act also places restrictions on the nature of the transactions in which, and the
persons from whom, securities can be purchased in order for such securities to
be considered Qualifying Assets. As a general matter, Qualifying Assets may only
be purchased from the issuer or an affiliate in a transaction not constituting a
public offering. The Fund may not purchase any security on margin, except such
short-term credits as are necessary for the clearance of portfolio transactions,
or engage in short sales of securities.
The Fund is permitted by the Investment Company Act, under specified
conditions, to issue multiple classes of senior debt and a single class of
preferred stock senior to the common stock if its asset coverage, as defined in
the Investment Company Act, is at least 200% after the issuance of the debt or
the senior stockholders' interests. In addition, provisions must be made to
prohibit any distribution to common shareholders or the repurchase of any shares
unless the asset coverage ratio is at least 200% at the time of the distribution
or repurchase.
The Fund generally may sell its securities at a price that is below the
prevailing net asset value per share only upon the approval of the policy by
shareholders holding a majority of the shares issued by the Fund, including a
majority of shares held by nonaffiliated shareholders. The Fund may, in
accordance with certain conditions established by the SEC, sell shares below net
asset value in connection with the distribution of rights to all of its
stockholders. The Fund may also issue shares at less than net asset value in
payment of dividends to existing shareholders.
Since the Fund is a closed-end business development company, stockholders
have no right to present their shares to the Fund for redemption. Recognizing
the possibility that the Fund's shares might trade at a discount, the Board of
Directors of the Fund has determined that it would be in the best interest of
stockholders for the Fund to be authorized to attempt to reduce or eliminate a
market value discount
16
from net asset value. Accordingly, the Fund from time to time may, but is not
required to, repurchase its shares (including by means of tender offers) to
attempt to reduce or eliminate any discount or to increase the net asset value
of its shares, or both.
The Fund may repurchase its shares, subject to the restrictions of the
Investment Company Act. During 2000, the Fund completed the 300,000 share
repurchase program begun in 1999 by repurchasing 191,127 shares for $1,976,152.
The 300,000 shares were repurchased for a total of $3,187,450 at an average
discount of 34.2% from net asset value. On May 11, 2000 the Fund announced
another repurchase program pursuant to which the Fund repurchased 241,800 shares
of common stock in open market transactions for $2,542,735. The 241,800 shares
were repurchased at an average discount of 36.4% from net asset value.
Many of the transactions involving the Fund and its affiliates (as well as
affiliates of such affiliates) require the prior approval of a majority of the
Independent Directors and a majority of the Independent Directors having no
financial interest in the transactions. However, certain transactions involving
closely affiliated persons of the Fund, including the Management Company,
require the prior approval of the SEC. In general (a) any person who owns,
controls or holds with power to vote more than 5% of the outstanding shares, (b)
any director or executive officer and (c) any person who directly or indirectly
controls, is controlled by or is under common control with such person, must
obtain the prior approval of a majority of the Independent Directors and, in
some situations, the prior approval of the SEC, before engaging in certain
transactions involving the Fund or any company controlled by the Fund. In
accordance with the Investment Company Act, a majority of the directors must be
persons who are not "interested persons" as defined in such act. Except for
certain transactions which must be approved by the Independent Directors, the
Investment Company Act generally does not restrict transactions between the Fund
and its Portfolio Companies.
ITEM 2. PROPERTIES.
The Fund does not have an interest in any physical properties.
ITEM 3. LEGAL PROCEEDINGS.
The Fund, its affiliates and certain of the Portfolio Companies are
involved in asserted claims and have the possibility for unasserted claims which
may ultimately affect the net asset value of the Fund or the fair value of the
Fund's portfolio investments.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS.
No matters were submitted to a vote of security holders during the fourth
quarter of 2000.
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER
MATTERS.
The Fund's shares of common stock began to trade on the New York Stock
Exchange on May 13, 1998, under the symbol "EQS". Prior to May 13, 1998, the
Fund's shares traded on the American Stock Exchange under the same symbol. The
Fund had approximately 6,800 shareholders at December 31, 2000, 1,500 of which
were registered holders. Registered holders do not include those shareholders
whose stock has been issued in street name. The net asset value per share of the
Fund's common stock at December 31, 2000, was $15.40.
The following table reflects the high and low sales prices per share of
the Fund's common stock on the New York Stock Exchange for the two years ended
December 31, 2000, by quarter.
17
QUARTER
ENDED HIGH LOW
-------- -------- --------
03/31/99 $ 16.625 $ 14.063
06/30/99 $ 16.250 $ 14.188
09/30/99 $ 16.750 $ 14.875
12/13/99 $ 16.312 $ 10.125
03/31/00 $ 10.625 $ 9.813
06/30/00 $ 10.688 $ 9.938
09/30/00 $ 10.688 $ 10.313
12/31/00 $ 10.688 $ 8.500
As a regulated investment company under Subchapter M of the Code, the Fund
is required to distribute to its shareholders, in a timely manner, at least 90%
of its taxable net investment income each year. If the Fund distributes, in a
timely manner, 98% of its taxable net capital gains and 98% of its taxable net
investment income each year (as well as any portion of the respective 2%
balances not distributed in the previous year), it will not be subject to the 4%
non-deductible federal excise tax on certain undistributed income of regulated
investment companies. Under the Investment Company Act, the Fund is not
permitted to pay dividends to shareholders unless it meets certain asset
coverage requirements.
Historically, net investment income and net realized gains from the sale
of portfolio investments have been distributed at least annually. The Fund
declared dividends of $3,843,842 ($0.60 per share), $23,814,714 ($4.25 per
share) and $3,138,520 ($0.65 per share) during 2000, 1999 and 1998,
respectively. The Fund has adopted a policy to make dividend distributions of at
least $0.60 per share on an annual basis. In the event that taxable income,
including realized capital gains, exceeds $0.60 per share in any year,
additional dividends may be declared to distribute such excess. The 2000, 1999
and 1998 dividends were paid in additional shares of common stock or in cash by
specific election of each shareholder in December 2000, 1999 and 1998,
respectively. The 2000 dividend represented long-term capital gains carried over
from 1999, ordinary income and was primarily a return of capital. The 1999 and
1998 dividends represented long-term capital gains. The Fund paid $1,482,244,
$9,511,374 and $991,853 in cash and issued 268,173, 1,337,542 and 125,812,
additional shares of stock at $8.80625, $10.69375 and $17.0625 per share in
December 2000, 1999 and 1998 respectively, in connection with such dividends. In
2000 and 1999, the Fund recorded non-cash compensation expense for the dividends
paid on stock held by the officers of $388,663 and $2,085,766, respectively, in
accordance with generally accepted accounting principles ("GAAP"). See footnote
10 for discussion related to GAAP requirements.
The Fund is investing in companies that it believes have a high potential
for capital appreciation, and the Fund intends to realize the majority of its
profits upon the sale of its investments in Portfolio Companies. Consequently,
most of the companies in which the Fund invests do not have established policies
of paying annual dividends.
A portion of the investments in portfolio securities held by the Fund is
comprised of interest-bearing subordinated debt securities or dividend-paying
preferred stock. The Fund will continue to distribute taxable net investment
income earned on these investments from time to time, to the extent not retained
for follow-on investments, expenses and contingencies. If taxable net investment
income is retained, the Fund will be subject to federal income tax.
The Fund reserves 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
18
be taxable to the Fund as long-term capital gains and shareholders will be able
to claim their proportionate share of the federal income taxes paid by the Fund
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.
19
ITEM 6. SELECTED FINANCIAL DATA.
Following is a summary of selected financial data and per share data of
the Fund and its predecessors for the five years ended December 31, 2000.
Amounts are in thousands except per share data.
2000 1999 1998 1997 1996
------------ ------------ ------------ ------------ ------------
Total investment income ................ $ 5,117 $ 5,157 $ 3,774 $ 4,013 $ 2,590
Net investment income (loss) ........... $ 549 $ (2,177) $ (2,179) $ (922) $ (8,267)
Realized gain (loss) on dispositions
of portfolio securities, net ........ $ (6,161) $ 40,353 $ (3,564) $ 7,566 $ 4,037
Increase (decrease) in
unrealized appreciation of
portfolio securities, net ........... $ 282 $ (45,412) $ (21,581) $ 24,222 $ 33,696
Total increase (decrease) in
net assets from operations .......... $ (5,329) $ (7,237) $ (27,324) $ 30,865 $ 29,467
Dividends .............................. $ 3,844 $ 23,815 $ 3,139 $ 2,380 $ 3,180
Total assets at end of year ............ $ 176,018 $ 175,022 $ 215,603 $ 228,095 $ 181,166
Net assets at end of year .............. $ 90,925 $ 101,419 $ 116,155 $ 144,471 $ 103,223
Net cash used by operating
activities .......................... $ (2,191) $ (3,303) $ (4,298) $ (1,043) $ (2,494)
Shares outstanding at end
of year ............................. 5,903 6,108 4,954 4,828 4,301
Average shares outstanding
during year ......................... 5,870 4,950 4,829 4,733 3,819
PER SHARE DATA:
2000 1999 1998 1997 1996
------------ ------------ ------------ ------------ ------------
Net investment income (loss) ........... $ 0.09 $ (0.44) $ (0.45) $ (0.19) $ (2.16)
Realized gain (loss) on dispositions
of portfolio securities, net ........ $ (1.05) $ 8.15 $ (0.74) $ 1.60 $ 1.06
Increase (decrease) in
unrealized appreciation of
portfolio securities, net ........... $ 0.05 $ (9.17) $ (4.47) $ 5.11 $ 8.82
Dividends .............................. $ 0.60 $ 4.25 $ 0.65 $ 0.50 $ 0.76
Net asset value (including
unrealized appreciation),
end of year ......................... $ 15.40 $ 16.61 $ 23.45 $ 29.92 $ 24.00
20
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS.
LIQUIDITY AND CAPITAL RESOURCES
At December 31, 2000, the Fund had $94,117,912 of its assets invested in
portfolio securities of 27 companies, and has committed to invest up to an
additional $8,968,500 in six of such companies and up to $6,120,000 in two new
companies. Current temporary cash investments, anticipated future investment
income, proceeds from borrowings, and proceeds from the sale of existing
portfolio securities are believed to be sufficient to finance these commitments.
At December 31, 2000, the Fund had $7,300,000 outstanding on a $32,500,000
revolving line of credit loan from a bank.
Net cash used by operating activities was $2,191,287, $3,302,678 and
$4,298,452 for the three years ended December 31, 2000, respectively.
At December 31, 2000, the Fund had $77,041,332 of its total assets of
$176,017,567 invested in temporary cash investments consisting of money market
securities. This amount includes proceeds of $77,000,000 from a $100,000,000
note payable to a bank that is utilized to enable the Fund to achieve adequate
diversification to maintain its pass-through tax status as a regulated
investment company. Such amount was repaid to the bank on January 2, 2001.
