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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, 2002
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. [_]
Indicate by check mark whether the registrant is an accelerated filer (as
defined in Exchange Act Rule 12b-2). Yes X No ___
---
Approximate aggregate market value of common stock held by non-affiliates of the
registrant: $37,744,882, computed on the basis of $6.89 per share, closing price
of the common stock on the New York Stock Exchange on April 4, 2003. For
purposes of calculating this amount only, all directors and executive officers
of the registrant have been treated as affiliates. There were 6,233,021 shares
of the registrant's common stock, $.001 par value, outstanding as of April 4,
2003. The net asset value of a share at December 31, 2002 was $12.35.
Documents incorporated by reference: Proxy Statement for 2003 Annual Meeting of
Stockholders is incorporated by reference in Part III.
TABLE OF CONTENTS
Page
----
PART I
Item 1. Business .............................................................................. 1
Item 2. Properties ............................................................................ 19
Item 3. Legal Proceedings ..................................................................... 19
Item 4. Submission of Matters to a Vote of Security Holders ................................... 19
PART II
Item 5. Market for Registrant's Common Equity and Related Stockholder Matters ................. 19
Item 6. Selected Financial Data ............................................................... 21
Item 7. Management's Discussion and Analysis of Financial
Condition and Results of Operations .................................................. 22
Item 7A. Quantitative and Qualitative Disclosure About Market Risk ............................. 31
Item 8. Financial Statements and Supplementary Data ........................................... 33
Item 9. Changes in and Disagreements with Accountants on
Accounting and Financial Disclosure ................................................. 61
PART III
Item 10. Directors and Executive Officers of the Registrant .................................... 61
Item 11. Executive Compensation ................................................................ 61
Item 12. Security Ownership of Certain Beneficial Owners and Management ........................ 61
Item 13. Certain Relationships and Related Transactions ........................................ 61
Item 14. Controls and Procedures ............................................................... 61
Item 15. Exhibits, Financial Statement Schedules and Reports on Form 8-K ....................... 62
ii
Item 1. Business
Equus II Incorporated (the "Fund") is a Delaware corporation that seeks to
achieve capital appreciation principally by making investments in equity and
equity-oriented securities issued by privately-owned companies in transactions
negotiated directly with such companies ("Portfolio Companies"). The Fund seeks
to invest primarily in companies that intend to acquire other businesses,
including through leveraged buyouts. The Fund may also invest in
recapitalizations of existing businesses or special situations from time to
time. The Fund's investments in Portfolio Companies consist principally of
equity securities such as common and preferred stock, but also include other
equity-oriented securities such as debt convertible into common or preferred
stock or debt combined with warrants, options or other rights to acquire common
or preferred stock. Current income is not a significant factor in the selection
of investments. The Fund has elected to be treated as a business development
company under the Investment Company Act of 1940 (the "Investment Company Act").
The Fund has eight directors. Six 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.
The Fund's revolving line of credit, which is used for liquidity to pay
operating expenses of the Fund and to make new or follow-on investments in
portfolio securities, expires on June 1, 2003, and is collateralized by a pledge
of the Fund's portfolio securities. The lender has asked the Fund to take steps
to pay off the revolving line of credit. Accordingly, the Fund is in discussions
with several interested parties regarding the sale of certain portfolio
securities at values that would enable the Fund to repay the line of credit. The
Fund is also pursuing arrangements to refinance the line of credit with another
lender and may approach the current lender for another extension of the due
date. Management believes it will either be able to extend the loan, repay it
from another lending source or repay it from the sale of portfolio securities.
If not, the Fund may be required to sell certain portfolio securities to
maintain liquidity, or the lender could exercise its rights pursuant to its
collateralized interest and require the Fund to sell portfolio securities. Such
sales could be at values materially less than Management's estimates of fair
value. See "Management's Discussion and Analysis of Financial Condition and
Results of Operations" for further discussion related to the Fund's borrowings
and liquidity.
1
Investment Practices
Substantially all of the net assets of the Fund are invested or committed
to be invested in securities of Portfolio Companies. Substantially all amounts
not invested in securities of Portfolio Companies are invested in short-term,
highly liquid investments consisting of interest-bearing bank accounts,
certificates of deposit or other short-term, highly liquid investments
providing, in the opinion of the Management Company, appropriate safety of
principal. At December 31, 2002, $58,000,000 of such short-term investments were
restricted and were pledged as collateral on certain bank borrowings.
The Fund's investments in portfolio securities are usually structured in
private transactions negotiated directly with the owner or issuer of the
securities acquired.
The Fund is concentrating its investment efforts on companies of a type and
size that, in management's view, provide opportunities for significant capital
appreciation, relative ease of acquisition and disposition, reduced competition
for investments and prudent diversification of risk.
The enterprise value of a Portfolio Company typically ranges from
$15,000,000 to $75,000,000, at the time of the Fund's initial investment. The
Fund's initial investment in a Portfolio Company typically ranges from
$1,500,000 to $7,500,000, depending on the investment. The balance of the
purchase price of a Portfolio Company is supplied by debt financing and other
equity investors, if necessary.
The Fund is attempting to reduce certain of the risks inherent in private
equity-oriented investments by investing in a portfolio of companies involved in
different industries. The Fund has limited its initial investment (whether in
the form of equity or debt securities, commitments to purchase securities or
debt guaranties) in any Portfolio Company to no more than 15% of the Fund's net
assets. However, if a follow-on investment is available or required, as
discussed below, the Fund's investment in a particular Portfolio Company may
exceed these initial investment limitations. Also, investments in certain
Portfolio Companies may be in excess of the Fund's initial investment
limitations due to increases in the value of such investments.
The Fund may make investments as a sole investor, with other professional
investors or with other persons. The Fund ordinarily is not 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
"Borrowings" 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
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.
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 other sources, which 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.
3
Current Portfolio Companies
The following is a description of the Fund's investments in its 21
Portfolio Companies and two venture capital funds at December 31, 2002.
Alenco Window Holdings II, LLC
Alenco Window Holdings II, LLC ("AWH2"), Bryan, Texas, was formed in
January 2002, to invest working capital into Alenco Holding Corporation
("Alenco"), a company formed to purchase certain assets of Reliant Building
Products, Inc. pursuant to a plan of reorganization confirmed in bankruptcy
court. Alenco manufactures aluminum and vinyl windows for single and
multi-family residential purposes. At December 31, 2002, the Fund's investment
in AWH2, valued at $2,900,000 with a cost of $227, consisted of an approximate
24% membership interest.
American Trenchless Technology, LLC / Glendale LLC
American Trenchless Technology, LLC ("ATT"), Houston, Texas, was formed to
acquire H & I Boring and Tunneling, a Houston based regional provider of
underground infrastructure services, utilizing boring, tunneling and directional
drilling technologies. ATT services the water, sewer, electrical and
telecommunications industries. ATT maintains a website at
www.americantrenchless.com. At December 31, 2002, the Fund's investment in ATT
was valued at zero with a cost of $1,324,694 and consisted of 1,934,532 shares
of common stock and 100,000 shares of preferred stock. The Fund's investment in
ATT represents an approximate 36.6% fully-diluted membership interest. In
conjunction with a restructuring of ATT's bank indebtedness in October 2002, the
Fund invested $300,000 to acquire 50% of the membership interest in Glendale,
LLC ("Glendale"), which was formed to acquire a $600,000 participation in the
secured bank loan to ATT. The Fund's ownership interest in Glendale is valued at
its cost of $300,000.
The Bradshaw Group
The Bradshaw Group ("TBG"), Dallas, Texas, provides innovative printing
solutions primarily for customers in need of high-speed mass printings. TBG
maintains a web site at www.bradshawgroup.com. At December 31, 2002, the Fund's
investment in TBG was valued at zero with a cost of $1,794,546. The Fund's
investment consisted of 1,335,000 shares of preferred stock, a warrant to buy
2,229,450 shares of common stock at $0.01 through May 2008, a 15% promissory
note in the amount of $459,545 and a prime + 2% promissory note in the amount of
$398,383, representing an approximate 17.8% fully-diluted equity interest. Gary
L. Forbes, a Vice President of the Fund, serves on TBG's Board of Directors.
Champion Window Holdings, Inc.
