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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, 1998
[ ] 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: $64,741,633, computed on the basis of $14.6875 per share, closing
price of the common stock on the New York Stock Exchange on March 1, 1999. For
purposes of calculating this amount only, all directors and executive officers
of the registrant have been treated as affiliates. There were 4,954,304 shares
of the registrant's common stock, $.001 par value, outstanding as of March 1,
1999. The net asset value of a share at December 31, 1998 was $23.45.
Documents incorporated by reference: Proxy Statement for 1999 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 ............. 18
PART II
Item 5. Market for Registrant's Common Equity and Related Stockholder
Matters........................................................ 18
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 ....... 27
Item 8. Financial Statements and Supplementary Data...................... 29
Item 9. Changes in and Disagreements with Accountants on
Accounting and Financial Disclosure ........................... 51
PART III
Item 10. Directors and Executive Officers of the Registrant .............. 51
Item 11. Executive Compensation........................................... 51
Item 12. Security Ownership of Certain Beneficial Owners and Management .. 51
Item 13. Certain Relationships and Related Transactions .................. 51
Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K.. 51
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 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 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 securities issued or guaranteed as to interest and
principal by the United States or by a person or entity controlled or supervised
by and acting as an instrumentality of the government of the United States that
have maturities of less than one year from the date of investment 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. Such securities consist principally of 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.
1
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.
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
$2,000,000 to $8,000,000, 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.
2
CO-INVESTMENTS
The Fund has coinvested in certain Portfolio Companies with Equus Capital
Partners, L.P., a 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 29
Portfolio Companies at December 31, 1998.
3
A. C. LIQUIDATING CORPORATION
A. C. Liquidating Corporation ("ACL"), Houston, Texas, has disposed of its
operating businesses and currently holds two parcels of real estate. ACL is
offering the real estate for sale and intends to distribute the net proceeds
from such sale and its remaining cash, if any, to its shareholders as soon as
possible. At December 31, 1998, the Fund's investment in ACL consisted of
$188,014 in 10% secured promissory notes which was recorded at no value.
Investments held by the Fund represent no equity interest in ACL. Mr. Lehmann,
President of the Fund, serves as a director of ACL.
ALLIED WASTE INDUSTRIES, INC. (NYSE: AW)
Allied Waste Industries, Inc. ("AW"), Scottsdale, Arizona, is a vertically
integrated solid waste management company providing non-hazardous waste
collection, transfer, recycling and disposal services to residential, municipal
and commercial customers. At December 31, 1998, the Fund's investment in AW,
valued at $21,626,797 with a cost of $2,970,721, consisted of 875,000 shares of
common stock valued at a discounted average of $22.92 per share and a warrant to
buy up to 125,000 shares of common stock at $5.00 per share. The December 31,
1998 closing price of AW's common stock on the New York Stock Exchange was
$23.625 per share. Due to restrictions on the Fund's ability to sell a portion
of the common stock and warrants, the aggregate value recorded by the Fund was
$1,373,203 less than the aggregate value based on the market price at December
31, 1998. The Fund's investment in AW represents a less than 1% fully-diluted
equity interest in AW. Mr. Lehmann serves on AW's Board of Directors.
AMERICAN RESIDENTIAL SERVICES, INC. (NYSE: ARS)
American Residential Services, Inc. ("ARS"), Houston, Texas, operates
businesses which provide heating and air conditioning, plumbing and electrical
installation and repair services. The December 31, 1998 closing price of ARS
common stock on the New York Stock Exchange was $3.25 per share. At December 31,
1998, the Fund's investment in ARS, valued at $3,223,175 with a cost of
$3,000,272, consisted of 1,125,000 shares of common stock valued at a discounted
average of $2.87 per share, and warrants to buy up to 100,000 shares of common
stock at $15.00 per share. Due to restrictions on the Fund's ability to sell the
common stock and warrants, the aggregate value recorded by the Fund was $433,076
less than the aggregate value based on the market price at December 31, 1998.
The Fund's investment in ARS represents an approximate 8% fully-diluted equity
interest in ARS. Mr. Lehmann and Mr. Hale, a Vice President of the Fund, serve
as directors of ARS.
ATLAS ACQUISITION, INC.
Atlas Acquisition, Inc. ("Atlas"), Atlanta, Georgia, acquired the
operations of a 68 year old distributor of "Atlas" branded tires, batteries and
accessories sold primarily to the auto repair and full service gas station
market. At December 31, 1998, the Fund's investment in Atlas, valued at $250,000
with an original cost of $850,000, consisted of a junior participation in a
prime + 1.5% promissory note.
CARRUTH-DOGGETT INDUSTRIES, INC.
Carruth-Doggett Industries, Inc. ("CDI"), Houston, Texas, operates five
Case Equipment dealerships in the Houston area, which are involved in the sale
and rental of new and used equipment, parts and services. Case is the second
largest manufacturer of farm equipment in North America and the largest
manufacturer of light and medium-sized construction equipment in the world. At
December 31, 1998, the Fund's investment in CDI, valued at $4,500,000 with a
cost of $2,250,000, consisted of a $2,250,000, 10% senior subordinated
promissory note, a warrant to buy up to 33,333 shares of CDI for $0.01 per share
and a warrant to buy up to 249 shares of CDE Corp., a sister company of CDI that
owns
4
the real property leased by CDI, for $0.01 per share. The Fund's investment in
CDI represents a 25% fully-diluted equity interest. The Fund has committed to
invest up to an additional $2,000,000 under certain circumstances. Mr. Forbes, a
Vice President of the Fund, serves on CDI's Board of Directors.
CONTAINER ACQUISITION, INC.
Container Acquisition, Inc. ("Container"), Houston, Texas, is a logistics
and maintenance services company serving owners of international shipping
containers. At December 31, 1998, the Fund's investment in Container, valued at
its original cost of $6,778,800, consisted of 1,370,000 shares of common stock,
54,078 shares of preferred stock and a warrant, exercisable under certain
conditions, to buy 370,588 shares of common stock at $0.01 per share. The Fund's
investment in Container represents a 65% fully-diluted equity interest. Mr.
Lehmann and Mr. Forbes 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. At December 31, 1998, the Fund's investment in CRC,
valued at $21,921,550 with a cost of $6,433,737, consisted of 59,891 shares of
common stock and a 12% subordinated promissory note in the amount of $959,700.
The Fund's investment in CRC represents an approximate 34% fully-diluted equity
interest. Mr. Lehmann and Mr. Forbes serve as directors of CRC.
THE DRILLTEC CORPORATION
The Drilltec Corporation ("Drilltec"), Houston, Texas, provides protection
and packaging of premium oil country tubular goods, drill pipe and line pipe and
manufactures thread protectors for customers worldwide. At December 31, 1998,
the Fund's investment in Drilltec, which was recorded at no value with an
original cost of $7,645,000, consisted of 1,400,000 shares of common stock and
62,450 shares of preferred stock. The Fund's investment in Drilltec represents a
70% fully-diluted equity interest. The Fund has committed to invest up to an
additional $1,000,000 under certain circumstances. Mr. Forbes and Mr. Cahill, a
Vice President of the Fund, serve on Drilltec's Board of Directors.
DRYPERS CORPORATION (NASDAQ: DYPR)
Drypers Corporation ("DYPR"), Houston, Texas, manufactures and distributes
disposable diapers and baby wipes sold under the trade name Drypers(R). DYPR is
believed to be the third leading branded diapeR manufacturer in the United
States, and has manufacturing facilities in Marion, Ohio; Vancouver, Washington;
Buenos Aires, Argentina; Guadalajara, Mexico; Sao Paulo, Brazil, Puerto Rico and
Malaysia. The December 31, 1998 closing price of DYPR's common stock on the
NASDAQ National Market was $3.25 per share. At December 31, 1998, the Fund's
investment in DYPR, valued at $9,646,838 with a cost of $9,328,556, consisted of
3,677,906 shares of common stock. The stock was valued at a discounted average
of $2.62 per share 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 $2,306,357. The Fund's investment in DYPR represents an approximate 21%
fully-diluted equity interest. Mr. Lehmann and Mr. Forbes serve as directors of
DYPR.
EQUICOM, INC. (FORMERLY TEXROCK RADIO, INC.)
Equicom, Inc. ("Equicom"), Austin, Texas, was formed to acquire radio
stations in small to medium-sized cities in Texas. At December 31, 1998, Equicom
owned and operated 26 radio stations. At December 31, 1998, the Fund's
investment in Equicom, valued at its original cost of $8,270,550,
5
consisted of 500,000 shares of common stock, 543,230 shares of preferred stock
and $2,682,000 in a 10% promissory note. The Fund's investment in Equicom
represents a 51% fully-diluted equity interest at December 31, 1998. The Fund
has committed to invest up to an additional $1,000,000 in Equicom under certain
circumstances. Mr. Hale and Ms. Cohen, a Vice President of the Fund, serve on
Equicom's Board of Directors.
GARDEN RIDGE CORPORATION (NASDAQ: GRDG)
Garden Ridge Corporation ("GRDG"), Houston, Texas, is a specialty retailer
of crafts and home decorative items. GRDG operates 27 megastores in 12 states
and is continuing its expansion into other areas of the United States. The
December 31, 1998 closing price of GRDG on the NASDAQ National Market was $9.063
per share. At December 31, 1998, the Fund's investment in GRDG, valued at
$4,175,267 with a cost of $685,030, consisted of 474,942 shares of common stock.
The stock was valued at a discounted average of $8.79 per share 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 $129,132. The
Fund's investment in GRDG represents an approximate 3% fully-diluted equity
interest in GRDG.
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 Brazos
Sportswear, Inc. At December 31, 1998, the Fund's investment in GCS consisted of
1,000 shares of common stock that was valued at $300,000, with a cost of
$132,910. The Fund owns 100% of the stock of GCS, and GCS owns 50% of the real
estate partnership. Mr. Douglass, Chairman and CEO of the 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, 1998, the Fund's investment in Hot & Cool, valued at $5,085,897
with a cost of $4,805,897, consisted of $1,120,000 in a 9% increasing rate
subordinated promissory note, $2,200,000 in 10% subordinated notes, $1,000,000
in a 12% senior unsecured promissory note, 12,147 shares of Series A 8%
preferred stock, and warrants to buy up to 16,316 and 14,942 shares of common
stock for $26 and $0.01 per share, respectively. The Fund has committed to
invest up to an additional $250,000 in Hot & Cool under certain circumstances.
The Fund's investment represents an approximate 22% fully-diluted equity
interest in Hot & Cool. Mr. Lehmann serves on Hot & Cool's Board of Directors.
HTD CORPORATION (FORMERLY TRIAD MEDICAL, INC.)