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 investment income and net 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 contingencies or to
make follow-on or new investments. Management believes that the availability
under its line of credit, as well as the ability to sell its investments in
publicly traded securities, are adequate to provide payment for any expenses and
contingencies of the Fund.
The Fund reserves 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 by the Fund 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.
The Fund may repurchase its shares, subject to the restrictions of the
Investment Company Act. During 2000, the Fund completed the 300,000 share
repurchase program begun in 1999 by repurchasing 191,127 shares for $1,976,152.
The 300,000 shares were repurchased for $3,187,450 at an average discount of
34.2% from net asset value. On May 11, 2000, the Fund announced another
repurchase program, pursuant to which the Fund repurchased 241,800 shares of
common stock in open market transactions for $2,542,735. The 241,800 shares were
repurchased at an average discount of 36.4% from net asset value.
RESULTS OF OPERATIONS
INVESTMENT INCOME AND EXPENSE
Net investment income (loss) after all expenses amounted to $549,448,
$(2,177,164) and $(2,178,659) for the three years ended December 31, 2000.
Income from portfolio securities was $4,629,928 in 2000, $5,060,617 in 1999 and
$3,726,430 in 1998. Amounts invested in interest- and
21
dividend-bearing portfolio securities were higher during 2000 and 1999 as
compared to 1998. Interest from temporary cash investments was $141,427 in 2000,
$57,908 in 1999 and $48,004 in 1998. The increase in 2000 as compared to 1999
and 1998 was a result of higher investable balances throughout the year.
Generally accepted accounting principles require that the options issued to
officers be accounted for using the variable plan accounting due to the limited
recourse provision of such notes. Therefore, interest recorded on the
non-recourse portion of the notes is required to be recorded as an increase in
additional paid-in capital. Interest income on notes receivable from officers
was $101,318 in 2000 and $38,405 in 1999. The increase in 2000 as compared to
1999 is due to interest being accrued for a full year in 2000 as compared to
only one quarter in 1999. The percentage used to calculate the compensation
expense for the non-recourse portion of the interest has increased to 82% in
2000 as compared to 75% in 1999 as a result of payments made on the notes. The
notes receivable from the officers of the Fund were received on September 30,
1999 as payment for common stock issued upon exercise of stock options pursuant
to the Stock Incentive Plan discussed below.
The net investment income in 2000 as compared to the net investment loss
in 1999 and 1998 was primarily attributable to a decrease in interest expense
and compensation expense in 2000. Interest expense was $1,508,788 in 2000 as
compared to $2,163,593 in 1999 and $1,970,973 in 1998 due to changes in the
average daily balances outstanding on the lines of credit to $18,950,064 in
2000, from $26,855,068 in 1999 and $23,469,957 in 1998. In addition, due to the
limited recourse provision of the notes receivable from the officers issued in
2000 and 1999, generally accepted accounting principles require that any
dividends paid on the non-recourse portion of the notes be treated as non-cash
compensation expense in the statement of operations. Accordingly, the Fund
recorded non-cash compensation expense of $388,663 and $2,085,766 related to its
dividend in 2000 and 1999, respectively. The decrease in 2000 as compared to
1999 was a result of a $0.60 dividend per share in 2000 as compared to a $4.25
dividend per share in 1999. The amount of the compensation expense was also
recorded as an increase in additional paid in capital, and therefore had no
effect on the Fund's net asset value.
Mailing, printing and other expenses were $172,339 during 2000, as
compared to $214,947 during 1999 and $383,644 during 1998. The reduction in 2000
and 1999 expenses as compared to 1998 is due to the lower cost for the
preparation and distribution of the annual report and proxy statement for the
annual shareholders' meeting held in May 2000 and to be held in May 2001.
Professional fees decreased to $167,785 during 2000 as compared to
$279,141 during 1999 and $490,954 during 1998. The decrease in 2000 compared to
1999 is due primarily to a reduction in fees paid to an investor relations
consulting firm and a refund of legal fees in the amount of $34,998 received
related to Paracelsus Healthcare Corporation shareholder litigation. The
decrease in 1999 compared to 1998 is due primarily to the higher costs
associated with the New York Stock Exchange listing in 1998.
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 $1,911,275, $2,179,413 and $2,706,325 during 2000, 1999 and 1998,
respectively. The lower amounts during the year ended December 31, 2000 and 1999
were due to the decrease in net assets during the years.
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 also
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 2,000 shares of the Fund's common stock. On May 10, 2000, options to
acquire a total of 12,000 shares at $9.94 per share were issued to the
directors. During 1999, two directors each exercised 1,000 of their options to
acquire
22
a total of 2,000 shares for $15.5625 per share.
Under the Stock Incentive Plan, options to purchase 306,773 and 294,773
shares of the Fund's common stock with a weighted average exercise price of
$18.71 and $19.07 per share were outstanding at December 31, 2000 and 1999,
respectively. Of these options, 261,970 and 91,150 shares, with a weighted
average exercise price per share of $18.96 and $22.33, were exercisable at
December 31, 2000 and 1999, respectively. Outstanding options at December 31,
2000 have exercise prices ranging from $9.94 to $27.44 and expire in May 2007
through May 2010. On September 30, 1999, options to purchase 654,358 shares of
common stock of the Fund were exercised by the officers of the Fund for $17 per
share. The exercise price of $11,124,086 was paid in the form of promissory
notes from the officers to the Fund. The notes bear interest at 5.42% per annum,
have limited recourse and are due on or before September 30, 2008. The notes are
secured by the 654,358 shares, including any proceeds or dividends paid thereon.
During 2000 and 1999, a dividend of $0.60 and $4.25 per share was paid,
respectively. As a result of these dividends in 2000 and 1999, 42,723 and
135,608 additional shares, respectively, were issued to the officers and pledged
to the Fund. In addition, principal payments of $991,161, representing 58,304
shares, were made on the notes in 1999. As a result of the additional shares
issued and payments made, the notes are secured by 832,689 and 789,966 shares of
common stock and the outstanding balance on the notes was $10,132,925 at
December 31, 2000 and 1999, respectively.
The notes receivable, as well as 771,927 and 731,662 of such shares of
common stock, are not included in the Fund's reported net asset value per share
at 2000 and 1999, respectively. The shares of stock financed by the notes from
the officers will be included in the net asset value per share as the shares are
paid for or released from collateral. The pledged shares included in the
calculation of net asset value is determined based on the percentage of the
officers' notes paid multiplied by the shares pledged. Pledged shares included
in the calculation of net asset value included 60,762 and 58,304 shares at
December 31, 2000 and 1999, respectively. Shares may be released as payments on
the notes are made or as the value of the collateral increases. Generally
accepted accounting principles require that the options issued to the officers
be accounted for using variable plan accounting due to the limited recourse
provision of such notes. Additionally, the dividends paid on the common stock
pledged on the non-recourse portion of the notes are required to be recorded as
compensation expense in the statements of operations, and interest recorded on
the non-recourse portion of the notes is required to be recorded as an increase
to additional paid-in capital. Accordingly, for the years ended December 31,
2000 and 1999, dividends of $388,663 and $2,085,766 were recorded as non-cash
compensation expense and interest of $447,887 and $115,217 was credited to
additional paid-in capital. Additionally, the limited recourse notes receivable
from the officers are required to be recorded as a reduction of net assets. If
the notes and the shares were included in the Fund's balance sheet, the net
asset value would have been $15.14 and $16.31 per share at December 31, 2000 and
1999, respectively.
As of December 31, 2000 and 1999, all outstanding options were "out of the
money" and would not have had a dilutive effect on net assets per share if
exercised, assuming the Fund would use the proceeds from the exercise of such
options to repurchase shares at the market price pursuant to the treasury stock
method.
REALIZED GAINS AND LOSSES ON DISPOSITIONS OF PORTFOLIO SECURITIES
During the year ended December 31, 2000, the Fund realized net capital
losses of $6,160,547 from the sale or write-off of securities of Portfolio
Companies as follows:
o sold 900,000 shares of Allied Waste Industries, Inc. for $11,656,249,
realizing a capital gain of $8,534,684;
23
o sold 1,703,200 shares of Drypers Corporation for $83,294, realizing a
capital loss of $7,270,556;
o sold 173,868 shares of Paracelsus Healthcare Corporation for $4,460,
realizing a capital loss of $974,839;
o sold 255,103 shares of LG&E Energy Corporation for $6,193,867, realizing a
capital gain of $1,911,944;
o a receivable from Restaurant Development Group was written-off, realizing
a capital loss of $8,315;
o the preferred stock of Hot & Cool Holdings, Inc. was sold for $1,
realizing a capital loss of $1,086,631;
o the remaining shares of Drypers Corporation were written-off, realizing a
capital loss of $1,974,706, and
o the preferred & common stock of The Drilltec Corporation was written-off,
realizing a capital loss of $7,645,000.
In addition, additional compensation related to the previous sale of three
Portfolio Companies was received. The Fund realized a capital gain of $680,636
as a result of additional compensation from the escrow account related to the
1998 sale of WMW Industries. The Fund realized a capital gain of $683,697 as a
result of additional compensation from the escrow account related to the 1999
sale of HTD Corporation. Also, during the year, the Fund received proceeds from
Video Rental of Pennsylvania, Inc. in the amount of $3,722,349 for repayment of
the outstanding notes payable and $250,000 for redemption of the common and
preferred stock and did not realize a capital gain. The Fund also received
proceeds from the liquidation of Equus Video Corporation and realized a capital
loss of $5,919. The Fund also received $3,500,000 from Champion Window, Inc. in
payment of a 12% subordinated promissory note, which did not result in a capital
gain or loss. Also, as a result of the earnout related to the sale of CRC
Holdings Corp. in 1999, the Fund received cash of $994,458 and 17,739 shares of
LGE and realized the $994,458 as a capital gain.
During the year ended December 31, 1999, the Fund realized a net capital
gain of $40,352,644 from the sale of securities of Portfolio Companies as
follows:
o sold 54,334 shares of United Rentals, Inc. for $1,738,036, realizing a
capital gain of $1,737,639;
o sold 135,472 common shares of United States Filter Corporation for
$3,884,978, realizing a capital gain of $2,324,700;
o sold 100,000 shares of Allied Waste Industries, Inc. common stock for
$1,832,122, realizing a capital gain of $1,357,966;
o sold 1,125,000 shares of American Residential Services, Inc. for
$6,468,750, realizing a capital gain of $3,468,478;
o sold 149,337 shares of Travis International, Inc. for $6,668,987,
realizing a capital gain of $6,114,095;
o sold its investments in HTD Corporation for $12,877,114, realizing a
capital gain of $3,341,547;
o sold its investment in CRC Holdings, Corp., realizing a capital gain of
$12,128,572;
o sold its investment in Carruth-Doggett Industries, Inc. for $7,309,250,
realizing a capital gain of $5,059,250;
o sold its investment in CDI Rental Services Inc. for $2,103,250, realizing
a capital gain of
24
$103,250; and
o sold 474,942 shares of Garden Ridge Corporation for $5,461,833, resulting
in a capital gain of $4,776,803.
