Equus Total Return, Inc. (NYSE:EQS) is a Delaware corporation that was formed in 1991 as a business development company (BDC) with the goal of providing shareholders the highest total return consisting of capital appreciation and current income. However, in recent years, the company has been actively exploring a transformation from a BDC to an operating company, a strategic shift that could significantly impact the trajectory of the business.

Business Overview and History

Formation and Early Years Equus was initially established on August 16, 1991, as Equus Investments II, L.P. On July 1, 1992, the Partnership underwent a reorganization, transferring all assets and liabilities to Equus in exchange for shares of common stock. The company's shares have since been trading on the New York Stock Exchange under the symbol EQS.

Strategic Shift In 2006, Equus shareholders approved a change in the company's investment strategy to a total return objective, seeking to maximize returns through a combination of capital appreciation and current income. This shift was accompanied by a name change from Equus II Incorporated to Equus Total Return, Inc.

Operational Initiatives Over the years, Equus has navigated a challenging market environment, executing initiatives to enhance liquidity, achieve a lower operational cost structure, and realize certain portfolio investments. These efforts have included changes to the Board of Directors and management team, the termination of follow-on investments, the internalization of the fund's management, the suspension of its distribution policy, the modification of its investment strategy to pursue shorter-term liquidation opportunities, and the sale of legacy and underperforming holdings.

Management Structure and Tax Status As an internally managed BDC, Equus expects its expenses to increase at a slower pace than any growth in the size of the fund, potentially allowing for efficiencies in the cost structure if the company can grow the fund in the future. Currently, Equus qualifies as a regulated investment company (RIC) for federal income tax purposes, which allows the company to avoid corporate income taxes on income and gains distributed to shareholders.

Investment Strategy and Portfolio Equus' investment strategy seeks to provide the highest total return by investing in the debt and equity securities of companies with a total enterprise value between $5 million and $75 million. The company targets firms pursuing growth through acquisition, leveraged buyouts, management buyouts, recapitalizations, and special situations. As of September 30, 2024, Equus' investment portfolio consisted primarily of two segments: control investments and U.S. Treasury bills. The control investments, which represent majority-owned positions, accounted for 40.5% of the company's total investments at fair value. These control investments include Equus Energy, LLC and Morgan EP, LLC.

Equus Energy, LLC is a wholly-owned subsidiary formed in 2011 to make investments in the energy sector, focusing on income-producing oil and gas properties. As of September 30, 2024, Equus Energy's portfolio consisted of working interests in 136 producing and non-producing oil and gas wells situated on approximately 21,320 acres in Texas and Oklahoma.

Morgan EP, LLC was established in 2023 as a wholly-owned subsidiary of Equus to acquire oil and gas properties in the Bakken-Three Forks formation in the Williston Basin of North Dakota. In May 2023, Morgan acquired an initial 4,750 net acres, subsequently adding an additional 1,100 net acres in September 2023 and 810 net acres in the second quarter of 2024.

The remaining 59.5% of Equus' total investments at fair value as of September 30, 2024 was held in U.S. Treasury bills, which the company utilizes to maintain its status as a regulated investment company (RIC) for tax purposes.

Financials

As of September 30, 2024, Equus reported net assets of $40.2 million, down from $48.3 million at the end of 2023. Net asset value per share decreased from $3.55 as of December 31, 2023, to $2.96 as of September 30, 2024, a decline of 16.6%. The company's common stock is currently trading at a 54.1% discount to its net asset value, compared to a 59.2% discount at the end of 2023.

For the nine months ended September 30, 2024, Equus reported a net investment loss of $2.7 million, compared to a net investment loss of $3.1 million in the same period of the prior year. Total investment income increased from $60,000 in the first nine months of 2023 to $948,000 in the corresponding period of 2024, primarily due to interest income from the company's portfolio investments.

For the most recent fiscal year (2023), Equus reported revenue of $17.21 million, net income of $12.95 million, operating cash flow of -$51.36 million, and free cash flow of -$51.36 million.