HTD Corporation ("HTD"), Laguna Hills, California, was formed to create a
leading national distributor of medical products and related services to the
healthcare market, principally hospitals and surgical and diagnostic centers. At
December 31, 1998, the Fund's investment in HTD, valued at $11,353,082 with a
cost of $9,502,530, consisted of 1,251,944 shares of common stock and a
$2,025,000 non-interest bearing promissory note valued at $1,337,530. The Fund's
investment in HTD represents an approximate 23% fully-diluted equity interest.
Mr. Lehmann serves on HTD'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. The
December 31, 1998 closing price of NCS's common stock on the
6
New York Stock Exchange was $28.125 per share. At December 31, 1998, the Fund's
investment in NCS consisted of 200,000 shares of common stock valued at
$5,625,000 with a cost of $159,784, which represents an approximate 1%
fully-diluted equity interest in NCI. Mr. Forbes serves as a director of NCS.
OEI INTERNATIONAL, INC.
OEI International, Inc. ("OEI"), Houston, Texas, was formed to acquire
companies providing diversified engineering services and engineered systems to a
broad spectrum of industrial, commercial and institutional clients. At December
31, 1998, the Fund's investment in OEI, valued at its original cost of
$2,500,635, consisted of 566,201 shares of common stock and $2,500,000 in a
prime + 1/2% promissory note. The Fund's investment in OEI represents aN
approximate 67% fully-diluted equity interest at such date. Mr. Lehmann and Mr.
Forbes serve on OEI's Board of Directors.
PARACELSUS HEALTHCARE CORPORATION (NYSE: PLS)
Paracelsus Healthcare Corporation ("PLS"), Houston, Texas, owns or
operates, directly or through hospital partnerships, 17 hospitals and four
skilled nursing facilities in nine states. The December 31, 1998 closing price
of PLS's common stock on the New York Stock Exchange was $1.563 per share. At
December 31, 1998, the Fund's investment in PLS, valued at $1,833,106 with a
cost of $5,278,748, consisted of 1,263,058 shares of common stock. The common
stock of PLS was valued by the Fund at a discounted average of $1.45 per share
at December 31, 1998, 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 $141,054. The Fund's investment in PLS represents an approximate
2% fully-diluted equity interest in PLS.
PETROCON ENGINEERING, INC.
Petrocon Engineering, Inc. ("Petrocon"), Beaumont, Texas, is an
international engineering, systems and construction management contractor,
servicing industrial customers with a primary focus in the process industries -
oil, chemical, petrochemical and forest products. At December 31, 1998, the
Fund's investment valued at its original cost of $2,500,000 consisted of a 15%
promissory note. The Fund has committed to invest up to an additional $2,000,000
in Petrocon under certain circumstances.
RAYTEL MEDICAL CORPORATION (NASDAQ: RTEL)
Raytel Medical Corporation ("RTEL"), San Mateo, California, is a leading
nationwide provider of alternate-site medical service to physicians, hospitals,
patients and managed care groups. The closing price of RTEL's common stock on
the NASDAQ National Market was $4.656 per share. At December 31, 1998, the
Fund's investment in RTEL, valued at $153,988 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% fully-diluted equity interest.
SOVEREIGN BUSINESS FORMS, INC.
Sovereign Business Forms, Inc. ("Sovereign"), Houston, Texas, is a
manufacturer of wholesale business forms in four states. At December 31, 1998,
the Fund's investment in Sovereign, valued at $3,640,000 with a cost of
$2,140,000, consisted of 13,400 shares of preferred stock, $800,000 in 15%
promissory notes and warrants to buy up to 551,894 and 25,070 shares of common
stock at $1 and $1.25 per share, respectively. The Fund has committed to invest
up to an additional $2,000,000 in Sovereign under certain circumstances. The
Fund's investment represents a 26% fully-diluted equity interest in Sovereign.
Mr. Forbes serves on Sovereign's Board of Directors.
7
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, 1998, the Fund's investment in LaFrance, valued at
$3,498,452 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. The
Fund's investment in LaFrance represents an approximate 17% fully-diluted equity
interest. Mr. Forbes serves on the Board of Directors of LaFrance.
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, 1998, the Fund's investment in SHI was valued
at its 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 warrants to buy 225,000, 100,000 and
2,219,237 shares of SHI at $0.4643, $1.50 and $0.01 per share, 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, 1998, the Fund's investment in SMIP was valued
at $325,000, its original cost. The Fund's investment in SMIP consists of 1,000
shares of common stock and a $175,000, 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 represents 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 owns Doane Pet Care Company and Windy
Hill Pet Food Holdings, Inc., which combined are believed to be the largest
manufacturer of private label dry pet food in the United States. At December 31,
1998, the Fund's investment in DPC was valued at $4,600,000, with an original
cost of $2,600,000. 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, builders' hardware and various other products used in the
construction industry. At December 31, 1998, the Fund's investment in Travis,
valued at $6,508,792 with a cost of $560,290, consisted of 66,784 shares of
common stock and 104,500 shares of Class A common stock, which represents an
approximate 14% fully-diluted equity interest in Travis. Mr.
Lehmann serves as a director of Travis.
TULSA INDUSTRIES, INC.
Tulsa Industries, Inc. ("Tulsa"), Broken Arrow, Oklahoma, manufactures
equipment for the oil and gas industry. At December 31, 1998, the Fund's
investment in Tulsa, was recorded at no value with
8
an original cost of $5,500,000. The Fund's investment consisted of 27,500 shares
of common stock, 546,615 shares of Series A preferred stock and warrants to buy
up to 31,731 shares of common stock for $0.001 per share, representing an
approximate 34% fully-diluted equity interest. The Fund has committed to invest
up to an additional $600,000 in Tulsa under certain circumstances. Mr. Forbes
and Mr. Hale serve on Tulsa's Board of Directors.
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, 1998, the Fund's investment in UIS was recorded at its original
cost of $3,500,100 and consisted of 35,000 shares of preferred stock and
warrants to buy up to 63,637 shares of common stock at $0.01 through June 2008.
The Fund's investment in UIS represents an approximate 38% fully-diluted equity
interest. Mr. Forbes serves on UIS's Board of Directors.
UNITED RENTALS, INC. (NYSE: URI)
United Rentals, Inc. ("URI"), Greenwich, Connecticut, was formed in
September 1997 for the purpose of creating a large, geographically diversified
equipment rental company. URI commenced rental operations in October 1997 by
acquiring six established equipment rental companies, including J&J Equipment
Rental, a Portfolio Company of the Fund. The December 31, 1998 closing price of
URI's common stock on the New York Stock Exchange was $33.125 per share. At
December 31, 1998, the Fund's investment in URI, valued at $1,799,814, with a
cost of $397, consisted of 54,334 shares of common stock, subject to adjustment.
The Fund's investment in URI represents a less than 1% fully-diluted equity
interest. The Fund sold its investment in URI in January 1999 for $1,738,037,
realizing capital gains of $1,737,639.
UNITED STATES FILTER CORPORATION (NYSE: USF)
United States Filter Corporation ("USF"), Palm Desert, California, is a
global provider of industrial and municipal water and wastewater treatment
systems, products and services. The December 31, 1998 closing price of USF's
common stock on the New York Stock Exchange was $22.875 per share. At December
31, 1998, the Fund's investment, valued at $2,980,613 with an original cost of
$1,544,606, consisted of 130,300 shares of common stock. The Fund's investment
in USF represents less than a 1% fully-diluted equity interest.
VRPI SPIN OFF, INC. AND RELATED ENTITY
VRPI Spin Off, Inc. ("VRS"), Houston, Texas, owns the rights to receive
over 50% of all general partner distributions from a limited partnership that
has franchise rights to operate 12 BLOCKBUSTER(R) Entertainment CorporatioN
video cassette stores in the Pittsburgh, Pennsylvania area. At December 31,
1998, the Fund's investment in VRS, valued at its original cost of $250,000,
consisted of 100 shares of common stock. VRS is wholly-owned by the Fund.
Messrs. Douglass, Lehmann and Dr. Williams, a director of the Fund, serve as
directors of VRS and Video Rental of Pennsylvania, Inc. ("VRP"), the managing
general partner of the limited partnership.
Equus Video Corporation ("Video"), Houston, Texas, owns an 80% limited
partnership interest in a partnership whose sole general partner is VRS. The
limited partnership operates 8 additional BLOCKBUSTER(R) EntertainmenT
Corporation video cassette stores in and around Pittsburgh. At December 31,
1998, the Fund's investment in 10,000 shares of common stock of Video was valued
at $20,000, with an original cost of $25,000. In addition, the Fund has invested
$2,672,349 in a 10% secured promissory note and $1,050,000 in a 12% secured
promissory note of such partnership. The
9
notes are guaranteed by VRP. Mr. Douglass and Mr. Lehmann serve as directors of
Video.
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. The Fund
expects to 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
10
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.
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.
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.
11
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 NationsBank, N.A. with
respect to the safekeeping of such securities. The principal business office of
such company is 700 Louisiana Street, Suite 3200, Houston, Texas 77002.
TRANSFER AND DISBURSING AGENT
The Fund employs ChaseMellon Shareholders Services ("ChaseMellon") as its
transfer agent to record transfers of the shares, maintain proxy records and to
process distributions. The principal business office of ChaseMellon is 2323
Bryan Street, Suite 2300, Dallas, Texas 75201.
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 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 1999 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.
12
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 29 Portfolio Companies, of which two exceed 10% and one
exceeds 15% of the value of its net assets.
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, 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
13
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-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 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
14
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. 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. 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. 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, 1998, approximately 93% 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
provide 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
15
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 the capital appreciation of the Fund's investments through
March 31, 1997, and for an incentive stock option plan thereafter.
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
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,
16
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 for 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.
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 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.
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. In the opinion of Management, the financial
position or results of operations of the Fund will not be materially affected by
these claims.
17
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 1998.
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 9,008 shareholders at December 31, 1998, 1,578 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, 1998, was $23.45.
The following table reflects the high and low sales prices per share of
the Fund's common stock on the New York Stock Exchange or American Stock
Exchange for the two years ended December 31, 1998, by quarter.
QUARTER
ENDED HIGH LOW
--------- ------ ------
03/31/97 17.375 16.000
06/30/97 21.750 16.000
09/30/97 25.500 20.438
12/31/97 27.313 19.500
03/31/98 28.875 22.125
06/30/98 28.563 26.063
09/30/98 26.500 17.625
12/31/98 19.500 15.188
Historically, net investment income and net realized gains from the sale
of portfolio investments have been distributed at least annually, to the extent
such amounts were not reserved for payment of contingencies or to make follow-on
or new investments.
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.