During 1999, the Fund sold CRC Holdings to LG&E Corp. ("LGE") and received
$12,128,572 in cash and 121,504 shares of LGE common stock. An additional
115,860 shares of LGE stock were held in escrow to secure contractual
representations and warranties. In addition, LGE was obligated to pay up to an
additional $11.7 million to the Fund if the CRC business sold to LGE achieves
certain annual levels of financial performance through March 31, 2002.
The Fund also realized a capital gain as a result of the receipt of
$654,570 in additional compensation from the escrow account related to the 1998
sale of WMW Industries. In addition, Atlas Acquisition paid $128,298 in
principal on its outstanding junior participation note and the Fund realized a
loss of $721,702 on the remaining balance of the note. The Fund also realized a
capital gain as a result of the receipt of $7,536, as payment on preferred stock
of Springtime, Inc., which had been previously written off as having no value.
In addition, a capital loss of $60 was realized on the write-off of CDR Fleet
Services as a result of the CDI Rental Services and Carruth-Doggett Industries,
Inc. sale.
During the year ended December 31, 1998, the Fund realized a net capital
loss of $3,563,556 from the sale or write-off of securities of eleven Portfolio
Companies as follows:
o sold 143,112 shares of Coach USA, Inc. common stock for $6,620,305,
realizing a capital gain of $4,756,948;
o sold 32,128 shares of United States Filter Corporation common stock for
$1,059,964, realizing a capital gain of $679,111;
o sold 225,000 shares of Allied Waste Industries, Inc. for $4,710,866,
realizing a capital gain of $3,644,015;
o its investment in Atlas Acquisition, Inc. was written off, realizing a
capital loss of $2,000,000;
o its investment in Brazos Sportswear, Inc. was written off, realizing a
capital loss of $8,235,367; and
o its investment in Restaurant Development Group was liquidated, realizing a
capital loss of $2,089,432.
In addition, the Fund realized a capital gain due to the receipt of $6,825
in additional compensation from the escrow account related to the 1997 sale of
Cardiovascular Ventures, Inc. The Fund realized a capital loss of $735,525 on
the conversion of its prime + 1% note due from Triad Medical Inc. into a
non-interest bearing loan due in 2005. The value of the note was discounted by
$735,525, representing original issue discount that will be accreted to income
over the life of the loan. The Fund also realized a loss of $212,980 from the
reduction in the value of the royalty receivable due from United Rentals, Inc.
related to the 1997 sale of J&J Rental Services, Inc. The Fund realized a
capital gain due to the receipt of additional proceeds of $575,708 related to
the 1997 sale of the Fund's investment in Industrial Equipment Rentals, Inc. The
Fund also realized a capital gain due to the receipt of $47,141 as payment on
preferred stock of Springtime, Inc., which had been previously written off as
having no value.
UNREALIZED APPRECIATION AND DEPRECIATION OF PORTFOLIO SECURITIES
Net unrealized depreciation decreased by $281,625 during the year ended
December 31, 2000,
25
from $1,100,588 to $818,963. Such net decrease resulted from an increase in
estimated fair value of securities of eight of the Fund's Portfolio Companies of
$11,678,434, a decrease in estimated fair value of securities of nine of the
Fund's Portfolio Securities of $15,789,610 and the transfer of $4,392,801 in net
unrealized depreciation to net realized losses from the sale of disposition of
investments in eight Portfolio Companies.
Net unrealized appreciation on investments decreased $45,412,285 during
the year ended December 31, 1999, from unrealized appreciation of $44,311,697 to
unrealized depreciation of $1,100,588. Such net decrease resulted from decreases
in the estimated fair value of securities of nine of the Fund's Portfolio
Companies aggregating $24,818,186, an increase in the estimated fair value of
securities of seven of the Fund's Portfolio Companies of $9,528,986 and the
transfer of $30,123,085 in net unrealized appreciation to net realized gains
from the sale or disposition of investments in ten Portfolio Companies. The
significant increase in net unrealized depreciation in 1999 as compared to 1998
was primarily attributable to the transfer of unrealized appreciation resulting
from the sales of CRC Holdings, Inc. and Travis International, Inc. and the
decline in stock prices of the Fund's publicly-traded securities.
Net unrealized appreciation on investments decreased $21,581,656 during
the year ended December 31, 1998, from $65,893,353 to $44,311,697. Such net
decrease resulted from decreases in the estimated fair value of securities of
eight of the Fund's Portfolio Companies aggregating $35,408,412, an increase in
the estimated fair value of securities of twelve portfolio companies of
$30,539,019, and the transfer of $5,504,231 and $11,208,032 in net unrealized
appreciation to net realized losses from the sale of investments in three
companies and the write off of investments in two companies, respectively. The
significant decrease in net unrealized appreciation in 1998 as compared to 1997
is primarily attributable to the decline in stock price of the Fund's
publicly-traded securities, the write down of investments in two other portfolio
companies providing equipment and services to the oil and gas industry and the
write off of investments in two other portfolio companies.
DIVIDENDS
The Fund declared dividends of $3,843,842 ($0.60 per share), $23,814,714
($4.25 per share) and $3,138,520 ($0.65 per share) during 2000, 1999 and 1998,
respectively. The Fund has adopted a policy to make dividend distributions of at
least $0.60 per share on an annual basis. In the event that taxable income,
including realized capital gains, exceeds $0.60 per share in any year,
additional dividends may be declared to distribute such excess. The 2000, 1999
and 1998 dividends were paid in additional shares of common stock or in cash by
specific election of each shareholder in December 2000, 1999 and 1998,
respectively. The 2000 dividend represented long-term capital gains carried over
from 1999, ordinary income and was primarily a return of capital. The 1999 and
1998 dividend represented long-term capital gains. The Fund paid $1,482,244,
$9,511,374 and $991,853 in cash and issued 268,173, 1,337,542 and 125,812
additional shares of stock at $8.80625, $10.69375 and $17.0625 per share, in
December 2000, 1999 and 1998, respectively, in connection with such dividends.
In 2000 and 1999, the Fund recorded non-cash compensation expense for the
dividends paid on stock held by officers of $388,663 and $2,085,766,
respectively, in accordance with GAAP.
PORTFOLIO INVESTMENTS
During the year ended December 31, 2000, the Fund invested $7,435,001 in
four new companies and made follow-on investments of $4,968,405 in ten portfolio
companies. These follow-on investments include $1,209,344 in accrued interest
and dividends received in the form of additional portfolio securities and
accretion of original issue discount on a promissory note.
26
During 2000, the Fund advanced $476,000 to The Drilltec Corporation
pursuant to a prime plus 9.75% promissory note, $571,496 to Equicom, Inc.
pursuant to a 10% promissory note, $500,000 to Hot & Cool Holdings, Inc.
pursuant to a 12% promissory note and $585,000 to United Industrial Services,
Inc. pursuant to a 15% promissory note.
During the year ended December 31, 2000, the Fund received an additional
4,593 and 1,363 shares of preferred stock of Container Acquisition, Inc. and
Sovereign Business Forms, Inc ("Sovereign") in payment of $459,300 and $136,300
in dividends, respectively. In addition, Sovereign elected to convert $493,744
of accrued interest into the balance of the 15% promissory note due to the Fund.
On February 28, 2000, the Fund invested an additional $726,565 in
Summit/DPC Partners to allow the partnership to purchase additional shares of
Doane Pet Care Enterprises, Inc. common stock
On March 15, 2000, the Fund committed to invest up to $3,000,000 in
Sternhill Partners I, L.P., a venture capital fund formed to invest in private,
early-stage, emerging-growth companies involved in information technology and,
on limited occasions, life science technologies. The Fund's investment consists
of a 3% limited partnership interest. Through December 31, 2000, $900,000 of
such commitment had been funded.
During the year ended December 31, 2000, the original issue discount
accretion on the discounted $4,000,000, 12% subordinated promissory note due
from Turfgrass America, Inc. ("Turfgrass") amounted to $120,000, bringing the
balance of the note to $3,595,000 at December 31, 2000. The original issue
discount is being accreted over the life of the note.
In March of 2000, the Fund committed to invest up to $3,000,000 in
Vanguard VII, L.P., a venture capital fund formed to invest in seed and early
stage communications, internet and life sciences technology companies. The
Fund's investment consists of a 1.3% limited partnership interest. Through
December 31, 2000, $600,000 of such commitment had been funded.
During May 2000, the Fund invested $1,335,001 in the Bradshaw Group, a
company that provides innovative printing solutions primarily for customers in
need of high speed mass printings. The Fund's investment consists of 1,335,000
shares of preferred stock and a warrant to acquire 2,229,450 shares of common
stock at $0.01 per share through May 2008.
During June 2000, the Fund invested $5,500,000 in FS Strategies, Inc., a
company formed to acquire the stock of Talent Tree Acquisition Corporation
(formerly Initial Staffing Services) and EESIS, Inc. ("EESIS"). Talent Tree
provides temporary staffing and permanent placement services. EESIS is a web
based human resources solutions provider. The Fund's investment consists of
110,000 shares of common stock.
During the year ended December 31, 1999, the Fund invested $20,638,398 in
six new companies and made follow-on investments of $10,591,965 in eleven
portfolio companies. These follow-on investments include $1,388,132 in accrued
interest and dividends received in the form of additional portfolio securities
and accretion of original issue discount on a promissory note. The Fund also
received note payments and proceeds from the sale of portfolio securities of
$4,933,338 in the form of additional portfolio securities.
During the year ended December 31, 1998, the Fund invested $13,645,100 in
three new companies and made follow-on investments of $33,087,284 in eleven
portfolio companies, including $1,998,989 in dividends and accrued interest
received in the form of additional portfolio securities and accretion of
original issue discount on a promissory note.
27
For a description of the business of each Portfolio Company in which the
Fund has invested, see "Current Portfolio Companies".
Of the companies in which the Fund has investments at December 31, 2000,
only NCS, PLHC, RTEL and The ServiceMaster Company ("SVM") are publicly held.
The others each have a small number of shareholders and do not generally make
financial information available to the public. However, each company's
operations and financial information are reviewed by Management to determine the
proper valuation of the Fund's investment. See "Valuation".
SUBSEQUENT EVENTS
Subsequent to December 31, 2000, the Fund repaid a net $75,600,000 of
notes payable to the bank.
On February 6, 2001, the Board of Directors of the Fund authorized the
repurchase of up to 5% of the outstanding common stock of the Fund, from time to
time in open market transactions.