Champion Window Holdings, Inc. ("Champion"), Houston, Texas, manufactures
and sells aluminum windows for single and multi-family residential purposes,
primarily in Houston, San Antonio and Austin, Texas. Champion maintains a web
site at www.championwindow.net. At December 31, 2002, the Fund's investment in
Champion, valued at $17,000,000 with a cost of $1,400,000, consisted of
1,400,000 shares of common stock. The Fund's investment in Champion represents
an approximate 32% fully-diluted equity interest. Nolan Lehmann, President of
the Fund, and Tracy H. Cohen, a Vice President of the Fund, serve as directors
of Champion.
4
CMC Investments, LLC
CMC Investments, LLC, ("CMC"), Houston, Texas, holds an investment in
Cooper Manufacturing Company, which manufactures drilling rigs for the oil and
gas industry. At December 31, 2002, the Fund's investment in CMC was valued at
$925,000 with a cost of $1,038,611. The investment in CMC was received by the
Fund upon the liquidation of Tulsa Industries, Inc., a former investment. The
Fund's investment consists of a 21% membership interest in CMC and 8,863 shares
of Weatherford International common stock.
Container Acquisition, Inc. / CCI-ANI Finance, LLC
Container Acquisition, Inc. ("Container"), Houston, Texas, is a logistics
and maintenance services company serving owners of international shipping
containers. Container maintains a web site at www.containercare.com. At December
31, 2002, the Fund's investment in Container, valued at $3,970,000 with a cost
of $10,773,800, consisted of 1,370,000 shares of common stock, 78,318 shares of
preferred stock and a warrant, exercisable under certain conditions, to buy
370,588 shares of common stock at $0.01 per share through February 2007. The
Fund's investment in Container represents an approximate 65% fully-diluted
equity interest. Sam P. Douglass, Chairman and CEO of the Fund and Mr. Lehmann
serve on Container's Board of Directors. In conjunction with a restructuring of
Container's bank indebtedness in April 2002, the Fund invested $1,571,000 to
acquire an 84.9% membership interest in CCI-ANI Finance, LLC ("CCI-ANI") which
was formed to purchase a subordinated note from the former owner of Container.
The note had a principal balance of $2,000,000 plus $233,333 in accrued interest
when it was acquired at a discounted price of $1,850,000. At December 31, 2002
the Fund's ownership interest in CCI-ANI is valued at $1,970,000, with a cost of
$1,571,000.
Doane PetCare Enterprises, Inc.
Doane PetCare Enterprises, Inc. ("Doane"), Nashville, Tennessee, is the
largest producer of private-label dry pet food in the United States. In 1995,
the Fund invested in Summit/DPC Partners, L.P. ("Summit"), which was formed to
invest in Doane. Summit was liquidated in April 2001 and the Fund received
common stock, a note receivable and warrants in Doane. At December 31, 2002, the
Fund's investment in Doane was valued at $6,787,803 with a cost of $5,724,446.
The Fund's investment consists of 1,943,598 shares of common stock and
$1,787,802 in a 15% promissory note with a face value of $1,805,556. The Fund's
investment in Doane represents an approximate 5% fully-diluted equity interest.
The Drilltec Corporation
The Drilltec Corporation ("Drilltec"), Houston, Texas, provides thread
protectors and packaging for premium tubular goods, drill pipe and line pipe,
utilized primarily in the oil and gas industry. Drilltec maintains a web site at
www.drilltec.com. At December 31, 2002, the Fund's investment in Drilltec,
valued at zero with a cost of $1,000,000, consisted of a prime + 9.75%
promissory note in the amount of $1,000,000. The Fund recognized a loss of
$7,645,000 on its investment in the preferred stock and common stock of Drilltec
in October 2000. The Fund's investment in Drilltec represents an approximate 62%
fully-diluted equity interest. Mr. Forbes serves on Drilltec's Board of
Directors.
5
ENGlobal Corporation (AMEX: ENG)
(formerly Industrial Data Systems Corporation and Petrocon Engineering
Inc.)
ENGlobal Corporation ("ENG"), Houston, Texas, provides engineering
consulting, control systems, field inspections and plant maintenance services,
primarily to the energy industry. ENG maintains a website at www.englobal.com.
On December 21, 2001, Petrocon Engineering Inc. ("Petrocon") was merged into ENG
in exchange for ENG common stock. At December 31, 2002, the Fund's investment in
ENG was valued at $6,598,650, with a cost of $6,084,461. The Fund's investment
consists of a 9.5% promissory note in the amount of $2,780,000, 1,225,758 shares
of common stock and 2,588,000 shares of convertible preferred stock. The Fund's
investment in ENG represents an approximate 10% fully diluted equity interest at
December 31, 2002.
Equicom, Inc. (formerly Texrock Radio, Inc.)
Equicom, Inc. ("Equicom"), Bryan, Texas, was formed to acquire radio
stations in small to medium-sized cities in Texas. At December 31, 2002, Equicom
owned and operated 18 radio stations. At December 31, 2002, the Fund's
investment in Equicom, valued at $3,166,730 with a cost of $9,834,090, consisted
of 452,000 shares of common stock, 657,611 shares of preferred stock and
$3,116,730 in 10% promissory notes. The Fund's investment in Equicom represents
an approximate 56% fully-diluted equity interest at December 31, 2002. The Fund
has guaranteed up to $758,520 related to an obligation to a financial
institution on Equicom's behalf. Ms. Cohen serves on Equicom's Board of
Directors.
Equipment Support Services, Inc.
Equipment Support Services, Inc. ("ESS"), Houston, Texas, was formed to buy
various companies in the equipment rental business including Carruth-Doggett
Industries, Inc. and CDI Rental Services, Inc., in which the Fund had an
investment. At December 31, 2002 the Fund's investment in ESS, valued at zero
with a cost of $3,168,500, consisted of 35,000 shares of common stock, 35,000
shares of preferred stock and $1,138,000 in an 8% promissory note. The Fund's
investment in ESS represents an approximate 3% fully diluted equity interest at
December 31, 2002.
FS Strategies, Inc.
FS Strategies, Inc. ("FSS"), Houston, Texas, was formed to acquire Talent
Tree Acquisition Corporation ("Talent Tree", formerly Initial Staffing Services)
and Talent Tree Employer Services, Inc. (formerly EESIS, Inc ("TTES"). Talent
Tree and TTES maintain web sites at www.talenttree.com and www.talentreehr.com,
respectively. Talent Tree operates a network of branch offices providing
temporary staffing and permanent placement services in 32 states. TTES is a
web-based human resources solution provider based in Houston. At December 31,
2002, the Fund's investment in FSS was valued at zero with a cost of $9,258,667.
The Fund's investment consists of 110,000 shares of common stock and 1,667
shares of preferred stock. The Fund's investment in FSS represents an
approximate 23% fully-diluted equity interest. Mr. Lehmann serves on the Board
of Directors of FSS.
GCS RE, Inc.
GCS RE, Inc. ("GCS"), College Station, Texas, was formed to be a general
partner of a real estate partnership, which owned a warehouse that is leased to
a former subsidiary of a previously owned portfolio company. During 2002, the
Fund contributed its investment in A.C. Liquidating Corporation, a former
portfolio company, to GCS. At December 31, 2002, the Fund's investment in GCS
consisted of
6
1,000 shares of common stock that was valued at $600,000, with a cost basis of
$320,924. The Fund owns 100% of the stock of GCS. Mr. Douglass and Mr. Lehmann
serve on the Board of Directors of GCS.
Jones Industrial Services, Inc. (formerly United Industrial Services, Inc.)
Jones Industrial Services, Inc. ("JIS"), Houston, Texas, was formed to
acquire businesses providing field services for the petrochemical and power
generation industries. At December 31, 2002, the Fund's investment in JIS was
valued at $2,500,000 with an 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 per share through June 2008. The Fund's investment in JIS
represents an approximate 37.4% fully-diluted equity interest. Mr. Forbes serves
on JIS's Board of Directors.
Milam Enterprises, LLC
Milam Enterprises, LLC ("Milam"), Houston, Texas, was formed to hold
certain assets of Travis International, Inc. ("Travis") not included in the sale
of Travis' business operations. The Fund contributed all of its shares in Travis
to Milam for a membership interest. At December 31, 2002, the Fund's investment
in Milam consisted of a 9% membership interest valued at $100,000 with a cost of
$1,911.