The Fund declared dividends of $3,138,520 ($0.65 per share), $2,380,327
($0.50 per share) and $3,180,422 ($0.76 per share) during 1998, 1997 and 1996,
respectively. The Fund has adopted a policy to make dividend distributions of at
least $0.50 per share on an annual basis. In the event that taxable income,
including realized capital gains, exceeds $0.50 per share in any year,
additional dividends may be declared to distribute such excess. The 1998
dividend was paid in additional shares of common stock or in cash by specific
election of the shareholder in December 1998, and represented long-term capital
gains. The 1997 dividend, which represented a return of capital, and the 1996
dividend, which represented the Fund's net investment income and net capital
gains, for tax purposes, were paid in additional shares of common stock or in
cash by specific election of the shareholders in January 1998 and 1997,
respectively. The Fund paid $991,853, $828,556 and $1,209,850 in cash and issued
125,812, 67,837 and 115,916 additional shares of stock at $17.0625, $22.875 and
$17.00 per share in December
18
1998 and January 1998 and 1997, respectively, in connection with such dividends.
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 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, 1998.
Amounts are in thousands except per share data.
1998 1997 1996 1995 1994
--------- --------- --------- --------- ---------
Total investment income ........ $ 3,774 $ 4,013 $ 2,590 $ 3,075 $ 1,921
Net investment income (loss) ... $ (2,179) $ (922) $ (8,267) $ (668) $ 518
Realized gain (loss) on sales
of portfolio securities, net $ (3,564) $ 7,566 $ 4,037 $ 7,669 $ (350)
Increase (decrease) in
unrealized appreciation of
portfolio securities, net ... $ (21,581) $ 24,222 $ 33,696 $ (1,281) $ (2,563)
Total increase (decrease) in
net assets from operations .. $ (27,324) $ 30,865 $ 29,467 $ 5,720 $ (2,395)
Dividends ...................... $ 3,139 $ 2,380 $ 3,180 $ 5,815 $ 763
Total assets at end of year .... $ 215,603 $ 228,095 $ 181,166 $ 132,450 $ 109,941
Net assets at end of year ...... $ 116,155 $ 144,471 $ 103,223 $ 61,853 $ 60,880
Net cash used by operating
activities .................. $ (4,298) $ (1,043) $ (2,494) $ (403) $ (186)
Shares outstanding at end
of year ..................... 4,954 4,828 4,301 3,139 3,053
Average shares outstanding
during year ................... 4,829 4,733 3,819 2,968 3,084
PER SHARE DATA:
1998 1997 1996 1995 1994
--------- --------- --------- --------- ---------
Net investment
income (loss) ............... $ (0.45) $ (0.19) $ (2.16) $ (0.22) $ 0.17
Realized gain (loss) on sales
of portfolio securities, net $ (0.74) $ 1.60 $ 1.06 $ 2.58 $ (0.12)
Increase (decrease) in
unrealized appreciation of
portfolio securities, net ... $ (4.47) $ 5.11 $ 8.82 $ (0.43) $ (0.83)
Dividends ...................... $ 0.65 $ 0.50 $ 0.76 $ 2.00 $ 0.25
Net asset value (including
unrealized appreciation),
end of year ................. $ 23.45 $ 29.92 $ 24.00 $ 19.71 $ 19.94
20
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS.
LIQUIDITY AND CAPITAL RESOURCES
At December 31, 1998, the Fund had $154,248,818 of its assets invested in
portfolio securities of 29 companies, and has committed to invest up to an
additional $8,850,000 in seven of such companies and $6,000,000 in one new
company under certain conditions. 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, 1998, the Fund had $38,500,000
outstanding on a $50,000,000 revolving line of credit loan from a bank.
Net cash used by operating activities was $4,298,452, $1,043,710 and
$2,493,597 for the three years ended December 31, 1998, respectively.
At December 31, 1998, the Fund had $60,214,266 of its total assets of
$215,603,144 invested in temporary cash investments consisting of money market
securities. This amount includes proceeds of $60,000,000 from a $150,000,000
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 4, 1999.
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.
RESULTS OF OPERATIONS
INVESTMENT INCOME AND EXPENSE
Net investment loss after all expenses amounted to $2,178,659, $922,117
and $8,266,606 for the three years ended December 31, 1998. Income from
portfolio securities was $3,726,430 in 1998, $3,926,814 in 1997 and $2,455,102
in 1996. Amounts invested in interest- and dividend- bearing portfolio
securities were lower during 1998 and 1996 as compared to 1997. Interest income
from temporary cash investments was $48,004 in 1998, $85,861 in 1997 and
$135,379 in 1996. The steady decrease in 1998 and 1997 as compared to 1996 was a
result of lower investable balances throughout the year.
The larger net investment loss in 1998 was primarily attributable to
interest expense which increased to $1,970,973 as compared to $429,940 in 1997.
The net investment loss in 1997 was lower as compared to 1996 due to the
decrease in the accrual of current and deferred management incentive fees which
were $482,326 and $7,546,705 in 1997 and 1996, respectively.
21
Mailing, printing and other expenses were $383,664 during 1998 as compared
to $337,531 during 1997 and $218,982 during 1996, due to the higher cost for the
preparation and distribution of the annual report and proxy statement for the
annual shareholder's meeting held in May 1998. Interest expense was $1,970,973,
as compared to $429,940 in 1997 and $582,884 in 1996 due to changes of the
average daily balances outstanding on the lines of credit to $23,469,957 in
1998, from $4,284,027 in 1997 and $5,956,570 in 1996.
Professional fees decreased to $490,954 during 1998 as compared to
$520,161 during 1997 and $303,545 during 1996, due primarily to the higher costs
associated with the Special Meeting of Stockholders held during 1997. The costs
included the Fund's portion of the independent third party appraisal of the
Fund's investment in portfolio securities and the legal expenses related to the
filing of the exemptive order with the SEC.
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 $2,706,325, $2,794,795 and $1,848,253 during 1998, 1997 and 1996,
respectively. The increase during the year ended December 31, 1997 was due to
the issuance of $11,210,529 in new equity and an increase in net assets from
$103,223,308 to $144,470,752.
Through March 31, 1997, the Management Company also received or reimbursed
a management incentive fee equal to 20% of net realized capital gains less
unrealized capital depreciation, computed on a cumulative basis over the life of
the Fund. Management incentive fees of $55,825 and $1,058,012 were accrued
during the years ended December 31, 1997 and 1996, respectively. Deferred
management incentive fee expense for the years ended December 31, 1997 and 1996
totaled $426,501 and $6,488,693, respectively. Pursuant to the vote of the
stockholders at the Special Meeting, the Fund entered into a new management
agreement with the Management Company which eliminated incentive fees based on
capital gains. For the year ended December 31, 1998, due to the new management
agreement, there were no management incentive fees incurred. Pursuant to the
vote of the stockholders at the Special Meeting, the deferred incentive fee of
$11,210,529 at March 31, 1997, was paid on May 15, 1997, by the issuance of
459,973 unregistered shares of common stock of the Fund. The number of shares
issued was determined by dividing the deferred incentive fee by $24.37 per
share, the net asset value per share at March 31, 1997.
At the Special Meeting, shareholders 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.
Implementation of this plan was subject to the receipt of an exemptive order
from the SEC, which was received on May 8, 1997.
The Stock Incentive Plan also provides that each director who is not an
officer of the Fund be granted an incentive stock option to purchase 5,000
shares of the Fund's common stock. In addition, beginning with the 1998 annual
meeting of shareholders, each director who was not an officer of the Fund was,
on the first business day following the annual meeting, granted a nonqualified
stock option to purchase 2,000 shares of the Fund's common stock.
Under the 1997 Stock Incentive Plan, options to purchase 939,131 and
927,131 shares of the Fund's common stock with a weighted average exercise price
of $17.66 and $17.54 per share were outstanding at December 31, 1998 and 1997,
respectively. The Fund had 671,849 and 431,308 shares in exercisable options
with a weighted average exercise price per share of $17.58 and $17.00 at
December 31, 1998 and 1997, respectively. Outstanding options at December 31,
1998 have exercise prices ranging from $17 to $27.44 and expire in May 2007
through May 2008. During 1998 and 1997, no
22
options were exercised. As of December 31, 1998, all options outstanding were
"out of the money" and would have an anti-dilutive effect on net assets per
share if exercised. If all options granted were exercised as of December 31,
1997, there would have been dilution of net assets per share of approximately
$1.28 per share, or 4.3%, as a result of such exercise.
REALIZED GAINS AND LOSSES ON SALES OF PORTFOLIO SECURITIES
During the year ended December 31, 1998, the Fund realized net capital
losses of $3,563,556 from the sale or write off of securities of eleven
Portfolio Companies. The Fund sold 143,112 shares of Coach USA, Inc. common
stock for $6,620,305, realizing a capital gain of $4,756,948 and 32,128 shares
of U.S. Filter Corporation common stock for $1,059,964, realizing a capital gain
of $679,111. 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 the $735,525, representing original issue discount which 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. The Fund sold 225,000 shares of
Allied Waste Industries, Inc. for $4,710,866, realizing a capital gain of
$3,644,015. A capital loss of $2,000,000 was recognized by the Fund for the
write off of its investment in Atlas Acquisition, Inc. due to the company's
liquidation. The Fund's investment in Brazos Sportswear, Inc. was also written
off, resulting in a realized capital loss of $8,235,367 due to the company's
declining financial performance and the subsequent filing of voluntary petitions
under Chapter 11 of the Bankruptcy Code in January 1999. The Fund also realized
a capital loss of $2,089,432 from the liquidation of Restaurant Development
Group.
During the year ended December 31, 1997 the Fund had net realized gains of
$7,565,699 from the sale of investments in eight portfolio companies. The Fund
sold 251,449 shares of Allied Waste Industries, Inc. for $4,236,177 realizing a
net capital gain of $3,163,942, sold 96,035 shares of American Residential
Services, Inc. for $2,186,926 realizing a net capital gain of $2,130,098, sold
its investment in Industrial Equipment Rentals, Inc. for $6,736,956 realizing a
net capital gain of $4,370,256, sold its investments in J&J Rental Service, Inc.
for $2,137,400 in cash, an $840,000 receivable and 62,149 shares of United
Rentals, Inc., realizing a capital gain of $977,400, sold its investment in
Midway Airlines for $271,000 realizing a net capital loss of $3,943,226, and
sold its investment in David's Supermarkets for $5,546,800 realizing a net
capital gain of $1,477,350. In August 1997, the Fund sold its investment in
Cardiovascular Ventures, Inc. to Raytel Medical Corporation ("RTEL") receiving
cash proceeds of $2,170,891 and 33,073 shares of common stock, valued at
$330,730, of RTEL. The Fund recognized a capital loss of $121,621 on such sale.
In December 1997, the Fund realized a loss of $488,500 on its investment in A.C.
Liquidating preferred stock which was deemed worthless.