On February 7, 2001, the Fund invested an additional $300,000 in Sternhill
Partners I, L.P.
On February 9, 2001, the Fund invested $1,116,550 in American Trenchless
Technology, LLC ("American Trenchless") in exchange for 100,000 units of Series
A preferred stock and 1,934,532 units of common stock. American Trenchless
provides underground boring and tunneling services to its customers.
On February 9, 2001, the Fund invested $3,686 in Reliant Window Holding,
LLC ("Reliant") and received 36.86% membership interest in Reliant. In addition,
the Fund committed to invest up to $5,000,000 in Reliant under certain
circumstances. Reliant was formed to invest in Reliant Building Products, Inc.,
which manufactures, distributes and installs aluminum and vinyl residential
windows.
On February 28, 2001, the Fund sold its investment in Stephen L. LaFrance
Holdings, Inc. for $10,000,000, realizing a capital gain of $7,501,548.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK
The Fund is subject to financial market risks, including changes in
interest rates with respect to its investments in debt securities and its
outstanding debt payable, as well as changes in marketable equity security
prices. The Fund does not use derivative financial instruments to mitigate any
of these risks. The return on the Fund's investments is generally not affected
by foreign currency fluctuations.
The Fund's investment in portfolio securities consists 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 the
Fund's determination of fair value of these debt securities. The Fund's debt
securities are generally held to maturity and their fair values are determined
on the basis of the terms of the debt security and the financial condition of
the issuer.
Borrowings under the Fund's $32.5 million line of credit expose the Fund
to certain market risks. Based on the average outstanding borrowings under the
line of credit for the year ended December 31, 2000 of approximately
$17,150,000, a change of one percent in the interest rate would have caused a
change in interest expense of approximately $171,500. This change would have
resulted in a change of $0.03 in the net asset value per share. The Fund did not
enter into its credit facility for trading purposes and the line
28
of credit carries interest at a pre-agreed upon percentage point spread from
either the prime rate or the 30-day LIBOR rate.
A portion of the Fund's investment portfolio consists of debt and equity
investments in private companies. The Fund would anticipate no impact on these
investments from modest changes in public market equity prices. However, should
significant changes in market equity prices occur, there could be a longer-term
effect on valuations of private companies, which could affect the carrying value
and the amount and timing of gains realized on these investments. A portion of
the Fund's 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.
29
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA.
Report of Independent Public Accountants
To Equus II Incorporated:
We have audited the accompanying balance sheets of Equus II Incorporated
(a Delaware corporation), including the schedules of portfolio securities, as of
December 31, 2000 and 1999, and the related statements of operations, changes in
net assets and cash flows for each of the three years in the period ended
December 31, 2000, and the selected per share data and ratios for each of the
five years in the period ended December 31, 2000. These financial statements and
selected per share data and ratios are the responsibility of the management of
Equus II Incorporated. Our responsibility is to express an opinion on these
financial statements and selected per share data and ratios based on our audits.
We conducted our audits in accordance with auditing standards generally
accepted in the United States. Those standards require that we plan and perform
the audit to obtain reasonable assurance about whether the financial statements
and selected per share data and ratios are free of material misstatement. An
audit includes examining, on a test basis, evidence supporting the amounts and
disclosures in the financial statements. Our procedures included physical
inspection or confirmation of securities owned as of December 31, 2000, by
correspondence with the custodian and brokers. An audit also includes assessing
the accounting principles used and significant estimates made by management, as
well as evaluating the overall financial statement presentation. We believe that
our audits provide a reasonable basis for our opinion.
As discussed in Note 3, the financial statements include investments in
portfolio securities valued at $90,328,540 (99% of net assets) and $111,571,919
(110% of net assets) as of December 31, 2000 and 1999, respectively, whose
values have been estimated by Equus Capital Management Corporation (the
"Management Company") and approved by the Board of Directors of Equus II
Incorporated in the absence of readily ascertainable market values. We have
reviewed the procedures used by the Management Company in arriving at their
estimates of value of such securities and have inspected the underlying
documentation, and in the circumstances we believe the procedures are reasonable
and the documentation is appropriate. However, because of the inherent
uncertainty of valuation, the Management Company's estimates of values may
differ significantly from the values that would have been used had a ready
market existed for the securities and the differences could be material.
In our opinion, the financial statements and selected per share data and
ratios referred to above present fairly, in all material respects, the financial
position of Equus II Incorporated as of December 31, 2000 and 1999, the results
of its operations, changes in net assets and cash flows for each of the three
years in the period ended December 31, 2000, and the selected per share data and
ratios for each of the five years in the period ended December 31, 2000, in
conformity with accounting principles generally accepted in the United States.
/s/ ARTHUR ANDERSEN LLP
ARTHUR ANDERSEN LLP
Houston, Texas
February 28, 2001
30
EQUUS II INCORPORATED
BALANCE SHEETS
DECEMBER 31, 2000 AND 1999
2000 1999
-------------- --------------
ASSETS
Investments in portfolio securities at fair value
(cost $94,936,875 and $116,473,793, ............. $ 94,117,912 $ 115,373,205
respectively)
Temporary cash investments, at cost which
approximates fair value ......................... 77,041,332 50,334,180
Cash ................................................. 2,200 5,485,502
Accounts receivable .................................. 867 1,050,606
Accrued interest receivable .......................... 4,855,256 2,778,922
-------------- --------------
Total assets ............................... $ 176,017,567 $ 175,022,415
============== ==============
LIABILITIES AND NET ASSETS
Liabilities:
Accounts payable ................................ $ 338,178 $ 696,501
Due to management company ....................... 454,624 507,094
Notes payable to bank ........................... 84,300,000 72,400,000
-------------- --------------
Total liabilities .......................... 85,092,802 73,603,595
-------------- --------------
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, 6,674,577 and 6,839,331
shares outstanding ........................... 6,675 6,839
Additional paid-in capital ...................... 98,046,809 102,676,963
Notes receivable from officers related to
771,927 and 731,662 shares of common stock ... (10,132,925) (10,132,925)
Undistributed net investment income ............. 36,936 --
Undistributed net capital gains ................. 3,786,233 9,968,531
Unrealized depreciation of
portfolio securities, net ..................... (818,963) (1,100,588)
-------------- --------------
Total net assets ........................... $ 90,924,765 $ 101,418,820
============== ==============
Net assets per share ....................... $ 15.40 $ 16.61
============== ==============
The accompanying notes are an
integral part of these financial statements.
31
EQUUS II INCORPORATED
STATEMENTS OF OPERATIONS
FOR THE YEARS ENDED DECEMBER 31, 2000, 1999 AND 1998
2000 1999 1998
------------ ------------ ------------
Investment income:
Income from portfolio securities ................ $ 4,629,928 $ 5,060,617 $ 3,726,430
Interest from temporary cash investments ........ 141,427 57,908 48,004
Interest on notes receivable from officers ...... 101,318 38,405 --
Other income .................................... 244,231 -- --
------------ ------------ ------------
Total investment income ..................... 5,116,904 5,156,930 3,774,434
------------ ------------ ------------
Expenses:
Management fee .................................. 1,911,275 2,179,413 2,706,325
Interest expense ................................ 1,508,788 2,163,593 1,970,973
Non-cash compensation expense ................... 388,663 2,085,766 --
Professional fees ............................... 167,784 279,141 490,954
Director fees and expenses ...................... 239,302 269,784 244,899
Mailing, printing and other expenses ............ 172,339 214,947 383,664
Franchise taxes ................................. 129,305 91,450 106,278
Administrative fees ............................. 50,000 50,000 50,000
------------ ------------ ------------
Total expenses ............................. 4,567,456 7,334,094 5,953,093
------------ ------------ ------------
Net investment income (loss) ......................... 549,448 (2,177,164) (2,178,659)
------------ ------------ ------------
Realized gain (loss) on dispositions of
portfolio securities, net ....................... (6,160,547) 40,352,644 (3,563,556)
------------ ------------ ------------
Unrealized appreciation (depreciation) of
portfolio securities, net:
End of year ..................................... (818,963) (1,100,588) 44,311,697
Beginning of year ............................... (1,100,588) 44,311,697 65,893,353
------------ ------------ ------------
Increase (decrease) in unrealized
appreciation of portfolio securities, net .... 281,625 (45,412,285) (21,581,656)
------------ ------------ ------------
Total decrease in net
assets from operations ....................... $ (5,329,474) $ (7,236,805) $(27,323,871)
============ ============ ============
The accompanying notes are an
integral part of these financial statements.
32
EQUUS II INCORPORATED
STATEMENTS OF CHANGES IN NET ASSETS
FOR THE YEARS ENDED DECEMBER 31, 2000, 1999 AND 1998
2000 1999 1998
-------------- -------------- --------------
Operations:
Net investment income (loss) .................... $ 549,448 $ (2,177,164) $ (2,178,659)
Realized gain (loss) on dispositions of
portfolio securities, net .................... (6,160,547) 40,352,644 (3,563,556)
Increase (decrease) in unrealized
appreciation of portfolio securities, net .... 281,625 (45,412,285) (21,581,656)
-------------- -------------- --------------
Decrease in net assets from operations ............... (5,329,474) (7,236,805) (27,323,871)
-------------- -------------- --------------
Capital transactions:
Non-cash compensation expense related
to officers' stock options ................... 388,663 2,085,766 --
Interest on non-recourse portion of
officer notes ............................... 447,887 115,217 --
Stock repurchase ................................ (4,518,887) (1,211,298) --
Option loans to officers, net of payments ....... -- (10,132,925) --
Exercise of incentive stock options ............. -- 11,155,211 --
Dividends ....................................... (3,843,842) (23,814,714) (3,138,520)
Shares issued in common stock dividend .......... 2,361,598 14,303,340 2,146,667
-------------- -------------- --------------
Decrease in net assets from capital
share transactions .......................... (5,164,581) (7,499,403) (991,853)
-------------- -------------- --------------
Decrease in net assets ............................... (10,494,055) (14,736,208) (28,315,724)
Net assets, at beginning of year ..................... 101,418,820 116,155,028 144,470,752
-------------- -------------- --------------
Net assets, at end of year ........................... $ 90,924,765 $ 101,418,820 $ 116,155,028
============== ============== ==============
The accompanying notes are an
integral part of these financial statements.