NCI Building Systems, Inc. (NYSE: NCS)
NCI Building Systems, Inc. ("NCS"), Houston, Texas, manufactures and
markets metal building systems, components and roll up doors from operating
facilities located throughout the United States and Mexico. NCS maintains a web
site at www.ncilp.com. The December 31, 2002 closing price of NCS's common stock
on the New York Stock Exchange was $21.82 per share. At December 31, 2002, the
Fund's investment in NCS consisted of 200,000 shares of common stock valued at
$4,364,000 with a cost of $159,784, which represents an approximate 1%
fully-diluted equity interest in NCS. Mr. Forbes serves as a director of NCS.
PalletOne, Inc.
PalletOne, Inc. ("PalletOne"), Bartow, Florida, was formed to acquire and
operate twelve wooden pallet manufacturing facilities in eight states. PalletOne
maintains a website at www.palletone.com. At December 31, 2002, the Fund's
investment in PalletOne, valued at $3,500,000 with a cost basis of $3,815,000,
consisted of 350,000 shares of common stock and 3,465,000 shares of preferred
stock, representing an approximate 21% fully-diluted equity interest. Mr.
Lehmann and Mr. Forbes serve as directors of PalletOne.
Reliant Window Holdings, LLC
Reliant Window Holdings, LLC ("RWH"), Houston, Texas, was formed to acquire
87.5% of Alenco Window Holdings, LLC ("AWH"). AWH acquired the senior secured
debt of a bankrupt entity, which it exchanged for notes receivable from and an
equity interest in Alenco Holding Corporation ("Alenco"), a company formed to
purchase certain assets of Reliant Building Products, Inc. pursuant to a plan of
reorganization confirmed in bankruptcy court. Alenco manufactures aluminum and
vinyl windows for single and multi-family residential purposes. Alenco maintains
a website at www.alencowindows.com. At December 31, 2002, the Fund's investment
in RWH, valued at $4,200,000
7
with a cost of $372,256, consisted of a 36.86% membership interest. AWH owns
approximately 36.1% of the fully-diluted equity interest of Alenco. The Fund has
committed to invest up to an additional $5,158,000 in RWH under certain
circumstances. Of this $5,158,000, $3,719,000 is a letter of credit that the
Fund has in place to secure potential obligations of RWH's operating subsidiary
to its insurance carrier. This letter of credit expires on April 1, 2003, and
the operating company has made arrangements to replace the Fund's letter of
credit at such time. The remaining commitment includes a guarantee by the Fund
of up to $1,439,000 of an obligation that RWH has to a financial institution.
Management does not expect the Fund to have to pay anything in relation to this
guarantee. Mr. Lehmann and Ms. Cohen serve as members of the board of managers
of RWH.
Sovereign Business Forms, Inc.
Sovereign Business Forms, Inc. ("Sovereign"), Houston, Texas, is a
manufacturer of wholesale business forms, with operations in six states. At
December 31, 2002, the Fund's investment in Sovereign, valued at its cost of
$5,658,835, consisted of 19,131 shares of preferred stock, $3,745,735 in 15%
promissory notes and warrants to buy up to 551,894, 25,070 and 273,450 shares of
common stock at $1, $1.25 and $1 per share through August 2006, October 2007 and
October 2009, respectively. The Fund's investment represents a 31% fully-diluted
equity interest in Sovereign. Mr. Forbes serves on Sovereign's Board of
Directors.
Spectrum Management, LLC
Spectrum Management, LLC ("Spectrum"), Dallas, Texas, was formed to acquire
a business which provides security devices to financial institutions. At
December 31, 2002, the Fund's investment in Spectrum, valued at its original
cost of $4,153,698, consisted of 285,000 units of Class A equity interest and a
16% subordinated promissory note in the amount of $1,303,698. The Fund's
investment in Spectrum represents an approximate 79% fully-diluted equity
interest. Mr. Forbes and Ms. Cohen serve on the Board of Directors of Spectrum.
Sternhill Partners I, L.P.
Sternhill Partners I, L.P. ("Sternhill"), Houston, Texas, is a venture
capital fund which was formed to invest in seed and early stage information,
communication and entertainment technology companies. Sternhill maintains a web
site at www.sternhillpartners.com. At December 31, 2002, the Fund's investment
in Sternhill was valued at $700,000 with a cost of $1,801,604. The Fund has
committed to invest up to an additional $720,000 in Sternhill. The Fund's
investment consisted of a 3% limited partnership interest.
Strategic Holdings, Inc. and related entity
Strategic Holdings, Inc. ("SHI"), Houston, Texas, was formed to acquire
Strategic Materials, Inc., formerly known as Allwaste Recycling, Inc., the glass
recycling division of Allwaste, Inc. SHI receives and processes used glass,
which is then sold to the container, fiberglass and bead industries as a raw
material source. At December 31, 2002, the Fund's investment in SHI was valued
at $13,540,014 with an original cost of $13,659,013. The Fund's investment in
SHI consists of 3,089,751 shares of common stock, 3,822,157 shares of Series B
preferred stock, $6,750,000 in a 15% promissory note and warrants to buy
225,000, 100,000 and 2,219,237 shares of SHI common stock at $0.4643, $1.50 and
$0.01 per share through August 2005, August 2005 and November 2005,
respectively. In addition, the Fund has accrued $500,000 in interest receivable
on the promissory note. Mr. Lehmann serves as a
8
director 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, 2002, the Fund's investment in SMIP was valued
at $188,423, with a cost of $325,000. The Fund's investment in SMIP consists of
1,000 shares of common stock and $175,000 in a 15% promissory note. SMIP is
wholly-owned by the Fund. Mr. Lehmann serves as a director of SMIP.
The Fund's investments in SHI and SMIP represent an approximate 80%
fully-diluted equity interest in SHI.
Turfgrass America, Inc.
Turfgrass America, Inc. ("Turfgrass"), Granbury, Texas, was formed for the
purpose of acquiring several companies which grow and market warm season
turfgrass, including Millberger Turf Farms and Thomas Bros. Grass. Turfgrass is
one of the largest warm season turfgrass companies in the United States.
Turfgrass maintains a web site at www.turfgrassamerica.com. At December 31,
2002, the Fund's investment in Turfgrass was valued at $5,341,057 with a cost of
$5,941,057. The Fund's investment consisted of 211,184 shares of common stock,
1,507,226 shares of convertible preferred stock, $3,781,804 invested in a 12%
subordinated promissory note with a face value of $4,000,000, two 12% promissory
notes totaling $790,615, and warrants to buy 250,412 shares of Turfgrass common
stock for $0.51 through April 2010, representing an approximate 16%
fully-diluted equity interest in Turfgrass.
Vanguard VII, L.P.
Vanguard VII, L.P. ("Vanguard"), Houston, Texas, is a venture capital fund
which was formed to invest in seed and early stage communications and life
science technology companies. Vanguard maintains a web site at
www.vanguardventures.com. At December 31, 2002, the investment in Vanguard was
valued at $700,000 with a cost of $1,200,000. The Fund has committed to invest
up to an additional $1,800,000 in Vanguard. The Fund's investment consists of a
1.3% limited partnership interest.
Temporary Investments
Pending investment in Portfolio Companies, the Fund invests its available
funds in interest-bearing bank accounts, money market mutual funds, U.S.
Treasury securities and/or certificates of deposit with maturities of less than
one year (collectively, "Temporary Investments"). Temporary Investments may also
include commercial paper (rated or unrated) and other short-term securities.
Temporary Investments constituting cash, cash items, securities issued or
guaranteed by the U.S. Treasury or U.S. Government agencies and high quality
debt securities (commercial paper rated in the two highest rating categories by
Moody's Investor Services, Inc. or Standard & Poor's Corporation, or if not
rated, issued by a company having an outstanding debt issue so rated, with
maturities of less than one year at the time of investment) will qualify for
determining whether the Fund has 70% of its total assets invested in Managed
Companies (as hereafter defined) or in qualified Temporary Investments for
purposes of the business development company provisions of the Investment
Company Act. At December 31, 2002, $58,000,000 of temporary investments were
restricted and were pledged as collateral on certain bank borrowings. See
"Regulation" below.
9
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. If the Fund is unable to maintain
its revolving line of credit and does not have sufficient funds to make
follow-on investments, the Portfolio Company in need of the investment may be
negatively impacted and/or the Fund's equity interest in the Portfolio Company
may be reduced.