During the year ended December 31, 1996, the Fund realized net capital
gains of $4,037,326 from the sale or disposition of securities of seven
portfolio companies. The Fund sold 233,044 shares of Allied Waste Industries,
Inc. common stock for $1,563,678, realizing a capital gain of $461,919;
exchanged 5,000 shares of Enterprises Holding Company preferred stock for
$1,765,243 in cash and 238,933 shares of American Residential Services, Inc.
common stock, realizing a capital gain of $1,765,243; sold 96,000 shares of
Garden Ridge Corporation common stock for $4,719,360 realizing a capital gain of
$4,343,372; was repaid $350,000 on a note receivable from Restaurant Development
Group, Inc. which had a basis of $275,000, realizing a capital gain of $75,000;
sold 32,789 shares of Tech-Sym Corporation for $1,029,901, realizing a capital
gain of $911,656; and exchanged $5,083,083
23
of notes receivable from Yellow Cab Service Corporation and $63,601 in cash for
71,440 shares of Coach USA, Inc. common stock, valued at $1,714,560, realizing a
capital loss of $3,432,124. In addition, the Fund realized a capital loss of
$87,740 on its investment in Sports & Leisure, Inc.
UNREALIZED APPRECIATION AND DEPRECIATION OF PORTFOLIO 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. The significant
decrease in net unrealized appreciation in 1998 as compared to 1997 and 1996 is
primarily attributable to the overall weakness in the small-cap equities market
in 1998, the write down of investments in two portfolio companies providing
equipment and services to the oil and gas industry and the write off of
investments in two portfolio companies.
Net unrealized appreciation of investments increased $24,221,889 during
the year ended December 31, 1997, from $41,671,464 to $65,893,353. Such net
increase resulted from increases in the estimated fair value of securities of
twelve of the Fund's Portfolio Companies aggregating $33,857,604, a decrease in
the estimated fair value of securities of five Portfolio Companies of $9,475,904
and the transfer of $159,811 in net unrealized appreciation to net realized
gains from the sale of investments in six companies.
Net unrealized appreciation on investments increased $33,696,196 during
the year ended December 31, 1996, from $7,975,268 to $41,671,464. Such net
increase resulted from increases in the estimated fair value of securities of
eleven of the Fund's Portfolio Companies aggregating $42,748,672, decreases in
the estimated fair value of the securities of four of the Fund's Portfolio
Companies aggregating $9,264,364, and the transfer of $211,888 in net unrealized
depreciation to net realized gains from the sale of investments in six
companies.
DIVIDENDS
The Fund declared dividends of $3,138,520 ($0.65 per share), $2,380,327
($0.50 per share) and $3,180,422 ($0.76 per share) during 1998, 1997 and 1996,
respectively. The Fund has adopted a policy to make dividend distributions of at
least $0.50 per share on an annual basis. In the event that taxable income,
including realized capital gains, exceeds $0.50 per share in any year,
additional dividends may be declared to distribute such excess. The 1998
dividend represented long-term capital gains and was paid in additional shares
of common stock or in cash by specific election of the shareholders in December
1998. The 1997 dividend, which represented a return of capital, and 1996
dividend, which represented the Fund's net investment income and net capital
gains, for tax purposes, were paid in additional shares of common stock or in
cash by specific election of the shareholders in January 1998 and 1997,
respectively. The Fund paid $991,853, $828,556 and $1,209,850 in cash and issued
125,812, 67,837 and 115,916 additional shares of stock at $17.0625, $22.875 and
$17.00 per share, in December 1998 and January 1998 and 1997, respectively, in
connection with such dividends. The stock issued in January 1998 and 1997 is
reflected as outstanding as of December 31, 1997 and 1996 in the accompanying
financial statements.
PORTFOLIO INVESTMENTS
During the year ended December 31, 1998, the Fund invested $13,645,100 in
three new
24
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 January 1998, the Fund advanced $3,595,380 under a 10% promissory note
to Equicom, Inc. ("Equicom"), in connection with the acquisition of 8 radio
stations. On January 27, 1998, the Fund converted $6,372,586 in promissory notes
along with $67,918 in accrued interest into 819,680 shares of common stock and
619,050 shares of preferred stock of Equicom. Subsequent to such conversion, the
Fund acquired for $3,134,030 an additional 313,403 shares of preferred stock of
Equicom. During the second quarter of 1998, Equicom completed a .976 for 1
reverse stock split of its common stock. On June 30, 1998, the Fund sold 300,000
shares of Equicom common stock and 389,223 shares of Equicom preferred stock to
co-investors for $93,750 and $3,892,230, respectively, the original cost of each
investment. During 1998, the Fund advanced $2,682,000 to Equicom under a 10%
subordinated note.
During the year ended December 31, 1998, the Fund made additional
investments by advancing $1,000,000, $2,433,819, $373,035 and $6,750,000 to Hot
& Cool Holdings, Inc., OEI International, Inc., HTD Corporation (formerly Triad
Medical Inc.), and Strategic Holdings, Inc., respectively, under subordinated
promissory notes.
In the first quarter of 1998, the Fund advanced an additional $850,000 to
a bank for a junior participation agreement in a loan to Atlas Acquisition, Inc.
In October 1998, Atlas Acquisition, Inc. was liquidated, and the bank foreclosed
on its collateral. The Fund expects to receive some funds as the collateral is
liquidated.
On January 15, 1998, the Fund exchanged its stock investment in WMW
Industries, Inc. for 162,428 shares of United States Filter Corporation ("U.S.
Filter") common stock. The Fund also received $1,012,576 in cash, in
satisfaction of its junior participation note. The Fund could receive up to an
additional 41,560 shares of U.S. Filter common stock, which were placed in an
escrow account as security for various representations made by the Fund. The
transaction with U.S. Filter, which is traded on the New York Stock Exchange,
was a tax-free exchange; therefore the Fund did not realize a capital gain from
such transaction.
On March 3, 1998, the Fund converted its 25,000 shares of 7.5% convertible
preferred stock of Drypers Corporation into 2,500,000 shares of Drypers common
stock. In addition, the Fund received 70,024 shares of Drypers common stock in
payment of $401,938 in dividends on such preferred stock.
Through December 31, 1998, the Fund received an additional 5,084 shares of
preferred stock of Container Acquisition, Inc. in payment for $508,400 of
dividends on the preferred stock.
In 1998, the Fund received an additional 1,410 shares of Sovereign
Business Forms, Inc. preferred stock in payment of $141,000 in dividends.
For the year ended December 31, 1998, the Fund received an additional
324,844, 110,476 and 90,460 shares of Series B1, B2 and B3 preferred stock of
Brazos Sportswear, Inc., respectively, in payment of $525,780 in dividends on
the preferred stock.
On May 27, 1998, the Fund acquired an additional 24,891 shares of CRC
Holdings, Corp. for $2,275,037, as a follow-on investment to enable CRC to make
an acquisition.
On April 14, 1998, the Fund's investment in Triad Medical Inc. ("Triad")
was reduced from 449,213 shares of common stock to 196,808 shares (excluding
14,493 shares held in escrow) of common stock, as the result of a reverse stock
split. On May 1, 1998, the Fund invested an additional $7,815,000
25
in Triad in exchange for 976,875 shares of common stock. In addition, on May 1,
1998, Triad acquired four companies in the specialty medical distribution
business, including Healthcare Technology Delivery, Inc. ("HTD"), in which the
Fund had an investment at September 30, 1998. The Fund received 78,261 shares of
Triad common stock for its investment in HTD. In addition, the Fund's prime
+1/2% promissory note due from Triad in the amount of $2,025,000 was renewed in
the form of a non-interest bearing promissory note due in 2005. In connection
with such renewal, the Fund forgave $102,232 of accrued interest receivable from
Triad. In addition, the Fund discounted the non-interest bearing note to
$1,289,475, realizing a capital loss of $735,525. Such original issue discount
is being accreted to income over the life of the note. For the year ended
December 31, 1998, the original issue discount accretion amounted to $48,055.
On July 1, 1998, the Fund acquired 35,000 shares of preferred stock of
United Industrial Services, Inc. ("UIS") for $3,500,000, and paid $100 to
acquire warrants to purchase up to 63,637 shares of common stock of UIS for
$0.01 per share through June 30, 2008. UIS, located in Houston, Texas,
specializes in field services for the petrochemical and power generation
industries.
On July 29, 1998, the initial public offering of OEI International, Inc.
was postponed due to the market conditions and other factors. In October 1998,
OEI International, Inc. completed a 0.487716 reverse stock split of its common
stock.
In August 1998, the Fund acquired 1,400,000 shares of common stock and
62,450 shares of preferred stock for $1,400,000 and $6,245,000, respectively,
from The Drilltec Corporation ("Drilltec"). Drilltec provides protection and
packaging of premium oil country tubular goods, drill pipe and line pipe and
manufactures thread protectors for customers throughout the world.
On September 10, 1998, the Fund advanced $2,500,000 under a 15% promissory
note with Petrocon Engineering, Inc. ("Petrocon"). Petrocon is an international
engineering, systems and construction management contractor, servicing
industrial customers with a primary focus in the process industries - oil,
chemical, petrochemical and forest products.
On December 31, 1998, the Fund received $485,897 in shares of Series A 8%
preferred stock from Hot & Cool Holdings, Inc. ("Hot & Cool") in payment of
$180,000 in principal on the 9% increasing rate subordinated promissory note and
$305,897 in interest on the promissory notes from Hot & Cool.
During the year ended December 31, 1997, the Fund invested $27,644,902 in
eleven new companies and made follow-on investments of $5,952,669 in eight
portfolio companies, including $1,238,434 in dividends and accrued interest
received in the form of additional portfolio securities and $330,730 in
securities received upon the sale of securities of another portfolio company.
During the year ended December 31, 1996, the Fund invested $9,800,000 in
three new Portfolio Companies and made follow-on investments in nine Portfolio
Companies of $10,274,910, including $435,679 in accrued interest and dividends
received in the form of additional portfolio securities and $750,000 in common
stock received through the net exercise of common stock warrants.
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, 1998,
only ARS, AW, DYPR, GRDG, NCS, PLS, RTEL, URI and USF 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
26
valuation of the Fund's investment. See "Valuation"
YEAR 2000
Many computer software systems in use today cannot properly process
date-related information from and after January 1, 2000. Should any of the
computer systems employed by the Management Company, any of the Fund's other
major service providers, or companies in which the Fund has an investment, fail
to process this type of information properly, that could have a negative impact
on the Fund's operations and the services provided to the Fund's stockholders.