33
EQUUS II INCORPORATED
STATEMENTS OF CASH FLOWS
FOR THE YEARS ENDED DECEMBER 31, 2000, 1999 AND 1998
2000 1999 1998
-------------- -------------- --------------
Cash flows from operating activities:
Interest and dividends received ...................... $ 2,279,113 $ 1,780,944 $ 1,614,656
Cash paid to management company,
directors, bank and suppliers ..................... (4,470,400) (5,083,622) (5,913,108)
-------------- -------------- --------------
Net cash used by operating activities ............. (2,191,287) (3,302,678) (4,298,452)
-------------- -------------- --------------
Cash flows from investing activities:
Purchase of portfolio securities ..................... (11,194,062) (24,908,893) (44,553,395)
Proceeds from dispositions of portfolio securities ... 20,565,743 55,962,420 18,382,928
Principal payments from portfolio securities ......... 7,222,349 4,272,725 1,012,576
Proceeds from exercise of options .................... -- 31,125 --
Repayments from (advances to) portfolio
companies, net ...................................... 50,263 211,640 (250,000)
-------------- -------------- --------------
Net cash provided (used) by
investing activities .............................. 16,644,293 35,569,017 (25,407,891)
-------------- -------------- --------------
Cash flows from financing activities:
Advances from bank ................................... 310,850,000 225,000,000 341,700,000
Repayments to bank ................................... (298,950,000) (251,100,000) (325,100,000)
Repurchase of common stock ........................... (4,634,820) (1,095,365) --
Dividends paid ....................................... (1,485,497) (9,505,282) (1,820,409)
Payments received on officer notes ................... 991,161 -- --
-------------- -------------- --------------
Net cash provided (used) by
financing activities ............................ 6,770,844 (36,700,647) 14,779,591
-------------- -------------- --------------
Net increase (decrease) in cash and
cash equivalents ................................... 21,223,850 (4,434,308) (14,926,752)
Cash and cash equivalents at
beginning of year .................................... 55,819,682 60,253,990 75,180,742
-------------- -------------- --------------
Cash and cash equivalents at end of year .................. $ 77,043,532 $ 55,819,682 $ 60,253,990
============== ============== ==============
The accompanying notes are an
integral part of these financial statements.
34
EQUUS II INCORPORATED
STATEMENTS OF CASH FLOWS
FOR THE YEARS ENDED DECEMBER 31, 2000, 1999 AND 1998
(Continued)
2000 1999 1998
-------------- -------------- --------------
Reconciliation of decrease
in net assets from operations to
net cash used by operating activities:
Decrease in net assets from operations .................... $ (5,329,474) $ (7,236,805) $ (27,323,871)
Adjustments to reconcile increase
(decrease) from operations to net cash
used by operating activities:
Realized (gain) loss on dispositions of
portfolio securities, net ......................... 6,160,547 (40,352,644) 3,563,556
Decrease (increase) in unrealized
appreciation, net ................................. (281,625) 45,412,285 21,581,656
Increase in accrued interest receivable .............. (1,628,447) (1,987,854) (162,228)
Accrued interest or dividends
exchanged for portfolio securities ................ (1,209,344) (1,388,132) (1,997,550)
Non-cash compensation expense ........................ 388,663 2,085,766 --
Commitment fees paid ................................. -- -- (37,500)
Amortization of commitment fee ....................... -- 31,250 25,000
Increase (decrease) in accounts payable .............. (239,137) 207,137 194,064
Decrease in due to management company ................ (52,470) (73,681) (141,579)
-------------- -------------- --------------
Net cash used by operating activities ..................... $ (2,191,287) $ (3,302,678) $ (4,298,452)
============== ============== ==============
The accompanying notes are an
integral part of these financial statements.
35
EQUUS II INCORPORATED
SELECTED PER SHARE DATA AND RATIOS
FOR THE FIVE YEARS ENDED DECEMBER 31, 2000
2000 1999 1998 1997 1996
---------- ---------- ---------- ---------- ----------
SELECTED PER SHARE DATA:
Investment income ............................ $ 0.87 $ 1.04 $ 0.78 $ 0.85 $ 0.68
Expenses ..................................... 0.78 1.48 1.23 1.04 2.84
---------- ---------- ---------- ---------- ----------
Net investment income (loss) ................. 0.09 (0.44) (0.45) (0.19) (2.16)
Realized gain (loss) on dispositions of
portfolio securities, net ................. (1.05) 8.15 (0.74) 1.60 1.06
Increase (decrease) in unrealized
appreciation of portfolio
securities, net ........................... 0.05 (9.17) (4.47) 5.11 8.82
---------- ---------- ---------- ---------- ----------
Increase (decrease) in net
assets from operations .................... (0.91) (1.46) (5.66) 6.52 7.72
---------- ---------- ---------- ---------- ----------
Capital transactions:
Dividends .................................... (0.60) (4.25) (0.65) (0.50) (0.76)
Effect of common stock repurchases ........... 0.51 0.10 -- -- --
Dilutive effect of shares issued in common
stock dividend and exercise of options .... (0.21) (1.23) (0.16) (0.10) (0.20)
Effect of Rights Offering .................... -- -- -- -- (2.47)
---------- ---------- ---------- ---------- ----------
Net decrease in assets from
capital transactions ...................... (0.30) (5.38) (0.81) (0.60) (3.43)
---------- ---------- ---------- ---------- ----------
Net increase (decrease) in net assets ........ (1.21) (6.84) (6.47) 5.92 4.29
Net assets at beginning of year .............. 16.61 23.45 29.92 24.00 19.71
---------- ---------- ---------- ---------- ----------
Net assets at end of year .................... $ 15.40 $ 16.61 $ 23.45 $ 29.92 $ 24.00
========== ========== ========== ========== ==========
Weighted average number of shares
outstanding during year, in thousands ..... 5,870 4,950 4,829 4,733 3,819
SELECTED RATIOS:
Ratio of expenses before interest and
non-cash compensation expense to
average net assets ........................ 2.78% 2.84% 3.06% 3.64% 12.45%
Ratio of total expenses to average
net assets ................................ 4.75% 6.74% 4.57% 3.98% 13.15%
Ratio of net investment income (loss)
to average net assets .................... 0.57% (2.00)% (1.67)% (0.74)% (10.02)%
Ratio of increase (decrease) in net
assets from operations to average
net assets ................................ (5.54)% (6.65)% (20.97)% 24.92% 35.70%
The accompanying notes are an
integral part of these financial statements.
36
EQUUS II INCORPORATED
SCHEDULE OF PORTFOLIO SECURITIES
DECEMBER 31, 2000
DATE OF
PORTFOLIO COMPANY INITIAL INVESTMENT COST FAIR VALUE
----------------- ------------------- ----- ----------
A. C. Liquidating Corporation February 1985
-10% secured promissory notes $ 188,014 $ --
The Bradshaw Group May 2000
-1,335,000 shares of preferred stock 1,335,000 1,335,000
-Warrant to buy 2,229,450 shares of common
stock for $0.01 through May 2008 1 1
Champion Window, Inc. March 1999
-1,400,000 shares of common stock 1,400,000 5,250,000
-20,000 shares of preferred stock 2,000,000 2,292,500
Container Acquisition, Inc. February 1997
-1,370,000 shares of common stock 1,370,000 2,870,000
-64,283 shares of preferred stock 6,428,300 6,428,300
-Conditional warrant to buy up to
370,588 shares of common stock
at $0.01 per share through June 2003 1,000 1,000
CRC Holdings, Corp. June 1997
-Earnout receivable 1,192,114 --
The Drilltec Corporation August 1998
-Prime +9.75% promissory note 1,000,000 1,000,000
-Warrant to buy 10% of the common
equity for $100 through September 2002 -- --
Equicom, Inc. July 1997
-452,000 shares of common stock 141,250 --
-657,611 shares of preferred stock 6,576,110 2,000,000
-10% promissory note 2,562,250 2,562,250
Equipment Support Services, Inc. December 1999
-35,000 shares of common stock 101,500 --
-35,000 shares of preferred stock 1,929,000 1,362,000
-8% promissory note 1,138,000 1,138,000
FS Strategies, Inc. June 2000
-110,000 shares of common stock 5,500,000 5,500,000
GCS RE, Inc. February 1989
-1,000 shares of common stock 132,910 600,000
The accompanying notes are an
integral part of these financial statements.
37
EQUUS II INCORPORATED
SCHEDULE OF PORTFOLIO SECURITIES
DECEMBER 31, 2000
(Continued)
DATE OF
PORTFOLIO COMPANY INITIAL INVESTMENT COST FAIR VALUE
----------------- ------------------- ------ ----------
Hot & Cool Holdings, Inc. March 1996
-9% increasing rate subordinated promissory note $1,075,000 $ --
-10% subordinated notes 2,200,000 --
-12% promissory note 2,500,000 --
-Warrant to buy up to 14,942 shares of common
stock at $0.01 per share through March 2006 -- --
-Warrant to buy 10,000 shares of common
stock at $0.01 through February 2003 -- --
NCI Building Systems, Inc. (NYSE - NCS) April 1989
-200,000 shares of common stock 159,784 3,762,500
Paracelsus Healthcare Corporation December 1990
(OTCBB - PLHC)
-1,844,345 shares of common stock 4,299,449 22,459
Petrocon Engineering, Inc. September 1998
-12% promissory note 4,663,356 4,663,356
-887,338 shares of common stock 635 635
-8% Series B junior subordinated
promissory note 2,659,332 2,659,332
-Warrant to buy up to 1,552,571 shares of common
stock at $0.01 per share through March 2009 -- --
Raytel Medical Corporation August 1997
(NASDAQ - RTEL)
-33,073 shares of common stock 330,730 26,872
The ServiceMaster Company (NYSE-SVM) May 1999
-Warrant to buy up to 29,411 shares of common
stock at $51 per share through September 2001 -- --
The accompanying notes are an
integral part of these financial statements.
38
EQUUS II INCORPORATED
SCHEDULE OF PORTFOLIO SECURITIES
DECEMBER 31, 2000
(Continued)
DATE OF
PORTFOLIO COMPANY INITIAL INVESTMENT COST FAIR VALUE
----------------- ------------------ ------ ----------
Sovereign Business Forms, Inc. August 1996
-16,011 shares of preferred stock $1,601,100 $1,601,100
-15% promissory notes 2,793,744 2,793,744
-Warrant to buy 551,894 shares of common
stock at $1 per share through August 2006 -- 1,062,890
-Warrant to buy 25,070 shares of common
stock at $1.25 per share through October 2007 -- 42,015
-Warrant to buy 273,450 shares of common
stock at $1 per share through October 2009 -- 526,637
Spectrum Management, LLC December 1999
-285,000 Units of Class A equity interests 2,850,000 2,850,000
Stephen L. LaFrance Holdings, Inc. September 1997
-2,498,452 shares of preferred stock 2,498,452 2,498,452
-Warrant to buy 269 shares of common stock
for $0.01 per share through September 2007 -- 7,000,000
Sternhill Partners I, L.P. March 2000
-3% limited partnership interest 900,000 1,000,000
Strategic Holdings, Inc. September 1995
-3,089,751 shares of common stock 3,088,389 --
-3,822,157 shares of Series B preferred stock 3,820,624 3,250,000
-15% promissory note 6,750,000 6,750,000
-Warrants to buy 225,000 shares of common
stock at $0.4643 per share through August 2005 -- --
-Warrant to buy 100,000 shares of common
stock at $1.50 per share through August 2005 -- --
-Warrant to buy 2,219,237 shares of common
stock at $0.01 per share through November 2005 -- --
-1,000 shares of SMIP, Inc. common stock 150,000 --
-15% promissory note of SMIP, Inc. 175,000 175,000
The accompanying notes are an
integral part of these financial statements.