The Fund has committed, under certain circumstances, to make follow-on
investments in certain Portfolio Companies. See further discussion of this in
the "Liquidity and Capital Resources" section in the "Management's Discussion
and Analysis of Financial Condition and Results of Operations" section.
Disposition of Investments
The method and timing of the disposition of the Fund's portfolio
investments is critical to the realization of capital appreciation and to the
minimization of any capital losses. The Fund expects to 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. The Fund currently plans to dispose of certain portfolio securities to
reduce or pay off its line of credit, and to increase the Fund's liquidity. See
"Management's Discussion and Analysis of Financial Condition and Results of
Operations" regarding the Fund's borrowings and liquidity.
Operating Expenses
The Management Company, at its expense, provides the Fund with office
space, facilities, equipment and personnel (whose salaries and benefits are paid
by the Management Company) necessary for the conduct of the Fund's business and
pays all costs related to proposed acquisitions of portfolio securities that are
not completed, unless such proposed acquisitions have been previously approved
by the Board of Directors of the Fund.
The Fund is responsible for paying certain expenses relating to its
operations, including: management fees to the Management Company; fees and
expenses of the Independent Directors; finder's fees; direct costs of proposed
investments in Portfolio Companies, whether or not completed, if such proposed
investments have been approved for acquisition by the Board of Directors of the
Fund; depositary fees of unaffiliated depositaries; fees of unaffiliated
transfer agents, registrars and disbursing agents; the administrative fee to the
Management Company; portfolio transaction expenses; interest; legal and
accounting expenses; costs of printing and mailing proxy materials and reports
to shareholders;
10
New York Stock Exchange fees; custodian fees; litigation costs; costs of
disposing of investments including brokerage fees and commissions; and other
unusual or nonrecurring expenses and other expenses properly payable by the
Fund. The Fund also has the ability to pay bonuses to its officers, but none
have been paid to date. See "Management's Discussion and Analysis of Financial
Condition and Results of Operations" regarding the Fund's liquidity.
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 accounting principles generally accepted in the United States
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 would be the amount the
Fund might reasonably expect to receive for it upon its current sale, in an
orderly manner. 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 a Portfolio
Company's earnings, cash flow and net worth, the market prices for similar
securities of comparable companies, an assessment of the company's current and
future financial prospects and various other factors and assumptions. In the
case of unsuccessful operations, the appraisal may be based upon liquidation
value. Appraisal valuations are necessarily subjective and the Management
Company's estimate of values may differ materially from amounts actually
received upon the disposition of portfolio securities. Also, failure by a
Portfolio Company to achieve its business plan or obtain and maintain its
financing arrangements could result in a significant and rapid change in its
value.
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.
Fund investments for which market quotations are readily available and
which are freely transferable are valued at the closing price 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 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 Board of Directors reviews 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.
Custodian
The Fund acts as the custodian of its securities to the extent
permitted under the Investment Company Act and is subject to the restrictions
imposed on self-custodians by the Investment Company Act and the rules and
regulations thereunder. The Fund has entered into an agreement with Bank of
America, N.A. with respect to the safekeeping of such securities. The principal
business office of the custodian is 700 Louisiana Street, 6/th/ Floor, Houston,
Texas 77002.
Transfer and Disbursing Agent
The Fund employs American Stock Transfer & Trust Company as its
transfer agent to record transfers of the shares, maintain proxy records and to
process distributions. The principal business office of such company is 59
Maiden Lane, New York, NY, 10007.
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 2003 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 or longer 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"
12
investment company under the Investment Company Act, which means the Fund is not
limited in the proportion of its assets that may be invested in the securities
of a single issuer. Generally, the Fund does not intend to initially invest more
than 15% of the value of its net assets in a single Portfolio Company. However,
follow-on investments, a disproportionate increase in the value of one Portfolio
Company or the sale of investments 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, or results of
operations of, 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 21 Portfolio Companies and two venture capital funds. The value
of one investment exceeds 20% of the value of the Fund's net assets and the
value of another exceeds 15%. The value of the Fund's investments in three
entities which are involved in the manufacture of residential windows exceeds
31% of the Fund's net asset value at December 31, 2002.
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. Many of the
Fund's Portfolio Companies have incurred substantial indebtedness in relation to
their overall capital base. Such indebtedness generally has a term that will
require that the balance of the loan be refinanced when it matures. In the event
a Portfolio Company cannot generate adequate cash flow to meet the principal and
interest payments on such indebtedness or is not successful in refinancing the
debt upon its maturity, the Fund's 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, if any, of the investments in such
companies, will depend in a significant part upon prevailing interest rates.
In addition, a number of financial institutions that have historically
been active in lending in the small and mid-cap markets on an asset-based or
cash-flow basis have withdrawn from the market and declined to extend existing
loans past their current maturity dates. Since most of the Fund's Portfolio
Companies borrow in this market, a number of Portfolio Companies are currently
faced with the necessity of refinancing their existing credit facilities in a
market where there are currently few other financing alternatives. If a
Portfolio Company cannot refinance its credit facility on a timely basis, it may
be required to sell assets to repay debt or seek protection under applicable
reorganization or bankruptcy laws. In either event the value of the Fund's
investment in such Portfolio Company may be materially affected.
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 of 1933 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
13
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. 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 private equity partnerships, other business development companies,
investment partnerships and corporations, small business investment companies,
large industrial and financial companies investing directly or through
affiliates, foreign investors of various types and individuals. Many of these
competitors have greater financial resources and more personnel than the Fund
and may be subject to different and frequently less stringent regulation.
Borrowings. 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 Internal Revenue 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 required to be liquidated in other than an
orderly manner.
Many financial institutions today are unwilling to lend against a
portfolio of illiquid, private securities. The decline in the number of
institutions in the Fund's credit market and the make-up of the Fund's portfolio
has made it more difficult for the Fund to borrow at the level and on the terms
that it desires. The Fund's borrowings have historically consisted of a
revolving line of credit, the proceeds of which have been utilized to provide
liquidity to the Fund for expenses and contingencies and to make new or
follow-on investments, and a line of credit promissory note, the proceeds of
which are utilized quarterly to enable the Fund to achieve adequate
diversification to maintain its pass-through tax status as a regulated
investment company.
14
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 "Loss of
Conduit Tax Treatment." 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.
See "Management's Discussion and Analysis of Financial Condition and
Results of Operations" and Note 2 in the "Notes to the Financial Statements" for
further discussion of the current status of the Fund's borrowings and liquidity.
Loss of Conduit Tax Treatment. The Fund may cease to qualify for
conduit tax treatment if it is unable to comply with the diversification and
gross income requirements of Subchapter M of the Internal Revenue Code.
Subchapter M requires that at the end of each quarter (i) at least 50% of the
value of the Fund's assets must consist of cash, government securities and other
securities of any one issuer that do not represent more than 5% of the value of
the Fund's total assets and 10% of the outstanding voting securities of such
issuer, and (ii) no more than 25% of the value of the Fund's assets may be
invested in the securities of any one issuer (other than United States
government securities), or of two or more issuers that are controlled by the
Fund and are engaged in the same or similar or related trades or businesses.
Additionally, at least 90% of the Fund's gross income must be derived from
interest, dividends, gains from sale of portfolio securities and other
qualifying sources. As discussed in "Borrowings", the Fund has historically
borrowed funds necessary to make qualifying investments to satisfy the foregoing
diversification requirements. If the Fund fails to satisfy such diversification
requirements and ceases to qualify for conduit tax treatment, the Fund will be
subject to income tax on its income and gains and stockholders will be subject
to income tax on distributions. The Fund may also cease to qualify for conduit
tax treatment, or be subject to a 4% excise tax, if it fails to distribute a
sufficient portion of its net investment income and net realized capital gains.
The Fund did not qualify as a regulated investment company ("RIC") for 2001;
however, in 2001 the Fund had no taxable income or gains that would have thus
been subject to federal income tax. Under applicable regulations, so long as the
Fund meets the Subchapter M requirements set out above for 2002, the Fund can
elect again to be taxed as a RIC in 2002. Management believes that the Fund has
met the Subchapter M requirements to be taxed as a RIC for 2002 and the Fund
intends to be taxed as such for 2002.