The Management Company has identified its computer systems to be replaced
and modified for Year 2000 compliance with installation anticipated to be
completed by June 30, 1999. In addition, the Fund has made inquiries of its
major service providers as well as its Portfolio Companies to determine if they
are in the process of reviewing their systems for Year 2000 compliance. The Fund
has received assurances from all of its major service providers that they are
preparing for Year 2000. The Fund has received assurances from a majority of its
Portfolio Companies, representing approximately 81% of the Fund's total value in
portfolio securities at December 31, 1998, and is continuing its process of
obtaining assurances from the remaining Portfolio Companies. While the Fund has
received assurances from major services providers and a majority of the
Portfolio Companies regarding Year 2000 compliance, there can be no guarantee
that Year 2000 problems originating from these third parties, whose systems
effect the Fund, will not occur. The Fund does not expect to incur any expenses
related to Year 2000 issues as such costs are primarily the responsibility of
the Management Company. The Fund will develop a contingency plan if significant
risks related to Year 2000 are identified.
SUBSEQUENT EVENTS
Subsequent to December 31, 1998, the Fund repaid a net $60,000,000 of
notes payable to the bank.
In January 1999, the Fund sold its investment of 54,334 shares of common
stock in United Rentals, Inc. for $1,738,037, realizing a capital gain of
$1,737,639.
On January 29, 1999, Brazos Sportswear, Inc. filed voluntary petitions
under Chapter 11 of the Bankruptcy Code. The Fund's investment in Brazos
Sportswear, Inc. was written off as of December 31, 1998.
On February 9, 1999, co-investors in Equicom, Inc. ("Equicom") purchased
48,000 shares of its common stock at its original cost of $15,000 from the Fund.
Co-investors in Equicom also purchased $1,043,500 of the $2,682,000 principal in
its 10% promissory note due to the Fund. The Fund then invested $748,310 in
Equicom and received 74,831 shares of preferred stock.
On February 11, 1999, the Fund invested $2,000,000 in CDI Rental Services,
Inc., a sister company of Carruth-Doggett Industries, Inc. The Fund's investment
consisted of a 10% senior subordinated promissory note and warrants to buy up to
12,500 and 21,250 shares of common stock for $0.01 and $0.0127 per share,
respectively, through February 2009.
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
27
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.
The Fund's liabilities consist of debt payable to a financial institution.
The revolving credit facilities are priced at floating rates of interest, with a
basis of LIBOR or prime rate at the Fund's option. As a result of the floating
rate, at any given time, a change in interest rates could result in either an
increase or decrease in the Fund's interest expense.
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 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 and warrants to
purchase common stock in publicly traded companies. These investments are
directly exposed to equity price risk, in that a hypothetical ten percent change
in these equity prices would result in a similar percentage change in the fair
value of these securities.
28
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA.
Report of Independent Public Accountants
To the Board of Directors of
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, 1998 and 1997, 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, 1998, and the selected per share data and ratios for each of the
five years in the period ended December 31, 1998. These financial statements,
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, selected per share data and ratios based on our audits.
We conducted our audits in accordance with generally accepted auditing
standards. 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 confirmation of securities
owned as of December 31, 1998, 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 $143,689,403 (124% of net assets) and
$147,899,786 (102% of net assets) as of December 31, 1998 and 1997,
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 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, 1998 and 1997, the results
of its operations, changes in net assets and cash flows for each of the three
years in the period ended December 31, 1998, and the selected per share data and
ratios for each of the five years in the period ended December 31, 1998, in
conformity with generally accepted accounting principles.
\s\ Arthur Andersen LLP
ARTHUR ANDERSEN LLP
Houston, Texas
February 26, 1999
29
EQUUS II INCORPORATED
BALANCE SHEETS
DECEMBER 31, 1998 AND 1997
1998 1997
------------- -------------
ASSETS
Investments in portfolio securities at fair value
(cost $109,937,121 and $85,556,433, respectively) ....... $ 154,248,818 $ 151,449,786
Temporary cash investments, at cost which
approximates fair value ................................. 60,214,266 75,164,751
Cash ......................................................... 39,724 15,991
Accounts receivable .......................................... 393,235 932,038
Accrued interest receivable .................................. 675,851 513,623
Commitment fees .............................................. 31,250 18,750
------------- -------------
Total assets ....................................... 215,603,144 228,094,939
------------- -------------
LIABILITIES AND NET ASSETS
Liabilities:
Accounts payable ........................................ 367,341 173,277
Dividend payable ........................................ -- 828,556
Due to management company ............................... 580,775 722,354
Notes payable to bank ................................... 98,500,000 81,900,000
------------- -------------
Total liabilities .................................. 99,448,116 83,624,187
------------- -------------
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, 4,954,304 and 4,828,492 shares outstanding 4,954 4,828
Additional paid-in capital .............................. 78,407,776 78,537,258
Undistributed net investment income ..................... -- --
Undistributed net capital gains (losses) ................ (6,569,399) 35,313
Unrealized appreciation of portfolio securities, net .... 44,311,697 65,893,353
------------- -------------
Total net assets ................................... $ 116,155,028 $ 144,470,752
============= =============
Net assets per share ............................... $ 23.45 $ 29.92
============= =============
The accompanying notes are an
integral part of these financial statements.
30
EQUUS II INCORPORATED
STATEMENTS OF OPERATIONS
FOR THE YEARS ENDED DECEMBER 31, 1998, 1997 AND 1996
1998 1997 1996
------------ ------------ ------------
Investment income:
Income from portfolio securities ............... $ 3,726,430 $ 3,926,814 $ 2,455,102
Interest from temporary cash investments ....... 48,004 85,861 135,379
------------ ------------ ------------
Total investment income .................... 3,774,434 4,012,675 2,590,481
------------ ------------ ------------
Expenses:
Management fee ................................. 2,706,325 2,794,795 1,848,253
Management incentive fees ...................... -- 55,825 1,058,012
Deferred management incentive fee .............. -- 426,501 6,488,693
Director fees and expenses ..................... 244,899 201,385 203,324
Professional fees .............................. 490,954 520,161 303,545
Administrative fees ............................ 50,000 50,000 50,000
Mailing, printing and other expenses ........... 383,664 337,531 218,982
Interest expense ............................... 1,970,973 429,940 582,884
Franchise taxes ................................ 106,278 106,924 79,934
Amortization ................................... -- 11,730 23,460
------------ ------------ ------------
Total expenses ............................ 5,953,093 4,934,792 10,857,087
------------ ------------ ------------
Net investment loss ................................. (2,178,659) (922,117) (8,266,606)
------------ ------------ ------------
Realized gain (loss) on sales of
portfolio securities, net ...................... (3,563,556) 7,565,699 4,037,326
------------ ------------ ------------
Unrealized appreciation of portfolio securities, net:
End of year .................................... 44,311,697 65,893,353 41,671,464
Beginning of year .............................. 65,893,353 41,671,464 7,975,268
------------ ------------ ------------
Increase (decrease) in unrealized
appreciation of portfolio securities, net ... (21,581,656) 24,221,889 33,696,196
------------ ------------ ------------
Total increase (decrease) in net
assets from operations ...................... $(27,323,871) $ 30,865,471 $ 29,466,916
============ ============ ============
The accompanying notes are an
integral part of these financial statements.
31
EQUUS II INCORPORATED
STATEMENTS OF CHANGES IN NET ASSETS
FOR THE YEARS ENDED DECEMBER 31, 1998, 1997 AND 1996
1998 1997 1996
------------- ------------- -------------
Operations:
Net investment loss ........................ $ (2,178,659) $ (922,117) $ (8,266,606)
Realized gain (loss) on sales of
portfolio securities, net ............... (3,563,556) 7,565,699 4,037,326
Increase (decrease) in unrealized
appreciation of portfolio securities, net (21,581,656) 24,221,889 33,696,196
------------- ------------- -------------
Increase (decrease) in net assets
from operations .............................. (27,323,871) 30,865,471 29,466,916
------------- ------------- -------------
Capital transactions:
Stock issued in payment of deferred
management incentive fee ................ -- 11,210,529 --
Proceeds from rights offering .............. -- -- 13,338,935
Rights offering expenses ................... -- -- (225,982)
Dividends .................................. (3,138,520) (2,380,327) (3,180,422)
Shares issued in common stock dividend ..... 2,146,667 1,551,771 1,970,572
------------- ------------- -------------
Increase (decrease) in net assets from
capital share transactions .............. (991,853) 10,381,973 11,903,103
------------- ------------- -------------
Increase (decrease) in net assets ............... (28,315,724) 41,247,444 41,370,019
Net assets, at beginning of year ................ 144,470,752 103,223,308 61,853,289
------------- ------------- -------------
Net assets, at end of year ...................... $ 116,155,028 $ 144,470,752 $ 103,223,308
============= ============= =============
The accompanying notes are an
integral part of these financial statements.
32
EQUUS II INCORPORATED
STATEMENTS OF CASH FLOWS
FOR THE YEARS ENDED DECEMBER 31, 1998, 1997 AND 1996
1998 1997 1996
------------- ------------- -------------
Cash flows from operating activities:
Interest and dividends received .................. $ 1,614,656 $ 3,157,683 $ 1,783,676
Cash paid to management company,
directors, bank and suppliers ................. (5,913,108) (4,201,393) (4,277,273)
------------- ------------- -------------
Net cash used by operating activities ......... (4,298,452) (1,043,710) (2,493,597)
------------- ------------- -------------
Cash flows from investing activities:
Purchase of portfolio securities ................. (44,553,395) (32,048,406) (18,889,231)
Proceeds from sales of portfolio securities ...... 18,382,928 18,546,690 8,328,182
Principal payments from portfolio securities ..... 1,012,576 5,206,728 9,281,122
Advance to portfolio company ..................... (250,000) -- --
------------- ------------- -------------
Net cash used by investing activities ......... (25,407,891) (8,294,988) (1,279,927)
------------- ------------- -------------
Cash flows from financing activities:
Advances from bank ............................... 341,700,000 354,100,000 261,250,000
Repayments to bank ............................... (325,100,000) (337,500,000) (261,700,000)
Proceeds from rights offering .................... -- -- 13,338,935
Rights offering expenses ......................... -- -- (225,982)
Dividends paid ................................... (1,820,409) (1,209,850) --
------------- ------------- -------------
Net cash provided by financing
activities ................................. 14,779,591 15,390,150 12,662,953
------------- ------------- -------------
Net increase (decrease) in cash and cash equivalents .. (14,926,752) 6,051,452 8,889,429
Cash and cash equivalents at
beginning of year ................................ 75,180,742 69,129,290 60,239,861
------------- ------------- -------------
Cash and cash equivalents at end
of year .......................................... $ 60,253,990 $ 75,180,742 $ 69,129,290
============= ============= =============
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, 1998, 1997 AND 1996
(Continued)
1998 1997 1996
------------- ------------- -------------
Reconciliation of increase in net assets
from operations to net cash used by
operating activities:
Increase (decrease) in net assets from operations ..... $ (27,323,871) $ 30,865,471 $ 29,466,916
Adjustments to reconcile increase from
operations to net cash used by operating
activities:
Realized (gain) loss on sales of portfolio
securities, net ............................... 3,563,556 (7,565,699) (4,037,326)
Decrease (increase) in unrealized
appreciation, net ............................. 21,581,656 (24,221,889) (33,696,196)
Decrease (increase) in accrued interest receivable (162,228) 383,442 (371,126)
Accrued interest or dividends exchanged
for portfolio securities ...................... (1,997,550) (1,238,434) (435,679)
Commitment fees paid ............................. (37,500) (75,000) (70,000)
Amortization of commitment fee ................... 25,000 73,750 90,000
Amortization of deferred
reorganization costs .......................... -- 11,730 23,460
Increase (decrease) in accounts payable .......... 194,064 (34,954) (34,055)
Stock issued to management company
in payment of deferred management
incentive fee ................................. -- 11,210,529 --
Increase (decrease) in due to
management company ............................ (141,579) (10,452,656) 6,570,409
------------- ------------- -------------
Net cash used by operating activities ................. $ (4,298,452) $ (1,043,710) $ (2,493,597)
============= ============= =============
The accompanying notes are an
integral part of these financial statements.