39
EQUUS II INCORPORATED
SCHEDULE OF PORTFOLIO SECURITIES
DECEMBER 31, 2000
(Continued)
DATE OF
PORTFOLIO COMPANY INITIAL INVESTMENT COST FAIR VALUE
----------------- ------------------ ------ ----------
Summit/DPC Partners, L.P. October 1995
-36.11% limited partnership interest $ 3,326,565 $ 10,000,000
Travis International, Inc. December 1986
-98,761 shares of common stock 5,398 1,500,000
Tulsa Industries, Inc. December 1997
-209,089 shares of common stock 5,500,000 --
-1,058 shares of Series B preferred stock 1,058,000 1,058,000
-Junior participation in promissory note 655,769 655,769
Turfgrass America, Inc. May 1999
-3,167,756 shares of common stock 600,000 600,000
-12% subordinated promissory note
with a face amount of $4,000,000 3,595,000 3,595,000
United Industrial Services, Inc. July 1998
-35,000 shares of preferred stock 3,500,000 2,500,000
-15% promissory note 585,000 585,000
-Warrants to buy 63,637 shares of common
stock at $0.01 through June 2008 100 100
-Warrants to buy 18,887 shares of common
stock at $0.01 through March 2011 -- --
Vanguard VII, L.P. June 2000
-1.3% limited partnership interest 600,000 600,000
------------ ------------
Total $ 94,936,875 $ 94,117,912
============ ============
The accompanying notes are an
integral part of these financial statements.
40
EQUUS II INCORPORATED
SCHEDULE OF PORTFOLIO SECURITIES
DECEMBER 31, 2000
(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, Inc., Container
Acquisition, Inc., The Drilltec Corporation, Hot & Cool Holdings, Inc.,
Sovereign Business Forms, Inc., Strategic Holdings, Inc., Turfgrass America,
Inc. and United Industrial Services, 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, during the year ended
December 31, 2000, the Fund was considered to have a controlling interest in
Champion Window, Inc., Container Acquisition, Inc., The Drilltec Corporation,
Equicom, Inc., Sovereign Business Forms, Inc., Spectrum Management LLC,
Strategic Holdings, Inc., Tulsa Industries, Inc. and United Industrial Services,
Inc. The fair value of the Fund's investment in Paracelus Healthcare Corporation
includes a discount of $1,518 from the closing market price to reflect the
estimated effect of restrictions on the sale of such securities at December 31,
2000.
Income was earned in the amount of $3,104,423, $2,251,120 and $2,542,677
for the years December 31, 2000, 1999 and 1998 respectively, on portfolio
securities of companies in which the Fund has a controlling interest.
As defined in the Investment Company Act of 1940, all of the Fund's
investments are in eligible portfolio companies. The Fund provides significant
managerial assistance to all of the portfolio companies in which it has
invested, except Equipment Support Services, Inc., Raytel Medical Corporation,
Sternhill Partners I, L.P., Summit/DPC Partners, L.P. and Vanguard VII, L.P. The
Fund provides significant managerial assistance to portfolio companies that
comprise 85% of the total value of the investments in portfolio companies at
December 31, 2000.
The accompanying notes are an
integral part of these financial statements.
41
EQUUS II INCORPORATED
SCHEDULE OF PORTFOLIO SECURITIES
DECEMBER 31, 1999
DATE OF
PORTFOLIO COMPANY INITIAL INVESTMENT COST FAIR VALUE
----------------- ------------------ ------ ----------
A. C. Liquidating Corporation February 1985
-10% secured promissory notes $ 188,014 $ --
Allied Waste Industries, Inc. (NYSE - AW) March 1989
-900,000 shares of common stock 3,121,565 7,561,125
Champion Window, Inc. March 1999
-1,400,000 shares of common stock 1,400,000 3,500,000
-20,000 shares of preferred stock 2,000,000 2,100,000
-12% subordinated promissory note 3,500,000 3,500,000
Container Acquisition, Inc. February 1997
-1,370,000 shares of common stock 1,370,000 3,870,000
-59,690 shares of preferred stock 5,969,000 5,969,000
-Conditional warrant to buy up to
370,588 shares of common stock
at $0.01 per share through June 2003 1,000 1,000
The Drilltec Corporation August 1998
-1,400,000 shares of common stock 1,400,000 --
-62,450 shares of preferred stock 6,245,000 --
-Prime +9.75% promissory note 524,000 524,000
-Warrant to buy 10% of the common
equity for $100 through September 2002 -- --
Drypers Corporation (NASDAQ - DYPR) July 1991
-3,677,906 shares of common stock 9,328,556 7,078,291
Equicom, Inc. July 1997
-452,000 shares of common stock 141,250 --
-657,611 shares of preferred stock 6,576,110 2,000,000
-10% promissory note 1,990,754 1,990,754
Equipment Support Services, Inc. December 1999
-35,000 shares of common stock 101,500 101,500
-35,000 shares of preferred stock 1,929,000 1,929,000
-8% promissory note 1,138,000 1,138,000
GCS RE, Inc. February 1989
-1,000 shares of common stock 132,910 300,000
The accompanying notes are an
integral part of these financial statements.
42
EQUUS II INCORPORATED
SCHEDULE OF PORTFOLIO SECURITIES
DECEMBER 31, 1999
(Continued)
DATE OF
PORTFOLIO COMPANY INITIAL INVESTMENT COST FAIR VALUE
----------------- ------------------ ------ ----------
Hot & Cool Holdings, Inc. March 1996
-9% increasing rate subordinated
promissory note $1,075,000 $1,075,000
-10% subordinated notes 2,200,000 2,200,000
-12% promissory note 1,500,000 1,500,000
-19,665 shares of Series A 8% preferred stock 786,631 --
-6,000 shares of Series B 8% preferred stock 300,000 --
-5,000 shares of Series C preferred stock 500,000 500,000
-Warrants to buy up to 14,942 shares of common
stock at $0.01 per share through March 2006 -- --
-Warrants to buy up to 16,316 shares of common
stock at $26.00 per share through April 2007 -- --
-Warrant to buy 10,000 shares of common stock
at $0.01 per share through February 2003 -- --
LG&E Energy Corp. (NYSE - LGE) July 1999
-121,504 shares of common stock 1,719,838 1,800,917
-Earnout and escrow receivable 3,754,199 6,800,000
NCI Building Systems, Inc. (NYSE - NCS) April 1989
-200,000 shares of common stock 159,784 3,700,000
Paracelsus Healthcare Corporation December 1990
(NYSE - PLS)
-2,018,213 shares of common stock 5,278,748 788,372
Petrocon Engineering, Inc. September 1998
-12% promissory note 4,663,356 4,663,356
-887,338 shares of common stock 635 635
-8% Series B junior subordinated
promissory note 2,659,332 2,659,332
-Warrant to buy up to 1,552,571 shares of common
stock at $0.01 per share through March 2009 -- --
The accompanying notes are an
integral part of these financial statements.
43
EQUUS II INCORPORATED
SCHEDULE OF PORTFOLIO SECURITIES
DECEMBER 31, 1999
(CONTINUED)
DATE OF
PORTFOLIO COMPANY INITIAL INVESTMENT COST FAIR VALUE
----------------- ------------------ ------ ----------
Raytel Medical Corporation August 1997
(NASDAQ - RTEL)
-33,073 shares of common stock $ 330,730 $ 101,286
The ServiceMaster Company (NYSE-SVM) May 1999
-Warrant to buy up to 29,411 shares
of common stock at $51 per share
through September 2001 -- --
Sovereign Business Forms, Inc. August 1996
-14,648 shares of preferred stock 1,464,800 1,464,800
-15% promissory notes 2,300,000 2,300,000
-Warrant to buy 551,894 shares of common
stock at $1 per share through August 2006 -- 413,920
-Warrant to buy 25,070 shares of common
stock at $1.25 per share through October 2007 -- 12,535
-Warrant to buy 273,450 shares of common
stock at $1 per share through October 2009 -- 205,088
Spectrum Management, LLC December 1999
-285,000 Units of Class A equity interest 2,850,000 2,850,000
Stephen L. LaFrance Holdings, Inc. September 1997
-2,498,452 shares of preferred stock 2,498,452 2,498,452
-Warrant to buy 269 shares of
common stock for $0.01 per share
through September 2007 -- 3,000,000
Strategic Holdings, Inc. September 1995
-3,089,751 shares of common stock 3,088,389 2,568,287
-3,822,157 shares of Series B preferred stock 3,820,624 3,820,624
-15% promissory note 6,750,000 6,750,000
-Warrants to buy 225,000 shares of common
stock at $0.4643 per share through August 2005 -- 187,026
-Warrant to buy 100,000 shares of common
stock at $1.50 per share through August 2005 -- --
-Warrant to buy 2,219,237 shares
of common stock at $0.01 per share
through November 2005 -- 1,844,687
-1,000 shares of SMIP, Inc. common stock 150,000 150,000
-15% promissory note of SMIP, Inc. 175,000 175,000
The accompanying notes are an
integral part of these financial statements.
44
EQUUS II INCORPORATED
SCHEDULE OF PORTFOLIO SECURITIES
DECEMBER 31, 1999
(Continued)
DATE OF
PORTFOLIO COMPANY INITIAL INVESTMENT COST FAIR VALUE
----------------- ------------------ ------ ----------
Summit/DPC Partners, L.P. October 1995
-36.11% limited partnership interest $ 2,600,000 $ 5,500,000
Travis International, Inc. December 1986
-98,761 shares of common stock 5,398 1,000,000
Tulsa Industries, Inc. December 1997
-209,089 shares of common stock 5,500,000 --
-1,058 shares of Series B
preferred stock 1,058,000 1,058,000
-Junior participation in promissory note 655,769 655,769
Turfgrass America, Inc. May 1999
-3,167,756 shares of common stock 600,000 600,000
-12% subordinated promissory note 3,475,000 3,475,000
United Industrial Services, Inc. July 1998
-35,000 shares of preferred stock 3,500,000 3,500,000
-Warrants to buy 63,637 shares of
common stock at $0.01 through
June 2008 100 100
VRPI Spin Off, Inc. January 1988
-100 shares of common stock 250,000 250,000
-10% secured promissory note 2,672,349 2,672,349
-12% secured promissory note 1,050,000 1,050,000
-10,000 shares of common stock of
Equus Video Corporation 25,000 20,000
------------- -------------
Total $ 116,473,793 $ 115,373,205
============= =============
The accompanying notes are an
integral part of these financial statements.