Market Value and Net Asset Value. The shares of the Fund's common stock
are listed on the NYSE. Investors desiring liquidity may trade their shares of
common stock on the NYSE at current market value, which historically has been
below the net asset value. Shares of closed-end investment companies frequently
trade at a discount from net asset value. This characteristic of shares of a
closed-end fund is a risk separate and distinct from the risk that the Fund's
net asset value will decrease. The risk of purchasing shares of a closed-end
fund that might trade at a discount is more pronounced for investors who wish to
sell their shares in a relatively short period of time because for those
investors, realization of a gain or loss on their investments is likely to be
more dependent upon the existence of a premium or discount than upon portfolio
performance. The Fund's shares have traded at a discount to net asset value
since they began trading. For information concerning the trading history of the
Fund's shares see "Market for Registrant's Common Equity and Related Stockholder
Matters."
15
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 materially differ from the fair value that
would have been used had a ready market existed for the securities. Appraisal
valuations are based on a Portfolio Company's historical performance and certain
assumptions concerning the company's future performance, the financial markets,
and general economic conditions. A Portfolio Company's failure to achieve its
business plan, changes in financial and other markets, or changes in general
economic conditions could result in significant and rapid changes in the value
of a Portfolio Company. At December 31, 2002, approximately 95% of the Fund's
fair value of portfolio securities were invested in securities for which market
quotations were not readily available. See "Valuation".
Possible Volatility of Stock Price. The market price of the Fund's
common stock could be subject to significant fluctuations in response to
variations in the net asset value of the Fund, its quarterly operating results,
and other factors. The market price of the common stock may be significantly
affected by such factors as the announcement of new or follow-on investments in
portfolio companies, the sale or proposed sale of a portfolio investment, the
results of operations or fluctuations in the market prices or appraised value of
one or more of the Fund's Portfolio Companies, changes in earnings estimates by
market analysts, speculation in the press or analyst community and general
market conditions or market conditions specific to particular industries. From
time to time in recent years, the securities markets have experienced
significant price and volume fluctuations that have often been unrelated or
disproportionate to the operating performance of particular companies. These
broad fluctuations may adversely affect the market price of the common stock. In
addition, the Fund is subject to the risk of the securities markets in which the
portfolio securities of the Fund are traded. Securities markets are cyclical and
the prices of the securities traded in such markets rise and fall at various
times. These cyclical periods may extend over significant periods of time.
Regulation
The Investment Advisers Act generally prohibits investment advisers
from entering into investment advisory contracts with an investment company that
provides for compensation to the investment adviser on the basis of a share of
capital gains or capital appreciation of the portfolio investments or any
portion of the funds of the investment company or pursuant to a stock option
plan. The Investment Advisers Act, however, does permit the payment of
compensation based on capital gains or the issuance of incentive stock options
to management in an investment advisory contract between an investment adviser
and a business development company. The Fund has elected to be treated as a
business development company under the Investment Company Act. Accordingly, it
has provided for incentive compensation to the officers of the Fund based on an
incentive stock option plan established in 1997.
The Fund may not withdraw its election to be treated as a business
development company without first obtaining the approval of a majority in
interest of its shareholders. The following brief
16
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 (1) is organized under the laws of, and has
its principal place of business in, any state or states, (2) is not an
investment company and (3)(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 (a) 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 (b) 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 (a) 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 (1) securities of companies that were eligible
portfolio companies at the time that the Fund acquired their securities; (2)
securities of companies that are actively controlled by the Fund; (3) securities
of bankrupt or insolvent companies that are not otherwise eligible portfolio
companies; (4) 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; (5) securities received in exchange for or distributed on or
with respect to any of the foregoing; and (6) cash items, government securities
and high-quality, short-term debt. The Investment Company Act also places
restrictions on the nature of the transactions in which, and the persons from
whom, securities can be purchased in order for such securities to be considered
Qualifying Assets. As a general matter, Qualifying Assets may only be purchased
from the issuer or an affiliate in a transaction not constituting a public
offering. The Fund may not purchase any security on margin, except such
short-term credits as are necessary for the clearance of portfolio transactions,
or
17
engage in short sales of securities.
The Fund is permitted by the Investment Company Act, under specified
conditions, to issue multiple classes of senior debt and a single class of
preferred stock senior to the common stock if its asset coverage, as defined in
the Investment Company Act, is at least 200% after the issuance of the debt or
the senior stockholders' interests. In addition, provisions must be made to
prohibit any distribution to common shareholders or the repurchase of any shares
unless the asset coverage ratio is at least 200% at the time of the distribution
or repurchase.
The Fund generally may sell its securities at a price that is below the
prevailing net asset value per share only upon the approval of the policy by
shareholders holding a majority of the shares issued by the Fund, including a
majority of shares held by nonaffiliated shareholders. The Fund may, in
accordance with certain conditions established by the SEC, sell shares below net
asset value in connection with the distribution of rights to all of its
stockholders. The Fund may also issue shares at less than net asset value in
payment of dividends to existing shareholders.
Since the Fund is a closed-end business development company,
stockholders have no right to present their shares to the Fund for redemption.
Recognizing the possibility that the Fund's shares might trade at a discount,
the Board of Directors of the Fund has determined that it would be in the best
interest of stockholders for the Fund to be authorized to attempt to reduce or
eliminate a market value discount from net asset value. Accordingly, the Fund
from time to time may, but is not required to, repurchase its shares (including
by means of tender offers) to attempt to reduce or eliminate any discount or to
increase the net asset value of its shares, or both.
The investments and business of the Fund are managed by the Management
Company, pursuant to a Management Agreement (the "Management Agreement")
initially approved by the stockholders of the Fund at a special meeting on April
9, 1997. The Management Agreement provides that the Management Company shall
provide, or arrange for suitable third parties to provide, any and all
management and administrative services reasonably necessary for the operation of
the Fund and the conduct of its business. In return for its service and the
expenses which the Management Company assumes under the Management Agreement,
the Fund pays the Management Company, on a quarterly basis, a management fee
equal to 0.5% of the net assets of the Fund on the last day of each calendar
quarter (2% per annum).
The Management Agreement will continue in effect until June 30, 2003,
and from year-to-year thereafter provided such continuance is approved at least
annually by (i) a vote of a majority of the outstanding shares of the Fund or
(ii) a majority of the directors who are not "interested persons" of the Fund,
at a meeting called for the purpose of voting on such approval. The Management
Agreement may be terminated at any time, without the payment of any penalty, by
a vote of the Board of Directors of the Fund or the holders of a majority of the
Fund's shares on 60 days' written notice to the Management Company, and would
automatically terminate in the event of its "assignment" (as defined in the
Investment Company Act).
Shareholders have approved the Equus II Incorporated 1997 Stock
Incentive Plan ("Stock Incentive Plan"), which authorizes the Fund to issue
options to the officers of the Fund, all of which are employed by the Management
Company, in an aggregate amount of up to 20% of the outstanding shares of common
stock of the Fund. Options are issued to the officers of the Fund at the
discretion of the compensation committee in accordance with the Stock Incentive
Plan.
Many of the transactions involving the Fund and its affiliates (as well
as affiliates of such
18
affiliates) require the prior approval of a majority of the Independent
Directors and a majority of the Independent Directors having no financial
interest in the transactions. However, certain transactions involving closely
affiliated persons of the Fund, including the Management Company, require the
prior approval of the SEC. In general (a) any person who owns, controls or holds
with power to vote more than 5% of the outstanding shares, (b) any director or
executive officer and (c) any person who directly or indirectly controls, is
controlled by or is under common control with such person, must obtain the prior
approval of a majority of the Independent Directors and, in some situations, the
prior approval of the SEC, before engaging in certain transactions involving the
Fund or any company controlled by the Fund. In accordance with the Investment
Company Act, a majority of the directors must be persons who are not "interested
persons" as defined in such act. Except for certain transactions which must be
approved by the Independent Directors, the Investment Company Act generally does
not restrict transactions between the Fund and its Portfolio Companies.
Item 2. Properties.
The Fund does not have an interest in any physical properties.
Item 3. Legal Proceedings.
The Fund, its affiliates and certain of the Portfolio Companies are
involved in asserted claims and have the possibility for unasserted claims which
may ultimately affect the net asset value of the Fund or the fair value of the
Fund's portfolio investments.
Item 4. Submission of Matters to a Vote of Security Holders.