34
EQUUS II INCORPORATED
SELECTED PER SHARE DATA AND RATIOS
FOR THE FIVE YEARS ENDED DECEMBER 31,1998
1998 1997 1996 1995 1994
--------- --------- --------- --------- ---------
SELECTED PER SHARE DATA:
Investment income ...................... $ 0.78 $ 0.85 $ 0.68 $ 1.04 $ 0.62
Expenses ............................... 1.23 1.04 2.84 1.26 0.45
--------- --------- --------- --------- ---------
Net investment income (loss) ........... (0.45) (0.19) (2.16) (0.22) 0.17
Realized gain (loss) on sales of
portfolio securities, net ........... (0.74) 1.60 1.06 2.58 (0.12)
Increase (decrease) in unrealized
appreciation of portfolio
securities , net .................... (4.47) 5.11 8.82 (0.43) (0.83)
--------- --------- --------- --------- ---------
Increase (decrease) in net
assets from operations .............. (5.66) 6.52 7.72 1.93 (0.78)
--------- --------- --------- --------- ---------
Capital transactions:
Dividends .............................. (0.65) (0.50) (0.76) (2.00) (0.25)
Effect of common stock repurchases ..... -- -- -- 0.35 0.10
Dilutive effect of shares issued
in common stock dividend ............ (0.16) (0.10) (0.20) (0.51) --
Effect of Rights Offering .............. -- -- (2.47) -- --
--------- --------- --------- --------- ---------
Net decrease in assets from
capital transactions ................ (0.81) (0.60) (3.43) (2.16) (0.15)
--------- --------- --------- --------- ---------
Net increase (decrease) in net assets .. (6.47) 5.92 4.29 (0.23) (0.93)
Net assets at beginning of year ........ 29.92 24.00 19.71 19.94 20.87
--------- --------- --------- --------- ---------
Net assets at end of year .............. $ 23.45 $ 29.92 $ 24.00 $ 19.71 $ 19.94
========= ========= ========= ========= =========
Weighted average number of shares
outstanding during year, in thousands 4,829 4,733 3,819 2,968 3,083
SELECTED RATIOS:
Ratio of expenses to average
net assets .......................... 4.57% 3.98% 13.15% 6.10% 2.23%
Ratio of net investment income
(loss) to average net assets ...... (1.67)% (0.74)% (10.02)% (1.09)% 0.83%
Ratio of increase (decrease) in net
assets from operations to average
net assets .......................... (20.97)% 24.92% 35.70% 9.32% (3.81)%
The accompanying notes are an
integral part of these financial statements.
35
EQUUS II INCORPORATED
SCHEDULE OF PORTFOLIO SECURITIES
DECEMBER 31, 1998
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
-875,000 shares of common stock ........................................... 2,970,721 20,051,719
-Warrants to buy up to 125,000 shares of common
stock at $5 per share through August 1999 ................................ -- 1,575,078
American Residential Services, Inc. (NYSE - ARS) December 1995
-1,125,000 shares of common stock ......................................... 3,000,272 3,223,175
-Warrants to buy up to 100,000 shares of common
stock at $15 per share through September 2001 ........................... -- --
Atlas Acquisition, Inc. May 1997
-Junior participation in prime + 1.5% note ................................ 850,000 250,000
Carruth-Doggett Industries, Inc. December 1995
-10% senior subordinated promissory note .................................. 2,250,000 2,250,000
-Warrant to buy up to 33,333 shares of common
stock at $0.01 per share through December 2005 ........................... -- 2,250,000
-Warrant to buy up to 249 shares of common stock
of CDE Corp. at $0.01 per share through December 2005 .................... -- --
Container Acquisition, Inc. February 1997
-1,370,000 shares of common stock ......................................... 1,370,000 1,370,000
-54,078 shares of preferred stock ......................................... 5,407,800 5,407,800
-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
-59,891 shares of common stock ............................................ 5,474,037 20,961,850
-12% subordinated promissory note ......................................... 959,700 959,700
The Drilltec Corporation August 1998
-1,400,000 shares of common stock ........................................ 1,400,000 --
-62,450 shares of preferred stock ........................................ 6,245,000 --
The accompanying notes are an
integral part of these financial statements.
36
EQUUS II INCORPORATED
SCHEDULE OF PORTFOLIO SECURITIES
DECEMBER 31, 1998
(Continued)
DATE OF
PORTFOLIO COMPANY INITIAL INVESTMENT COST FAIR VALUE
------------------ ----------- -----------
Drypers Corporation (NASDAQ - DYPR) July 1991
-3,677,906 shares of common stock .................................. $ 9,328,556 $ 9,646,838
Equicom, Inc. (formerly Texrock Radio, Inc.) July 1997
-500,000 shares of common stock .................................... 156,250 156,250
-543,230 shares of preferred stock ................................. 5,432,300 5,432,300
-10% promissory note ............................................... 2,682,000 2,682,000
Garden Ridge Corporation (NASDAQ - GRDG) July 1992
-474,942 shares of common stock .................................... 685,030 4,175,267
GCS RE, Inc. February 1989
-1,000 shares of common stock ...................................... 132,910 300,000
Hot & Cool Holdings, Inc. March 1996
-9% increasing rate subordinated promissory note ................... 1,120,000 1,120,000
-10% subordinated notes ............................................ 2,200,000 2,200,000
-12% senior unsecured promissory note .............................. 1,000,000 1,000,000
-12,147 shares of Series A 8% preferred stock ...................... 485,897 485,897
-Warrants to buy up to 14,942 shares of common
stock at $0.01 per share through March 2006 ...................... -- 280,000
-Warrants to buy up to 16,316 shares of common
stock at $26.00 per share through April, 2007 .................... -- --
HTD Corporation (formerly Triad Medical Inc.) April 1997
-1,251,944 shares of common stock .................................. 8,165,000 10,015,552
-0% promissory note ................................................ 1,337,530 1,337,530
NCI Building Systems, Inc. (NYSE - NCS) April 1989
-200,000 shares of common stock .................................... 159,784 5,625,000
OEI International, Inc. October 1997
-566,201 shares of common stock .................................... 635 635
-prime + 1/2% promissory note ...................................... 2,500,000 2,500,000
Paracelsus Healthcare Corporation (NYSE - PLS) December 1990
-1,263,058 shares of common stock .................................. 5,278,748 1,833,106
The accompanying notes are an
integral part of these financial statements.
37
EQUUS II INCORPORATED
SCHEDULE OF PORTFOLIO SECURITIES
DECEMBER 31, 1998
(Continued)
DATE OF
PORTFOLIO COMPANY INITIAL INVESTMENT COST FAIR VALUE
------------------ ---------- ----------
Petrocon Engineering, Inc. September 1998
-15% promissory note ........................................................ $2,500,000 $2,500,000
Raytel Medical Corporation (NASDAQ - RTEL) August 1997
-33,073 shares of common stock .............................................. 330,730 153,988
Sovereign Business Forms, Inc. August 1996
-13,400 shares of preferred stock ........................................... 1,340,000 1,340,000
-15% promissory notes ....................................................... 800,000 800,000
-Warrant to buy 551,894 shares of common
stock at $1 per share through August 2006 ................................. -- 1,440,818
-Warrant to buy 25,070 shares of common stock
at $1.25 per share through October 2007 ................................... -- 59,182
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 ................................ -- 1,000,000
Strategic Holdings, Inc. September 1995
-3,089,751 shares of common stock ........................................... 3,088,389 1,795,035
-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 ............................ -- 26,249
-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 ............................. -- 1,267,105
-1,000 shares of SMIP, Inc. common stock .................................... 150,000 150,000
-15% promissory note of SMIP, Inc. .......................................... 175,000 175,000
Summit/DPC Partners, L.P. October 1995
-36.11% limited partnership interest ........................................ 2,600,000 4,600,000
The accompanying notes are an
integral part of these financial statements.
38
EQUUS II INCORPORATED
SCHEDULE OF PORTFOLIO SECURITIES
DECEMBER 31, 1998
(Continued)
DATE OF
PORTFOLIO COMPANY INITIAL INVESTMENT COST FAIR VALUE
------------------ ------------ ------------
Travis International, Inc. December 1986
-66,784 shares of common stock ....................................... $ 534,589 $ 2,537,792
-104,500 shares of Class A common stock .............................. 25,701 3,971,000
Tulsa Industries, Inc. December 1997
-27,500 shares of common stock ....................................... 33,846 --
-546,615 shares of Series A preferred stock .......................... 5,466,154 --
-Warrants to buy 31,731 shares of common
stock at $0.001 per share ........................................... -- --
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
United Rentals, Inc. (NYSE:URI) October 1997
-54,334 shares of common stock ....................................... 397 1,799,814
United States Filter Corporation (NYSE: USF)
-130,300 shares of common stock ...................................... 1,544,606 2,980,613
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 ............................................................. $109,937,121 $154,248,818
============ ============
The accompanying notes are an
integral part of these financial statements.