45
EQUUS II INCORPORATED
NOTES TO FINANCIAL STATEMENTS
DECEMBER 31, 2000, 1999 AND 1998
(1) ORGANIZATION AND BUSINESS PURPOSE
Equus II Incorporated (the "Fund"), a Delaware corporation with perpetual
existence, 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 acquire other businesses, including
leveraged buyouts. 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 common or preferred stock or debt combined with warrants,
options or other rights to acquire common or preferred stock. Current income is
not a significant factor in the selection of investments. The Fund elected to be
treated as a business development company under the Investment Company Act of
1940, as amended.
(2) MANAGEMENT
The Fund has entered into a management agreement with Equus Capital
Management Corporation, a Delaware corporation (the "Management Company").
Pursuant to such agreement, the Management Company performs certain services,
including certain 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, of which $50,000 is included in the accompanying
Statements of Operations for each of the three years ended December 31, 2000.
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 $25,000 paid quarterly in
arrears, a fee of $3,000 for each meeting of the Board of Directors attended in
person, a fee of $1,500 for participation in each telephonic meeting of the
Board of Directors and for each committee meeting attended ($500 for each
committee meeting if attended on the same day as a Board Meeting), and
reimbursement of all out-of-pocket expenses relating to attendance at such
meetings. In addition, each director who is not an officer of the Fund is
granted incentive stock options to purchase shares of the Fund's stock from time
to time. (See Note 10). Certain officers and directors 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.
(3) SIGNIFICANT ACCOUNTING POLICIES
Valuation of Investments - Portfolio investments are carried at fair value
with the net change in
46
unrealized appreciation or depreciation included in the determination of net
assets. Investments in companies whose securities are publicly traded are valued
at their quoted market price, less a discount to reflect the estimated effects
of restrictions on the sale of such securities ("Valuation Discount"), if
applicable. Cost is used to approximate fair value of other investments until
significant developments affecting an investment 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. The fair market 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. Because of
the inherent uncertainty of the valuation of portfolio securities which do not
have readily ascertainable market values, amounting to $90,328,540 (including
$22,459 in publicly-traded securities, net of a $1,518 Valuation Discount) and
$111,571,919 (including $17,228,705 in publicly-traded securities, net of a
$2,554,017 Valuation Discount) at December 31, 2000 and 1999, respectively, the
Fund's estimate of fair value may significantly differ from the fair 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 or management
incentive fees 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 and the Fund's website, www.equuscap.com.
Investment Transactions - Investment transactions are recorded on the
accrual method. Realized gains and losses on investments sold are computed on a
specific identification basis.
Cash Flows - For purposes of the Statements of Cash Flows, the Fund
considers all highly liquid temporary cash investments purchased with an
original maturity of three months or less to be cash equivalents.
Income Taxes - No provision for federal income taxes has been made in the
accompanying financial statements as the Fund has qualified for pass-through
treatment as a "regulated investment company" under Subchapter M of the Internal
Revenue Code of 1986. As such, all net income is allocable to the stockholders
for inclusion in their respective tax returns. Net capital losses are not
allocable to the shareholders but can be carried over to offset future earnings
of the Fund.
(4) BOOK TO TAX RECONCILIATION
The Fund accounts for dividends in accordance with Statement of Position
93-2 which relates to the amounts distributed by the Fund as net investment
income or net capital gains, which are often not equal to the corresponding
income or gains shown in the Fund's financial statements. The Internal Revenue
Service approved the Fund's request, effective October 31, 1998, to change its
year-end for determining capital gains for federal income tax from December 31
to October 31, which allows current year dividends to be paid prior to the end
of the calendar year.
For the year ended December 31, 2000, the Fund had net investment income
for book purposes of $549,448 and $609,034 for tax purposes. The difference
between book and tax was primarily non-cash compensation expense recorded on the
books related to dividends paid on shares owned by officers which secure limited
recourse notes receivable by the Fund and non-taxable dividends received from
one portfolio company. For tax purposes, the Fund had net capital losses of
$2,773,745 for the twelve months ended October 31, 2000. For the period of
November 1, 2000 through December 31, 2000, the Fund had realized net capital
gains of $6,559,978. For the period of November 1, 1999 through
47
December 31, 1999, the Fund had realized net capital gains of $9,946,780.
Therefore, the Fund, for book purposes, had net capital losses of $6,160,547 for
the year ended December 31, 2000.
For the year ended December 31, 1999, the Fund had a net investment loss
for book purposes of $2,177,164 and net investment income of $108,174 for tax
purposes. The difference between book and tax was primarily non-cash
compensation expense recorded on the books related to dividends paid on shares
owned by officers which secure limited recourse notes receivable by the Fund.
For tax purposes, the Fund distributed net capital gains of $23,814,714 for the
twelve months ended October 31, 1999. For the period from November 1, 1999
through December 31, 1999, the Fund had undistributed capital gains of
$9,946,780. For the period from November 1, 1998 through December 31, 1998, the
Fund had net capital losses of $6,558,635. Therefore, the Fund, for book
purposes, had net capital gains of $40,352,644 for the year ended December 31,
1999.
For the year ended December 31, 1998, the Fund had a net investment loss
for tax purposes and did not distribute investment income. On November 4, 1998,
the Fund declared undistributed net capital gains for the ten months ended
October 31, 1998 of $2,995,079 as a dividend. In addition, on July 1, 1998, the
Fund declared undistributed capital gains for 1997 of $132,677 as a dividend.
For the period from November 1, 1998 through December 31, 1998, the Fund had
undistributed net capital losses of $6,558,635. For book purposes, the Fund had
net capital losses of $3,563,556 for the year ended December 31, 1998.
The following is a reconciliation of the difference in the Fund's net
realized gain or loss on the sale of portfolio securities for book and tax
purposes:
2000 1999 1998
------------ ------------ ------------
Net realized gain (loss) on the
dispositions of portfolio securities, book
as of 12/31/00 ................................. $ (6,160,547) $ 40,352,644 $ (3,563,556)
Undistributed 1997 gains ......................... -- -- 132,677
Realized capital loss 11/1/98 -
12/31/98 ....................................... -- (6,558,635) 6,558,635
Realized capital gains 11/1/99 -
12/31/99 ....................................... 9,946,780 (9,946,780) --
Realized capital gains 11/01/00-
12/31/00 ....................................... (6,559,978) -- --
------------ ------------ ------------
Net realized gain (loss) on the
dispositions of portfolio securities, tax
as of 10/31/00 ................................. $ (2,773,745) $ 23,847,229 $ 3,127,756
============ ============ ============
(5) DIVIDENDS
The Fund declared dividends of $3,843,842 ($0.60 per share), $23,814,714
($4.25 per share) and $3,138,520 ($0.65 per share) during 2000, 1999 and 1998,
respectively. The Fund has adopted a policy to make dividend distributions of at
least $0.60 per share on an annual basis. In the event that taxable income,
including realized capital gains, exceeds $0.60 per share in any year,
additional dividends may be declared to distribute such excess. The 2000, 1999
and 1998 dividend were paid in additional shares of common stock or in cash by
specific election of the shareholders in December 2000, 1999 and 1998.
48
The 2000 dividend represents long-term capital gains, ordinary income and return
of capital. The 1999 and 1998 dividend represented long-term capital gains. The
Fund paid $1,482,244, $9,511,374 and $991,853 in cash and issued 268,173,
1,337,542 and 125,812 additional shares of stock at $8.80625, $10.69375 and
$17.0625 per share, in December 2000, 1999 and 1998 in connection with such
dividends. In 2000 and 1999, the Fund recorded non-cash compensation expense for
the dividends paid on stock held by officers of $388,663 and $2,085,766,
respectively, in accordance with GAAP.
(6) TEMPORARY CASH INVESTMENTS
Temporary cash investments, which represent the short-term utilization of
cash prior to investment in securities of portfolio companies, distributions to
the shareholders or payment of loans and expenses, consist of $77,041,332 and
$50,334,180 in money market accounts with Bank of America, N.A. earning interest
at rates ranging from 4.22% to 4.90% and 4.64% to 5.21% at December 31, 2000,
and 1999, respectively.
(7) ACCOUNTS RECEIVABLE
At December 31, 2000, the accounts receivable balance was $867. At
December 31, 1999, the accounts receivable balance was $1,050,606, and primarily
consisted of $991,161 in principal due on the notes receivable from officers
that were issued to the Fund when the officers exercised some of their stock
options. The $991,161 was received in January 2000. In addition, $38,818 was
included in receivables due from two portfolio companies as reimbursement for
expenses incurred on behalf of portfolio companies which was received in 2000.
(8) PORTFOLIO SECURITIES
During the year ended December 31, 2000, the Fund invested $7,435,001 in
four new companies and made follow-on investments of $4,968,405 in ten portfolio
companies, including $1,209,344 in accrued interest and dividends received in
the form of additional portfolio securities and accretion of original issue
discount on a promissory note. In addition, the Fund realized a net capital loss
of $6,160,547 during the year ended December 31, 2000.
During the year ended December 31, 1999, the Fund invested $20,638,398 in
six new companies and made follow-on investments of $10,591,965 in eleven
portfolio companies, including $1,388,132 in accrued interest and dividends
received in the form of additional portfolio securities and accretion of
original issue discount on a promissory note. The Fund also received note
payments and proceeds from the sale of portfolio securities of $4,933,338 in the
form of additional portfolio securities. In addition, the Fund realized a net
capital gain of $40,352,644 during the year ended December 31, 1999.
During the year ended December 31, 1998, the Fund invested $13,645,100 in
three new companies and made follow-on investments of $33,087,284 in eleven
portfolio companies, including $1,998,989 in accrued interest and dividends
received in the form of additional portfolio securities and accretion of
original issue discount on a promissory note. In addition, the Fund realized a
net capital loss of $3,563,556 during the year ended December 31, 1998.
(9) NOTES PAYABLE TO BANK
The Fund has a $100,000,000 line of credit promissory note with Bank of
America N.A., with interest payable at 1/2% over the rate earned in its money
market account at December 31, 2000. The Fund had $77,000,000 and $50,000,000
outstanding on such notes, at December 31, 2000 and 1999, respectively, that was
secured by $77,000,000 and $50,000,000 of the Fund's temporary cash
49
investments. The Fund paid $37,500 in commitment fees in 1998, which were
capitalized and amortized over the commitment period. Effective July 1, 2000,
the Fund extended the line of credit promissory note to July 1, 2001.
The Fund has a $32,500,000 revolving line of credit with Bank of America,
N.A. that expires on July 1, 2001. In 1999, the Fund had a $40,000,000 revolving
line of credit with Bank of America, N.A. that expired on July 1, 2000. The Fund
had $7,300,000 and $22,400,000 outstanding under such lines of credit at
December 31, 2000 and 1999, respectively, which is secured by the Fund's
investments in portfolio securities. The interest rate ranges from prime -1/2%
to prime +1/4% or LIBOR + 1.65%. The Fund also pays interest at the rate of 1/4%
per annum on the unused portion of the line of credit.