No matters were submitted to a vote of security holders during the
fourth quarter of 2002.
Item 5. Market for Registrant's Common Equity and Related Stockholder
Matters.
The Fund's shares of common stock are listed on the New York Stock
Exchange under the symbol "EQS". The Fund had approximately 6,441 shareholders
at December 31, 2002, 1,237 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, 2002,
was $12.35.
The following table reflects the high and low sales prices per share of
the Fund's common stock on the New York Stock Exchange for the two years ended
December 31, 2002, by quarter.
Quarter
Ended High Low
----- ---- ---
March 31, 2001 $ 8.555 $ 7.909
June 30, 2001 $ 8.591 $ 7.900
September 30, 2001 $ 8.500 $ 7.473
December 31, 2001 $ 7.830 $ 7.280
March 31, 2002 $ 7.930 $ 7.600
June 30, 2002 $ 7.830 $ 7.400
September 30, 2002 $ 7.460 $ 6.440
December 31, 2002 $ 6.840 $ 6.470
As a regulated investment company under Subchapter M of the Internal
Revenue Code, the Fund
19
is required to distribute to its shareholders, in a timely manner, at least 90%
of its taxable net investment income each year. If the Fund distributes, in a
timely manner, 98% of its taxable net capital gains and 98% of its taxable net
investment income each year (as well as any portion of the respective 2%
balances not distributed in the previous year), it will not be subject to the 4%
non-deductible federal excise tax on certain undistributed income of regulated
investment companies. Under the Investment Company Act, the Fund is not
permitted to pay dividends to shareholders unless it meets certain asset
coverage requirements.
Historically, net investment income and net realized gains from the
sale of portfolio investments have been distributed at least annually. However,
the Fund did not have any net taxable ordinary income or capital gains for the
calendar year 2002 or 2001. Accordingly, the Board of Directors did not declare
a dividend in 2002. The Board of Directors declared a 10% stock dividend in
2001, and the Fund issued 566,638 shares on December 17, 2001. All shares and
per share amounts have been retroactively adjusted to reflect the 10% stock
dividend. There are restrictions on the Fund's ability to pay dividends under
its credit facility. See "Management's Discussion and Analysis of Financial
Condition and Results of Operations" regarding the Fund's liquidity and capital
resources.
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 distributes 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 and excise taxes.
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.
20
Item 6. Selected Financial Data.
Following is a summary of selected financial data and per share data of
the Fund for the five years ended December 31, 2002. Amounts are in thousands
except per share data. All shares and per share amounts have been retroactively
adjusted to reflect the 10% stock dividend declared and paid in 2001.
2002 2001 2000 1999 1998
---- ---- ---- ---- ----
Total investment income $ 2,987 $ 2,714 $ 5,117 $ 5,157 $ 3,774
Net investment income (loss) $ 145 $ 1,155 $ 549 $ (2,177) $ (2,179)
Realized gain (loss) on dispositions
of portfolio securities, net $ 802 $ (7,196) $ (6,161) $ 40,353 $ (3,564)
Increase (decrease) in unrealized
appreciation of portfolio
securities, net $ (924) $ (3,674) $ 282 $(45,412) $ (21,581)
Total increase (decrease) in net assets
from operations $ 24 $ (9,716) $ (5,329) $ (7,237) $ (27,324)
Dividends declared $ - $ - $ 3,844 $ 23,815 $ 3,139
Total assets at end of year $ 148,337 $ 150,819 $176,018 $175,022 $ 215,603
Net assets at end of year $ 76,976 $ 76,967 $ 90,925 $101,419 $ 116,155
Net cash used by operating activities $ (2,009) $ (1,506) $ (2,191) $ (3,303) $ (4,298)
Shares outstanding at end of year 6,233 6,233 6,493 6,719 5,449
Average shares outstanding during year 6,233 6,363 6,457 5,445 5,312
Per Share Data:
2002 2001 2000 1999 1998
---- ---- ---- ---- ----
Net investment income (loss) $ 0.02 $ 0.18 $ 0.08 $ (0.40) $ (0.41)
Realized gain (loss) on dispositions of
portfolio securities, net $ 0.13 $ (1.13) $ (0.95) $ 7.41 $ (0.67)
Increase (decrease) in unrealized
appreciation of portfolio securities,
net $ (0.15) $ (0.57) $ 0.05 $ (8.34) $ (4.06)
Dividends declared $ - $ - $ 0.55 $ 3.86 $ 0.59
Net asset value (including unrealized
appreciation), end of year $ 12.35 $ 12.35 $ 14.00 $ 15.10 $ 21.32
The financial statements for 1998 through 2001 were audited by Arthur
Andersen LLP, which has ceased operations. A copy of the auditor's report
previously issued by Arthur Andersen LLP on our financial statements as of
December 31, 2001 and 2000 and for each of the three years in the period ended
December 31, 2001 is included elsewhere in the Form 10-K. Arthur Andersen LLP
did not reissue its report.
21
Item 7. Management's Discussion and Analysis of Financial Condition and
Results of Operations.
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. Valuations of portfolio securities are
performed in accordance with accounting principles generally accepted in the
United States and the financial reporting policies of the Securities and
Exchange Commission ("SEC"). The applicable methods prescribed by such
principles and policies are described below:
Publicly-traded portfolio securities - Investments in companies whose
securities are publicly traded are valued at their quoted market price at the
close of business on the valuation date, less a discount to reflect the
estimated effects of restrictions on the sale of such securities ("Valuation
Discount"), if applicable.
Privately-held portfolio securities - The fair value of investments for
which no market exists (95% of the investments held by the Fund at December 31,
2002) 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 would be the amount the Fund might reasonably expect to receive
for it upon its current sale, in an orderly manner. Appraisal valuations are
necessarily subjective and the Management Company's estimate of values may
differ materially from amounts actually received upon the disposition of
portfolio securities.
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. Thereafter, portfolio investments are carried at
appraised values as determined quarterly by the Management Company, subject to
the approval of the Board of Directors. Appraisal valuations are based upon such
factors as a Portfolio Company's earnings, cash flow and net worth, the market
prices for similar securities of comparable companies, an assessment of the
company's current and future financial prospects and various other factors and
assumptions. In the case of unsuccessful operations, the appraisal may be based
upon liquidation value.
Most of the Fund's common equity investments are appraised at a
multiple of free cash flow generated by the Portfolio Company in its most recent
fiscal year, less outstanding funded indebtedness and other senior securities
such as preferred stock. Projections of current year free cash flow may be
utilized and adjustments for non-recurring items are considered. Multiples
utilized are estimated based on the Management Company's experience in the
private company marketplace, and are necessarily subjective in nature. Most of
the Portfolio Companies utilize a high degree of leverage. The banking
environment currently has resulted in pressure on several of these Portfolio
Companies to reduce the amount of leverage in order to maintain such financing.
From time to time, Portfolio Companies are in default of certain covenants in
their loan agreements. When the Management Company has a reasonable belief that
the Portfolio Company will be able to restructure the loan agreements to adjust
for any defaults, the Portfolio Company's securities continue to be valued
assuming that the company is a going concern. In the event a Portfolio Company
cannot generate adequate cash flow to meet the principal and interest payments
on such indebtedness or is not successful in refinancing the debt upon its
maturity, the value of the Fund's investment could be reduced or eliminated
through foreclosure on the Portfolio Company's assets or the Portfolio Company's
reorganization or bankruptcy.
The Fund may also use, when available, third-party transactions in a
Portfolio Company's
22
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.
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 conditions 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.
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 value that would have
been used had a ready market existed for the securities.
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.
Federal Income Taxes - The Fund intends to comply with the requirements
of the Internal Revenue Code necessary to qualify as a regulated investment
company and, as such, will not be subject to federal income taxes on otherwise
taxable income (including net realized capital gains) which is distributed to
shareholders. Therefore, no provision for federal income taxes is recorded in
the financial statements. As of December 31, 2002, the Fund has a capital loss
carryforward of $2,218,000, which may be used to offset future taxable capital
gains. The Fund borrows money from time to time to maintain its tax status under
the Internal Revenue Code as a regulated investment company ("RIC"). See
"Borrowings" and "Loss of Conduit Tax Treatment" for further discussions of the
Fund's borrowings.