39
EQUUS II INCORPORATED
SCHEDULE OF PORTFOLIO SECURITIES
DECEMBER 31, 1998
(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 Allied Waste Industries, Inc.,
American Residential Services, Inc., Container Acquisition, Inc., CRC Holdings,
Corp., The Drilltec Corporation, Drypers Corporation, HTD Corporation, Hot &
Cool Holdings, Inc., Sovereign Business Forms, Inc., Strategic Holdings, 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, 1998, the Fund was considered to have a controlling interest in
Atlas Acquisition, Inc., Brazos Sportswear, Inc., Container Acquisition, Inc.,
CRC Holdings, Corp., The Drilltec Corporation, Drypers Corporation, OEI
International Inc., Restaurant Development Group, Inc., Sovereign Business
Forms, Inc., Strategic Holdings, Inc., Tulsa Industries, Inc., United Industrial
Services, Inc. and VRPI Spin Off, Inc. In addition, HTD Corporation and Travis
International, Inc. are considered to be affiliated entities of the Fund. The
fair values of the Fund's investments in publicly traded securities include
discounts from the closing market prices to reflect the estimated effects of
restrictions on the sale of such securities at December 31, 1998. Such
discounts, shown in the following table, total $4,382,822 or $0.88 per share as
of December 31, 1998.
DISCOUNT FROM
MARKET VALUE
-------------
Allied Waste Industries, Inc. ................................. $ 1,373,203
American Residential Services, Inc. ........................... 433,076
Drypers Corporation ........................................... 2,306,357
Garden Ridge Corporation ...................................... 129,132
Paracelsus Healthcare Corporation ............................. 141,054
-------------
Total discount .......................................... $ 4,382,822
=============
Income was earned in the amount of $2,542,677, $2,102,520 and $1,577,564
for the years December 31, 1998, 1997 and 1996 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 Garden Ridge Corporation, Raytel Medical Corporation,
Summit/DPC Partners, L.P., United Rentals, Inc. and United States Filter
Corporation. The Fund provides significant managerial assistance to portfolio
companies that comprise 91% of the total value of the investments in portfolio
companies at December 31, 1998.
The accompanying notes are an
integral part of these financial statements.
40
EQUUS II INCORPORATED
SCHEDULE OF PORTFOLIO SECURITIES
DECEMBER 31, 1997
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. (NASDAQ - AWIN) March 1989
-1,100,000 shares of common stock ......................................... 4,037,572 24,874,438
-Warrants to buy up to 125,000 shares of common
stock at $5.00 per share through August 1999 ............................. -- 1,545,977
American Residential Services, Inc. (NYSE - ARS) December 1995
-1,125,000 shares of common stock ......................................... 3,000,272 14,395,793
-Warrants to buy up to 100,000 shares of common
stock at $15 per share through September 2001 ........................... -- --
Atlas Acquisition, Inc. May 1997
-32,000 shares of common stock ............................................ 32,000 32,000
-19,680 shares of preferred stock ......................................... 1,968,000 1,968,000
Brazos Sportswear, Inc. (NASDAQ - BRZS) February 1989
-2,160,308 shares of common stock ......................................... 1,331,187 10,531,501
-3,940,779 shares of 8% Series B1 preferred stock ......................... 3,940,779 3,940,779
-1,340,210 shares of 8% Series B2 preferred stock ......................... 1,340,210 1,340,210
-1,097,410 shares of 8% Series B3 preferred stock ......................... 1,097,410 1,097,410
-Warrants to buy up to 30,261 and 140,578 shares
of common stock at $4.62 and $6.59 per share
through August 2006 and March 2007, respectively ........................ -- 7,717
-1,000 shares of common stock of GCS RE, Inc. ............................. 132,910 300,000
Carruth-Doggett Industries, Inc. December 1995
-10% senior subordinated promissory note .................................. 2,250,000 2,250,000
-Warrant to buy up to 33,333 shares of common
stock at $0.01 per share through December 2005 ........................... -- 1,500,000
-Warrant to buy up to 249 shares of common stock
of CDE Corp. at $0.01 per share through December 2005 .................... -- --
The accompanying notes are an
integral part of these financial statements.
41
EQUUS II INCORPORATED
SCHEDULE OF PORTFOLIO SECURITIES
DECEMBER 31, 1997
(Continued)
DATE OF
PORTFOLIO COMPANY INITIAL INVESTMENT COST FAIR VALUE
------------------ ----------- -----------
Coach USA, Inc. (NYSE - CUI) August 1996
-143,112 shares of common stock ........................................... $ 1,863,357 $ 4,650,424
Container Acquisition, Inc. February 1997
-1,370,000 shares of common stock ......................................... 1,370,000 1,370,000
-48,994 shares of preferred stock ......................................... 4,899,400 4,899,400
-Warrant to buy up to 370,588 shares of common
stock at $.01 per share through February 2007 ............................ 1,000 1,000
CRC Holdings, Corp. June 1997
-35,000 shares of common stock ............................................ 3,199,000 3,199,000
-12% subordinated promissory note ......................................... 959,700 959,700
Drypers Corporation (NASDAQ - DYPR) July 1991
-1,107,882 shares of common stock ......................................... 6,426,618 4,807,017
-25,000 shares of 7.5% convertible preferred stock ........................ 2,500,000 10,847,314
Equicom, Inc. (formerly Texrock Radio, Inc.) July 1997
-10% promissory note ...................................................... 2,777,207 2,777,207
Garden Ridge Corporation (NASDAQ - GRDG) July 1992
-474,942 shares of common stock ........................................... 685,030 6,458,830
Healthcare Technology Delivery, Inc. April 1997
-9,000 shares of common stock ............................................. 50,000 50,000
Hot & Cool Holdings, Inc. March 1996
-9% increasing rate subordinated promissory note .......................... 1,300,000 1,300,000
-10% subordinated notes ................................................... 2,200,000 2,200,000
-Warrants to buy up to 14,942 shares of common
stock at $.01 per share through March 2006 .............................. -- 280,000
-Warrants to buy up to 13,155 shares of common
stock at $26 per share through April, 2007 .............................. -- --
NCI Building Systems, Inc. (NASDAQ - BLDG) April 1989
-100,000 shares of common stock ........................................... 159,784 3,550,000
The accompanying notes are an
integral part of these financial statements.
42
EQUUS II INCORPORATED
SCHEDULE OF PORTFOLIO SECURITIES
DECEMBER 31, 1997
(Continued)
DATE OF
PORTFOLIO COMPANY INITIAL INVESTMENT COST FAIR VALUE
------------------ ---------- ----------
One Engineering, Inc. October 1997
-666.7 shares of common stock ............................................ $ 667 $ 667
-prime + 1/2% promissory note ............................................ 66,181 66,181
Paracelsus Healthcare Corporation (NYSE - PLS) December 1990
-1,263,058 shares of common stock ........................................ 5,278,748 3,958,090
Raytel Medical Corporation (NASDAQ - RTEL) August 1997
-33,073 shares of common stock ........................................... 330,730 326,803
Restaurant Development Group, Inc. June 1987
-610,909 shares of Class A common stock .................................. 2,891,156 700,000
-Warrants to buy up to 62,500 shares of common
stock at $3 per share through April 1998 ................................ -- --
Sovereign Business Forms, Inc. August 1996
-11,990 shares of preferred stock ........................................ 1,199,000 1,199,000
-15% promissory notes .................................................... 800,000 800,000
-Warrant to buy 551,894 shares of common
stock at $1 per share through August 2006 .............................. -- --
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 $.01 per share through September 2007 .............................. -- --
Strategic Holdings, Inc. September 1995
-3,089,751 shares of common stock ........................................ 3,088,389 3,088,389
-3,822,157 shares of Series B preferred stock ............................ 3,820,624 3,820,624
-Warrants to buy 225,000 and 100,000 shares of
common stock at $0.4643 and $1.50 per share,
respectively, through August 2005 ...................................... -- 100,000
-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.
43
EQUUS II INCORPORATED
SCHEDULE OF PORTFOLIO SECURITIES
DECEMBER 31, 1997
(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 $ 2,600,000
Travis International, Inc. December 1986
-66,784 shares of common stock ....................................... 534,589 1,502,640
-104,500 shares of Class A common stock .............................. 25,701 2,351,250
Triad Medical Inc. April 1997
-449,213 shares of common stock ...................................... 300,000 300,000
-Prime + 1/2% promissory note ........................................ 1,651,965 1,651,965
Tulsa Industries, Inc. December 1997
-27,500 shares of common stock ....................................... 33,846 33,846
-546,615 shares of Series A preferred stock .......................... 5,466,154 5,466,154
-Warrants to buy 31,731 shares of common
stock at .001 per share ............................................. -- --
United Rentals, Inc. (NYSE:URI) October 1997
-62,149 shares of common stock ....................................... 397 928,200
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
WMW Industries, Inc. October 1989
-602,707 shares of common stock ...................................... 1,031,576 2,700,000
-12% subordinated promissory note .................................... 893,883 893,883
-Junior participation in prime + 1.5% note ........................... 1,012,576 1,012,576
------------ ------------
Total ............................................................. $ 85,556,433 $151,449,786
============ ============
The accompanying notes are an
integral part of these financial statements.
44
EQUUS II INCORPORATED
NOTES TO FINANCIAL STATEMENTS
DECEMBER 31, 1998 AND 1997
(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, 1998.
Through March 31, 1997, the Management Company also received a management
incentive fee equal to 20% of net realized capital gains less unrealized capital
depreciation, computed on a cumulative basis over the life of the Fund. The
management incentive fee was paid quarterly in arrears. Pursuant to the vote of
the stockholders at a special meeting held on April 9, 1997 ("Special Meeting"),
the Fund entered into a new management agreement with the Management Company.
The only significant change from the previous management agreement was the
elimination of incentive fees based on capital gains effective as of April 1,
1997. As a result, the Fund did not incur a management incentive fee for the
year ended December 31, 1998. Management incentive fees of $55,825 and
$1,058,012 were included in the accompanying Statements of Operations for the
years ended December 31, 1997 and 1996, respectively.
Pursuant to the vote of the stockholders at the Special Meeting, the
deferred incentive fee, which was calculated on the net unrealized appreciation
of investments in portfolio securities and which amounted to $11,210,529 at
March 31, 1997, was paid on May 15, 1997, by the issuance to the Management
Company of 459,973 unregistered shares of common stock of the Fund. The number
of shares issued was determined by dividing the deferred incentive fee by $24.37
per share, the net asset value per share at March 31, 1997. Deferred management
incentive fee expense of $426,501 and
45
$6,488,693 resulting from increases in net unrealized appreciation on portfolio
securities have been included in the accompanying Statements of Operations for
the two years ended December 31, 1997 and 1996, respectively.
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 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
$143,689,403 (including $40,505,183 in publicly-traded securities, net of a
$4,382,822 Valuation Discount) and $147,899,786 (including $89,710,511 in
publicly-traded securities, net of a $17,100,722 Valuation Discount) at December
31, 1998 and 1997, 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
46
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 Fund declared
undistributed capital gains from 1997 of $132,677 as a dividend on July 31,
1998. 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. These
capital gains dividends were paid on December 30, 1998. The Fund had a net
investment loss for tax purposes for the years ended December 31, 1998 and 1997,
and therefore distributed no net investment income. 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 purposes from December 31
to October 31, which allows current year dividends to be paid prior to the end
of the year. For tax purposes, the Fund distributed net capital gains of
$3,127,756 for the ten months ended October 31, 1998. For the period from
November 1, 1998 to December 31, 1998, the Fund had undistributed net capital
losses of $6,558,635. Therefore, the Fund, for book purposes, had net capital
losses of $3,563,556 as of 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.