In the most recent quarter (Q3 2024), the company reported revenue of -$8.67 million, net income of -$9.63 million, operating cash flow of $5.09 million, and free cash flow of $1.77 million. The decreases in revenue, net income, and operating cash flow were primarily due to declines in the value of the Company's portfolio investments, particularly its investments in the energy sector which have been impacted by volatile oil and gas prices. The Company's free cash flow was positive for the quarter as a result of sales of certain portfolio securities.

Equus Energy generated revenue of $484,000 and a net loss of $52,000 during the nine months ended September 30, 2024, compared to revenue of $455,000 and net income of $5,000 for the same period in 2023. The decrease in performance was primarily due to a decline in oil prices during the period.

Morgan EP generated oil and gas revenue of $2.64 million but recorded a net loss of $3.28 million for the nine months ended September 30, 2024, primarily due to high operating costs and interest expenses related to the debt financing.

Liquidity

As of September 30, 2024, Equus had a debt-to-equity ratio of 0.93. The company reported $1.15 million in cash and cash equivalents, along with $54.99 million in U.S. Treasury bills held as restricted cash to comply with RIC requirements. Equus utilizes a margin account facility to borrow funds to maintain its RIC status, with $54.99 million borrowed under this facility as of September 30, 2024.

The company's current ratio and quick ratio both stood at 0.35 as of September 30, 2024. To finance Morgan EP's acquisitions, Equus provided a senior debt facility, which had been fully drawn to $10.5 million as of September 30, 2024.

Conversion to an Operating Company

In recent years, Equus has been actively exploring a transformation from a BDC to an operating company. This strategic shift has been driven by the company's belief that it could better enhance shareholder value by transitioning to a business model focused on direct operations rather than passive investments.

Equus has obtained shareholder authorization in the past to withdraw its election to be classified as a BDC, though this authorization has since expired. The company expects to receive a further authorization from shareholders in 2024 or 2025 as a consequence of its expressed intent to transform into an operating company.

However, Equus has stated that it will not submit a withdrawal of its BDC election until it has entered into a definitive agreement to effect a transformative transaction. Additionally, even if the company is again authorized to withdraw its BDC election, it will require a subsequent affirmative vote from a majority of its outstanding voting shares to enter into any such definitive agreement or change the nature of its business.

Risks and Challenges

The transition from a BDC to an operating company presents several risks and challenges for Equus. The company may face difficulties in identifying and executing a suitable transformative transaction, as well as securing the necessary financing and shareholder approval. Additionally, the company's current portfolio investments and their performance could be negatively impacted during the transition period, potentially affecting the company's liquidity and financial position.

Furthermore, Equus' sole remaining portfolio company, Equus Energy, LLC, a wholly-owned subsidiary focused on the energy sector, has faced its own set of challenges. The company has been impacted by fluctuations in oil and gas prices, which have affected the valuation and performance of its investments. Equus Energy has also been exploring options to secure additional financing or divest certain assets to maintain its operations.

The company's investment strategy and concentration in the energy sector expose it to significant volatility. Equus is a non-diversified investment company, with its two remaining portfolio companies comprising 93.4% of its net asset value as of September 30, 2024. The company's portfolio company valuations, and consequently its net asset value, are subject to significant volatility and may be materially impacted by changes in commodity prices, production levels, and other factors affecting its energy-focused investments.

Conclusion

Equus Total Return, Inc. (NYSE:EQS) is at a critical juncture in its transformation from a BDC to an operating company. The company's efforts to enhance shareholder value through this strategic shift have been met with both opportunities and challenges. While Equus has made progress in streamlining its operations and realizing investments, the success of its transition to an operating company remains uncertain. The company has faced challenges in recent years, including volatile oil and gas prices that have impacted the value of its portfolio investments, particularly its energy-focused investments. This has led to decreases in the Company's net asset value per share. Investors should closely monitor the company's progress in executing a transformative transaction and navigating the risks and challenges inherent in this process, as well as its ability to manage its liquidity and financial position during this transition period.