Liquidity and Capital Resources
At December 31, 2002, the Fund had $87,194,210 of its assets invested
in portfolio securities of 21 companies and two venture capital funds. The Fund
had a $22,500,000 revolving line of credit with Bank of America, N.A. that
expired on December 31, 2002. The line of credit was subsequently extended until
June 1, 2003, and amended to provide for maximum borrowings of $18,000,000. The
Fund uses its revolving line of credit for liquidity to pay operating expenses
of the Fund and for new and follow-on investments in portfolio securities. The
Fund had $12,775,000 outstanding under this line of credit at December 31, 2002,
which is collateralized by the Fund's investments in portfolio securities. In
addition, the Fund had irrevocable letters of credit in the amount of $3,719,000
outstanding at year end, which reduces the amount of additional borrowings
available under the line of credit. The letters of credit expired subsequent to
year-end. As of April 1, 2003, the Fund's availability under the revolving line
of credit is approximately $1,590,000.
The line of credit, as amended, provides that any proceeds received
from the sale of portfolio securities or from repayments by portfolio companies
of the principal amount of loans must be used to pay down the line of credit. As
such payments are made, the Fund's availability under the facility will be
reduced by a corresponding amount. The line of credit also restricts the Fund's
ability to incur additional indebtedness, pay dividends, merge with another
entity, dispose of assets outside the ordinary course of business and engage in
certain transactions with affiliates.
The lender has asked the Fund to take steps to pay off the line of
credit. Accordingly, the Fund is
23
currently in discussions with several interested parties regarding the sale of
certain portfolio securities at values that could enable the Fund to repay the
line of credit. The Fund is also pursuing arrangements to refinance the line of
credit with another lender and may approach the current lender for another
extension of the due date. There can be no assurance that the Fund can sell
securities sufficient to pay off the line of credit, extend the existing line of
credit or obtain a replacement facility by June 1, 2003. Should the Fund be
unable to repay the line of credit, extend it or refinance it with another
lender, portfolio securities may be required to be sold and such sales may be at
values that are materially less than Management's estimates of fair value.
Under certain circumstances, the Fund may be called on to make
follow-on investments in certain Portfolio Companies. The Fund has guaranteed
obligations to financial institutions on behalf of Reliant Window Holdings, LLC
("RWH") and Equicom, Inc. ("Equicom") in the respective amounts of $1,439,000
and $759,000. RWH is currently servicing its obligations to the financial
institution, and Management does not expect the Fund to have to pay anything in
relation to this guarantee. The Fund has made loans to Equicom from time to time
to enable the company to service its debt, but Management does not expect the
Fund to advance more than $150,000 in 2003 for such purpose. In addition, the
Fund has committed to invest up to $5,550,000 in the two venture capital funds
in its portfolio. At December 31, 2002, $3,030,000 of such amount had been
funded, and an additional $300,000 was funded on March 3, 2003. Management does
not expect the Fund to advance more than $900,000 of its remaining commitments
to the venture capital funds in 2003. If the Fund does not have sufficient funds
to make follow-on investments, the Portfolio Company in need of the investment
may be negatively impacted. Also, the Fund's equity interest in and its
estimated fair value of the Portfolio Company could be reduced.
Net cash used by operating activities was $2,009,341, $1,505,851 and
$2,191,287 for the three years ended December 31, 2002, 2001 and 2000,
respectively. Management expects net cash needed for operating activities to
remain at comparable levels during 2003. Management believes that borrowings
available under the revolving line of credit, net investment income and proceeds
from sales of portfolio securities will be sufficient for the liquidity needs of
the Fund. Approximately $24.2 million in estimated value of the Fund's
investments are in the form of notes receivable from Portfolio Companies. At
December 31, 2002, three of these notes, with an estimated fair value of
$9,315,342, provide that interest is paid in kind or that the original issue
discount is accreted over the life of the notes, by adding such amount to the
principal of the notes.
Because of the nature and size of its portfolio investments, the Fund
periodically borrowed money under a line of credit promissory note to make
qualifying investments to maintain its tax status under the Internal Revenue
Code as a RIC. The Fund's line of credit promissory note expired on January 1,
2003. Management believes the Fund will be able to borrow sufficient funds to
maintain its RIC status in the future by utilizing an established margin account
with a securities brokerage firm, supplemented by collateralized loans from
banks, if necessary. However, there are no assurances that such arrangement will
be available to the Fund in the future. If the Fund is unable to borrow funds to
make qualifying investments, the Fund may no longer qualify as a RIC. The Fund
would then be subject to corporate income tax on its net investment income and
realized capital gains, and stockholders would be subject to income tax on
distributions. Failure to continue to qualify as a RIC could be material to the
Fund's shareholders.
At December 31, 2002, the Fund had $58,516,236 of its total assets of
$148,336,857 invested in temporary cash investments consisting of money market
securities. This amount includes restricted temporary cash investments of
$58,000,000 purchased from borrowings pursuant to a note payable to a bank. The
Fund utilized such investments at December 31, 2002 to achieve adequate
diversification to
24
maintain its pass-through tax status as a regulated investment company. The note
payable to the bank is collateralized by these restricted temporary cash
investments, which were used to repay the bank on January 2, 2003.
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 expenses and
contingencies or to make follow-on or new investments. Pursuant to the
restrictions in the Fund's existing line of credit, the Fund is not allowed to
incur additional indebtedness unless approved by the lender.
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 income after all expenses amounted to $145,483,
$1,154,695 and $549,448 for the years ended December 31, 2002, 2001 and 2000,
respectively. With respect to investment income, income from portfolio
securities was $2,725,541 in 2002, $2,600,030 in 2001 and $4,629,928 in 2000.
The decrease in 2002 and 2001 compared to 2000 is attributable primarily to
interest no longer being accrued and accrued interest written off on notes
receivable from certain portfolio companies in 2002 and 2001, plus the receipt
in 2000 of previously unaccrued interest from one Portfolio Company. Interest
from temporary cash investments was $21,170 in 2002, $58,655 in 2001 and
$141,427 in 2000. The decrease in 2002 and 2001 as compared to 2000 was a result
of lower investable balances and interest rates throughout the years.
With respect to investment expense, interest expense was $573,997 in
2002 as compared to $437,197 in 2001 and $1,508,788 in 2000. The average daily
balances outstanding on the lines of credit were $12,325,119 in 2002 and
$8,572,877 in 2001 as compared to $18,950,064 in 2000. Interest expense
increased during 2002 due to the increase in the average daily balance
outstanding on the lines of credit; however this increase is partially offset by
a reduction of interest rates in 2002. Upon cancellation of the notes receivable
from officers in September 2001, there was a credit to non-cash compensation
expense of $1,536,856. The amount of non-cash compensation benefit was recorded
as an adjustment to additional paid in capital, and therefore had no effect on
the Fund's total net assets.
Professional fees were $250,704 in 2002 as compared to $452,414 during
2001 and $167,784 during 2000. The increase in 2001 as compared to 2002 and 2000
is due primarily to legal fees incurred in 2001 related to (i) a potential
purchase of a Portfolio Company that did not occur and (ii) the sale of the
Fund's investment in Stephen L. LaFrance Holdings, Inc.
Mailing, printing and other expenses were $119,747 in 2002 as compared
to $179,531 during 2001 and $172,339 during 2000. The decrease in 2002 as
compared to 2001 and 2000 is due primarily to a reduction in the printing costs
of the 2002 annual report.
25
The Management Company receives management fee compensation at an
annual rate of 2% of the net assets of the Fund paid quarterly in arrears. Such
fees amounted to $1,532,152, $1,618,784 and $1,911,275 during 2002, 2001 and
2000, respectively.
During 1999, the officers of the Fund exercised options to purchase
719,794 shares of common stock of the Fund. The exercise price was paid in the
form of promissory notes from the officers to the Fund. During 2001, the
officers of the Fund surrendered their shares in payment of their notes. Under
variable plan accounting applicable to these transactions, compensation expense
was adjusted to reflect the change in benefit that the officers would have
received assuming that their notes were settled with their pledged common stock
at the end of each reporting period, based on the net asset value of the Fund.
Non-cash compensation expense (benefit) under this arrangement was $(1,536,856)
and $388,663 for the years ended December 31, 2001 and 2000, respectively, and
was recorded as an adjustment to additional paid in capital.