TWO MONTHS TEN MONTHS
ENDED 12/31/98 ENDED 10/31/98 1997 1996
-------------- -------------- ----------- -----------
Net realized gain (loss) on the sales
of portfolio securities, book ..... $ (6,558,635) $ 2,995,079 $ 7,565,699 $ 4,037,326
Management incentive fee ............ -- -- (7,530,386) (1,058,012)
Undistributed 1997 capital gains .... -- 132,677 -- --
-------------- -------------- ----------- -----------
Net realized gain (loss) on the sales
of portfolio securities, tax ...... $ (6,558,635) $ 3,127,756 $ 35,313 $ 2,979,314
============== ============== =========== ===========
(5) DIVIDENDS
The Fund declared dividends of $3,138,520 ($0.65 per share), $2,380,327
($0.50 per share) and $3,180,422 ($0.76 per share) during 1998, 1997 and 1996,
respectively. The Fund has adopted a policy to make dividend distributions of at
least $0.50 per share on an annual basis. In the event that taxable income,
including realized capital gains, exceeds $0.50 per share in any year,
additional dividends may be declared to distribute such excess. The 1998
dividend was paid in additional shares of common stock or in cash by specific
election of the shareholders in December 1998, and represented long-term capital
gains. The 1997 and 1996 dividends, which represented the Fund's net investment
income and net capital gains for tax purposes, were paid in additional shares of
common stock or in cash by specific election of the shareholders in January 1998
and 1997, respectively. The Fund paid $991,853, $828,556 and $1,209,850 in cash
and issued 125,812, 67,837 and 115,916 additional shares of stock at $17.0625,
$22.875 and $17.00 per share, in December 1998 and January 1998 and 1997,
respectively, in connection with such dividends. The stock issued in January
1998 and 1997 is reflected as outstanding as of
47
December 31, 1997 and 1996 in the accompanying financial statements.
(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 expenses, consist of $60,214,266 and $75,164,751
in money market accounts with NationsBank, N.A. earning interest at rates
ranging from 3.50% to 5.30% at December 31, 1998 and 1997, respectively.
(7) ACCOUNTS RECEIVABLE
Accounts receivable at December 31, 1998, consisted primarily of a
$250,000 cash advance to Tulsa Industries, $122,148 in escrow related to the
1997 sale of the Fund's investment in Industrial Equipment Rentals, Inc. which
was received in January 1999 and $19,760 in proceeds from the liquidation of
Restaurant Development Group, Inc.
(8) 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 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.
During the year ended December 31, 1997, the Fund invested $27,644,902 in
eleven new companies and made follow-on investments of $5,952,669 in eight
portfolio companies, including $1,238,434 in accrued interest and dividends
received in the form of additional portfolio securities and $330,730 in
securities received upon the sale of securities of another portfolio company. In
addition, the Fund realized a net capital gain of $7,565,699 during the year
ended December 31, 1997.
During the year ended December 31, 1996, the Fund invested $9,800,000 in
three new companies and made follow-on investments of $10,274,910 in nine
portfolio companies, including $435,679 in dividends and accrued interest
received in the form of additional portfolio securities and $750,000 of common
stock received through the net exercise of common stock warrants. In addition,
the Fund realized net capital gains of $4,037,326 during the year ended December
31, 1996.
(9) NOTES PAYABLE TO BANK
The Fund has a $150,000,000 line of credit promissory note with
NationsBank N.A., with interest payable at 1% over the rate earned in its money
market account. The Fund had $60,000,000 and $75,000,000 outstanding on such
note at December 31, 1998 and 1997, respectively, that was secured by
$60,000,000 and $75,000,000 of the Fund's temporary cash investments. The Fund
paid $37,500 and $75,000 in commitment fees in 1998 and 1997, which were
capitalized and amortized over the commitment period. Effective April 1, 1998,
the Fund extended the line of credit promissory note to April 1, 1999, and
lowered the rate to 1/2% over the rate earned on its money market account.
The Fund has a $50,000,000 revolving line of credit with NationsBank, N.A.
that expires on April 1, 1999. The Fund had $38,500,000 and $6,900,000
outstanding under such line of credit at December 31, 1998 and 1997,
respectively, which is secured by the Fund's investments in portfolio
securities. The interest rate was lowered during the year from a range of prime
+ 1/4% to prime + 3/4% to a range of prime - 1/2 % to prime + 1/4% or Libor +
1.65%. The Fund also pays 1/4% interest on the
48
unused portion of the line of credit.
The average daily balances outstanding on the Fund's notes payable during
the years ended December 31, 1998 and 1997, were $23,469,957 and $4,284,027,
respectively.
(10) STOCK OPTION PLAN
At a special meeting of shareholders of the Fund on April 9, 1997,
shareholders 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. Implementation of this plan was
subject to the receipt of an exemptive order from the Securities and Exchange
Commission ("SEC"), which was received on May 8, 1997.
The Stock Incentive Plan also provides that each director who is not an
officer of the Fund be granted an incentive stock option to purchase 5,000
shares of the Fund's common stock. In addition, beginning with the 1998 annual
meeting of shareholders, each director who was not an officer of the Fund was,
on the first business day following the annual meeting, granted an incentive
stock option to purchase 2,000 shares of the Fund's common stock.
Under the 1997 Stock Incentive Plan, options to purchase 939,131 and
927,131 shares of the Fund's common stock with a weighted average exercise price
of $17.66 and $17.54 per share were outstanding at December 31, 1998 and 1997,
respectively. The Fund had 671,849 and 431,308 shares in exercisable options
with a weighted average exercise price per share of $17.58 and $17.00 at
December 31, 1998 and 1997, respectively. Outstanding options at December 31,
1998 have exercise prices ranging from $17 to $27.44 and expire in May 2007
through May 2008. During 1998 and 1997, no options were exercised. As of
December 31, 1998, all options outstanding were "out of the money" and would
have an anti-dilutive effect on net assets per share if exercised. If all
options granted were exercised as of December 31, 1997, there would have been
dilution of net assets per share of approximately $1.28 per share, or 4.3%, as a
result of such exercise.
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 1998 and 1997 was $6.39
and $3.86 per share, respectively. These values for 1998 and 1997 were estimated
using the Black-Scholes option-pricing model with the following weighted average
assumptions: expected dividend of 4.9% and 5.1%, expected volatility of 28.8%
and 25.3% and risk free interest rates of 5.8% and 6.4%, respectively. An
expected life of 10 years was used for 1998 and 1997. Had compensation expense
been recorded based on these hypothetical values, the Fund's 1998 and 1997
change in net assets from operations would have been reduced by $1,135,967 and
$712,734, 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 Carruth-Doggett Industries, Inc. (see Note 12),
$1,000,000 in The Drilltec Corporation, $1,000,000 in Equicom, Inc., $250,000 in
Hot & Cool Holdings, Inc., $2,000,000 in Petrocon
49
Engineering, Inc., $2,000,000 in Sovereign Business Forms, Inc. and $600,000 in
Tulsa Industries, Inc. In addition, the Fund has committed to invest up to
$6,000,000 in one new portfolio company.
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. In the opinion of
Management, the financial position or operating results of the Fund will not be
materially affected by these claims.
(12) SUBSEQUENT EVENTS
Subsequent to December 31, 1998, the Fund repaid a net $60,000,000 of
notes payable to the bank.
In January 1999, the Fund sold its investment of 54,334 shares of common
stock in United Rentals, Inc. for $1,738,037, realizing a capital gain of
$1,737,639.
On January 29, 1999, Brazos Sportswear, Inc. filed voluntary petitions
under Chapter 11 of the Bankruptcy Code. The Fund's investment in Brazos
Sportswear, Inc. was written off as of December 31, 1998.
On February 9, 1999, co-investors in Equicom, Inc. ("Equicom") purchased
48,000 shares of its common stock at its original cost of $15,000 from the Fund.
Co-investors in Equicom also purchased $1,043,500 of the $2,682,000 principal in
its 10% promissory note due to the Fund. The Fund then invested $748,310 in
Equicom and received 74,831 shares of preferred stock.
On February 11, 1999, the Fund invested $2,000,000 in CDI Rental Services,
Inc., a sister company of Carruth-Doggett Industries, Inc. The Fund's investment
consisted of a 10% senior subordinated promissory note and warrants to buy up to
12,500 and 21,250 shares of common stock for $0.01 and $0.0127 per share,
respectively, through February 2009.
50
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
1999 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,
1999 (the "1999 Proxy Statement").
ITEM 11. EXECUTIVE COMPENSATION.
Information regarding Executive Compensation is incorporated by reference
to the Fund's 1999 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 1999 Proxy Statement.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS.
Information regarding Certain Relationships and Related Transactions is
incorporated by reference to the Fund's 1999 Proxy Statement.
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K.
(a)(1) FINANCIAL STATEMENTS PAGE
Report of Independent Public Accountants 29
Balance Sheets
December 31, 1998 and 1997 30
Statements of Operations for the years
ended December 31, 1998, 1997 and 1996 31
Statements of Changes in Net Assets for the
years ended December 31, 1998, 1997 and 1996 32
Statements of Cash Flows for the years ended
December 31, 1998, 1997 and 1996 33
Selected Per Share Data and Ratios for the
five years ended December 31, 1998 35
Schedule of Portfolio Securities
at December 31, 1998 36
51
Schedule of Portfolio Securities
at December 31, 1997 41
Notes to Financial Statements 45
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.]
(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.
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, 1999 Nolan Lehmann, President
52
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, 1999
(Gregory J. Flanagan)
\S\ ROBERT L. KNAUSS Director March 2, 1999
(Robert L. Knauss)
\S\ GARY R. PETERSEN Director March 2, 1999
(Gary R. Petersen
\S\ JOHN W. STORMS Director March 2, 1999
(John W. Storms)
\S\ FRANCIS D. TUGGLE Director March 2, 1999
(Francis D. Tuggle)
\S\ EDWARD E. WILLIAMS Director March 2, 1999
(Edward E. Williams)
\S\ NOLAN LEHMANN President and Director March 2, 1999
(Nolan Lehmann) (principal financial and
accounting officer)
\S\ SAM P. DOUGLASS Chairman of the Board and March 2, 1999
(Sam P. Douglass) Chief Executive Officer
(principal executive officer)
53