The average daily balances outstanding on the Fund's notes payable during
the years ended December 31, 2000 and 1999, were $18,950,064 and $26,855,068,
respectively.
(10) 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 also
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 2,000 shares of the Fund's common stock. On May 10, 2000, options to
acquire a total of 12,000 shares at $9.94 per share were issued to the
directors. During 1999, two directors each exercised 1,000 of their options to
acquire a total of 2,000 shares for $15.5625 per share.
Under the Stock Incentive Plan, options to purchase 306,773 and 294,773
shares of the Fund's common stock with a weighted average exercise price of
$18.71 and $19.07 per share were outstanding at December 31, 2000 and 1999,
respectively. Of these options, 261,970 and 91,150 shares, with a weighted
average exercise price per share of $18.96 and $22.33, were exercisable at
December 31, 2000 and 1999, respectively. Outstanding options at December 31,
2000 have exercise prices ranging from $9.94 to $27.44 and expire in May 2007
through May 2010. On September 30, 1999, options to purchase 654,358 shares of
common stock of the Fund were exercised by the officers of the Fund for $17 per
share. The exercise price of $11,124,086 was paid in the form of promissory
notes from the officers to the Fund. The notes bear interest at 5.42% per annum,
have limited recourse and are due on or before September 30, 2008. The notes are
secured by the 654,358 shares, including any proceeds or dividends paid thereon.
During 2000 and 1999, a dividend of $0.60 and $4.25 per share was paid by the
Fund, respectively. As a result of these dividends paid in 2000 and 1999, 42,723
and 135,608 additional shares, respectively, were issued to the officers and
pledged to the Fund. In addition, principal payments of $991,161, representing
58,304 shares, were made on the notes. As a result of the additional shares
issued and payments made, the notes are secured by 832,689 and 789,966 shares of
common stock and the outstanding balance on the notes was $10,132,925 at
December 31, 2000 and 1999, respectively.
The notes receivable, as well as 771,927 and 731,662 of such shares of
pledged common stock, are not included in the Fund's reported net asset value
per share at 2000 and 1999, respectively. The shares of stock financed by the
notes from the officers will be included in the net asset value per share as the
shares are paid for or released from collateral. The pledged shares included in
the calculation of net asset value is determined based on the percentage of the
officers' notes paid multiplied by the total shares pledged. Pledged shares
included in the calculation of net asset value included 60,762 and 58,304 shares
at December 31, 2000 and 1999, respectively. Shares may be released as payments
on the notes are made or as the value of the collateral increases. Generally
accepted accounting principles require that the options issued to the officers
be accounted for using variable plan accounting due to the limited recourse
50
provision of such notes. Additionally, the dividends paid on the common stock
pledged on the non-recourse portion of the notes are required to be recorded as
compensation expense in the statements of operations, and interest recorded on
the non-recourse portion of the notes is required to be recorded as an increase
to additional paid-in capital. Accordingly, for the year ended December 31, 2000
and 1999, dividends of $388,663 and $2,085,766 were recorded as non-cash
compensation expense and interest of $447,887 and $115,217 was credited to
additional paid-in capital, respectively. Additionally, the limited recourse
notes receivable from the officers are required to be recorded as a reduction of
net assets. If the notes and the shares were included in the Fund's balance
sheet, the net asset value would have been $15.14 and $16.31 per share at
December 31, 2000 and 1999, respectively.
As of December 31, 2000 and 1999, all outstanding options were "out of the
money" and would not have had a dilutive effect on net assets per share if
exercised, assuming the Fund would use the proceeds from the exercise of such
options to purchase shares at the market price pursuant to the treasury stock
method.
In accordance with the terms of Accounting Principles Board Opinion No. 25
Accounting for Stock Issued to Employees ("APB 25"), because the exercise price
of the Fund's Incentive Options equals the market price of the underlying stock
on the date of grant, the Fund records no compensation expense for its stock
option awards. As required by the Financial Accounting Standards Board Statement
No. 123, Accounting for Stock-based Compensation ("SFAS 123"), the Fund provides
the following disclosure of hypothetical values for these awards. The weighted
average grant-date fair value of options granted during 2000, 1999 and 1998 was
$1.71, $1.80 and $6.39 per share, respectively. These values for 2000, 1999 and
1998 were estimated using the Black-Scholes option-pricing model with the
following weighted average assumptions: expected dividend of 6.5%, 8.4% and
4.9%, expected volatility of 26.3%, 27.6% and 28.8% and risk free interest rates
of 6.8%, 6.0% and 5.8%, respectively. An expected life of 10 years was used for
2000, 1999 and 1998. Had compensation expense been recorded based on these
hypothetical values, the Fund's 2000, 1999 and 1998 change in net assets from
operations would have been reduced by $551,808, $1,146,718 and $1,135,967,
respectively. Because options vest over several years and additional grants are
expected, the effects of these hypothetical calculations are not likely to be
representative of similar future calculations.
(11) COMMITMENTS AND CONTINGENCIES
The Fund has made commitments to invest, under certain circumstances, up
to an additional $2,000,000 in Container Care International, Inc., $93,500 in
Equicom, Inc., $750,000 in FS Strategies, Inc., $625,000 in Sovereign Business
Forms, Inc., $2,100,000 in Sternhill Partners I, L.P., $1,000,000 in Turfgrass
America Inc. and $2,400,000 in Vanguard VII, L.P. In addition, the Fund has
committed to invest up to $6,120,000 in two new companies.
The Fund and certain of the portfolio companies are involved in asserted
claims and have the possibility for unasserted claims which may ultimately
affect the fair value of the Fund's portfolio investments.
(12) SUBSEQUENT EVENTS
Subsequent to December 31, 2000, the Fund repaid a net $75,600,000 of
notes payable to the bank.
On February 6, 2001, the Board of Directors of the Fund authorized the
repurchase of up to 5% of the outstanding common stock of the Fund, from time to
time in open market transactions.
On February 7, 2001, the Fund invested an additional $300,000 in Sternhill
Partners I, L.P.
51
On February 9, 2001, the Fund invested $1,116,550 in American Trenchless
Technology, LLC ("American Trenchless") in exchange for 100,000 units of Series
A preferred stock and 1,934,532 units of common stock. American Trenchless
provides underground boring and tunneling services to its customers.
On February 9, 2001, the Fund invested $3,686 in Reliant Window Holding,
LLC ("Reliant") and received 36.86% membership interest in Reliant. In addition,
the Fund committed to invest up to $5,000,000 in Reliant under certain
circumstances. Reliant was formed to invest in Reliant Building Products, Inc.,
which manufactures, distributes and installs aluminum and vinyl residential
windows.
On February 28, 2001, the Fund sold its investment in Stephen L. LaFrance
Holdings, Inc. for $10,000,000, realizing a capital gain of $7,501,548.
52
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE.
None.
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT.
Information about the Directors and Executive Officers of the Registrant
is incorporated by reference to the Fund's Definitive Proxy Statement for the
2001 Annual Meeting of Stockholders, to be filed pursuant to Regulation 14A
under the Securities and Exchange Act of 1934, as amended, prior to April 30,
2001 (the "2001 Proxy Statement").
ITEM 11. EXECUTIVE COMPENSATION.
Information regarding Executive Compensation is incorporated by reference
to the Fund's 2001 Proxy Statement.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT.
Information regarding Security Ownership of Certain Beneficial Owners and
Management is incorporated by reference to the Fund's 2001 Proxy Statement.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS.
Information regarding Certain Relationships and Related Transactions is
incorporated by reference to the Fund's 2001 Proxy Statement.
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K.
(a)(1) FINANCIAL STATEMENTS PAGE
-------------------- ----
Report of Independent Public Accountants 30
Balance Sheets
December 31, 2000 and 1999 31
Statements of Operations for the years
ended December 31, 2000, 1999 and 1998 32
Statements of Changes in Net Assets for the
years ended December 31, 2000, 1999 and 1998 33
Statements of Cash Flows for the years ended
December 31, 2000, 1999 and 1998 34
Selected Per Share Data and Ratios for the
five years ended December 31, 2000 36
Schedule of Portfolio Securities
December 31, 2000 37
53
Schedule of Portfolio Securities
December 31, 1999 42
Notes to Financial Statements 46
All other information required in the financial statement schedules has
been incorporated in the financial statements or notes thereto or has been
omitted since the information is not applicable, not present or not present in
amounts sufficient to require submission of the schedule.
(a)(3) 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) Amended and Restated Loan Agreement by and between Equus II
Incorporated and NationsBank of Texas, N.A., dated March 29, 1996
[Incorporated by reference to Exhibit 10(g) to Registrant's
Quarterly Report on Form 10-Q for the quarter ended March 31, 1996.]
(d) Second Amendment and Restated Loan Agreement by and between Equus II
Incorporated and Nations Bank, N.A., d/b/a Bank of America, N.A.
dated June 1,1999. [Incorporated by reference to Exhibit 10 to
Registrant's Quarterly Report on form 10-Q for the quarter ended
June 30, 1999.]
(e) Form of promissory note and security agreement-pledge dated
September 30, 1999. [Incorporated by reference to Exhibit 10 to
Registrant's Quarterly Report on Form 10-Q for the quarter ended
September 30, 1999.]
(b) REPORTS ON FORM 8-K
No reports on Form 8-K were filed by the Fund during the last
quarter of the period covered by this report.
54
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.
EQUUS II INCORPORATED
/s/ NOLAN LEHMANN
Date: March 2, 2001 Nolan Lehmann, President
Pursuant to the requirements of the Securities Exchange Act of 1934, this
report has been signed below by the following persons on behalf of the
Registrant and in the capacities and on the dates indicated.
SIGNATURE TITLE DATE
--------- ----- ----
/s/ GREGORY J. FLANAGAN Director March 2, 2001
(Gregory J. Flanagan)
/s/ ROBERT L. KNAUSS Director March 2, 2001
(Robert L. Knauss)
/s/ GARY R. PETERSEN Director March 2, 2001
(Gary R. Petersen)
/s/ JOHN W. STORMS Director March 2, 2001
(John W. Storms)
/s/ FRANCIS D. TUGGLE Director March 2, 2001
(Francis D. Tuggle)
/s/ EDWARD E. WILLIAMS Director March 2, 2001
(Edward E. Williams)
/s/ NOLAN LEHMANN President and Director March 2, 2001
(Nolan Lehmann) (principal financial and
accounting officer)
/s/ SAM P. DOUGLASS Chairman of the Board and Chief March 2, 2001
(Sam P. Douglass) Executive Officer (principal
executive officer)
55