On November 14, 2001, options to acquire a total of 990,000 shares at
$7.69 per share (market price on date of grant) were issued to officers of the
Fund. These options include dividend equivalent rights. Generally accepted
accounting principles require that the options be accounted for using variable
plan accounting as a result of the terms of the dividend equivalent rights. Such
accounting resulted in additional non-cash compensation (benefit) of $(14,434)
for the year ended December 31, 2002. See Note 8 in the "Notes to the Financial
Statements" for a table that reflects stock option activity for the three years
ended December 31, 2002.
Realized Gains and Losses on Dispositions of Portfolio Securities
During the year ended December 31, 2002, the Fund realized a net
capital gain of $802,235 from the sale or disposition of securities of Portfolio
Companies as follows:
. sold 60,595 shares of common stock of Weatherford International for
$2,844,558, realizing a capital loss of $666,922;
. sold a portion of its investment in Travis International, Inc. for
$921,577 in cash plus an interest in Milam Enterprises, LLC, realizing
a capital gain of $918,091;
. received proceeds from Jones Industrial Holdings, Inc. for the
redemption of 18,667 warrants, realizing a capital gain of $148,131;
and
. received proceeds from its investment in Milam Enterprises LLC,
realizing a capital gain of $402,935.
During the year ended December 31, 2001, the Fund realized a net
capital loss of $7,196,407 from the sale or write-off of securities of Portfolio
Companies as follows:
. sold its investment in Stephen L. LaFrance Holdings, Inc. for
$10,000,000, realizing a capital gain of $7,501,548;
. the remaining shares of Paracelsus Healthcare Corporation were
written-off, realizing a capital loss of $4,299,449;
. the remaining investment in Hot & Cool Holdings, Inc. was written-off,
realizing a capital loss of $5,775,000;
. the remaining investment in CRC Holdings, Corp. was written off,
realizing a capital loss of $1,192,114;
26
. the sale of an investment in Sternhill Partners, L.P. resulted in a
realized capital gain of $7,055;
. sold 11,024 shares of Raytel Medical Corporation for $66,527, realizing
a capital loss of $264,203;
. received 69,458 shares of Weatherford International common stock
pursuant to a plan of liquidation of Tulsa Industries, Inc. and in
payment of a note receivable, realizing a capital loss of $2,663,678;
and
. received ENGlobal, Inc. (formerly Industrial Data Systems Corporation
("IDS")) common stock as a result of the merger of IDS and Petrocon
Engineering Inc., realizing a capital loss of $510,566.
During the year ended December 31, 2000, the Fund realized a net
capital loss of $6,160,547 from the sale or write-off of securities of Portfolio
Companies as follows:
. sold 900,000 shares of Allied Waste Industries, Inc. for $11,656,249,
realizing a capital gain of $8,534,684;
. sold 1,703,200 shares of Drypers Corporation for $83,294, realizing a
capital loss of $7,270,556;
. sold 173,868 shares of Paracelsus Healthcare Corporation for $4,460,
realizing a capital loss of $974,839;
. sold 255,103 shares of LG&E Energy Corporation for $6,193,867,
realizing a capital gain of $1,911,944;
. a receivable from Restaurant Development Group was written-off,
realizing a capital loss of $8,315;
. the preferred stock of Hot & Cool Holdings, Inc. was sold for $1,
realizing a capital loss of $1,086,631;
. the remaining shares of Drypers Corporation were written-off, realizing
a capital loss of $1,974,706; and
. the preferred and common stock of The Drilltec Corporation was
written-off, realizing a capital loss of $7,645,000.
In addition, additional proceeds related to the previous sale of three
Portfolio Companies were received in 2000. The Fund realized a capital gain of
$680,636 as a result of additional compensation from the escrow account related
to the 1998 sale of WMW Industries. The Fund realized a capital gain of $683,697
as a result of additional compensation from the escrow account related to the
1999 sale of HTD Corporation. Also, as a result of the earnout related to the
sale of CRC Holdings Corp. in 1999, the Fund received cash of $994,458 and
17,739 shares of LGE and realized the $994,458 as a capital gain. The Fund also
received proceeds from the liquidation of Equus Video Corporation and realized a
capital loss of $5,919.
Unrealized Appreciation and Depreciation of Portfolio Securities
See "Factors that May Affect Future Results, the Market Price of Common
Stock, and the Accuracy of Forward-Looking Statements" regarding the valuation
of the Fund's Portfolio Companies. The valuation of the Portfolio Companies is
the most significant area of judgment impacting the financial statements.
27
Net unrealized depreciation increased by $924,020 during the year ended
December 31, 2002 from $4,492,994 to $5,417,014. Such increase resulted from an
increase in estimated fair value of securities of ten of the Fund's Portfolio
Companies of $20,949,486, a decrease in estimated fair value of securities of
fourteen of the Fund's Portfolio Companies of $20,457,188, and the transfer of
$1,416,318 in net unrealized depreciation to net realized losses from the sale
or disposition of investments in five Portfolio Companies.
Net unrealized depreciation increased by $3,674,031 during the year
ended December 31, 2001 from $818,963 to $4,492,994. Such increase resulted from
an increase in estimated fair value of securities of two of the Fund's Portfolio
Companies of $3,730,000, a decrease in estimated fair value of securities of
fourteen of the Fund's Portfolio Companies of $17,455,390, and the transfer of
$10,051,359 in net unrealized depreciation to net realized losses from the sale
or disposition of investments in seven Portfolio Companies.
Net unrealized depreciation decreased by $281,625 during the year ended
December 31, 2000, from $1,100,588 to $818,963. Such net decrease resulted from
an increase in estimated fair value of securities of eight of the Fund's
Portfolio Companies of $11,678,434, a decrease in estimated fair value of
securities of nine of the Fund's Portfolio Securities of $15,789,610 and the
transfer of $4,392,801 in net unrealized depreciation to net realized losses
from the sale or disposition of investments in eight Portfolio Companies.
Dividends
No dividends were declared in 2002. In lieu of any cash dividends in
2001, the board of directors declared a stock dividend of one additional share
for each ten shares held by its stockholders of record on December 3, 2001 and
the Fund issued 566,638 shares on December 17, 2001. The board of directors
declared a dividend of $3,843,842 ($0.55 per share) during 2000. The 2000
dividends were paid in additional shares of common stock or in cash by specific
election of each shareholder in December 2000. The 2000 dividend represented
some long-term capital gains carried over from 1999 and ordinary income but was
primarily a return of capital. The Fund paid $1,482,244 in cash and issued
294,990 additional shares of stock at $8.00568, in December 2000, in connection
with such dividends. In 2000, the Fund recorded non-cash compensation expense
for the dividends paid on stock held by officers of $388,663.
Portfolio Investments
During the year ended December 31, 2002, the Fund invested $783,749 in
two new limited liability companies, which in turn invested in two existing
Portfolio Companies, and made follow-on investments of $8,451,097 in twelve
portfolio companies, including $2,354,775 in accrued interest and dividends
received in the form of additional portfolio securities and accretion of
original issue discount on promissory notes.
For the year ended December 31, 2002, the Fund received an additional
5,576, 88,000, 315,000 and 1,629 shares of preferred stock of Container
Acquisition, Inc., ENGLobal Corporation ("ENG"), PalletOne, Inc. and Sovereign
Business Forms, Inc. ("Sovereign") in payment of $557,600, $88,000, $315,000 and
$162,900 in dividends, respectively. In addition, Sovereign elected to convert
$502,659 of accrued interest into the balance of the 15% promissory notes due to
the Fund.
On January 4, 2002, the Fund invested $483,749 to acquire a 24% member
interest in Alenco
28
Window Holdings II, LLC ("AWH2"), which was formed to loan $2,000,000 to Alenco
Holding Corporation ("AHC") in exchange for a secured promissory note and a
warrant to acquire 93,675 shares of AHC common stock for $0.01 per share. On
September 16, 2002, AWH2 paid a distribution to the Fund of $483,522, after AHC
repaid the loan.
On January 7, 2002, the Fund invested an additional $425,000 in FS
Strategies, Inc. ("FSS") as a capital contribution. On March 29, 2002, the Fund
invested an additional $1,667,000 in FSS in exchange for 1,667 shares of
preferred stock.
On February 27, 2002, the Fund invested an additional $150,000 in the
form of a working capital loan to Spectrum Management, LLC, ("Spectrum") which
was repaid on August 7, 2002. In addition, on October 30, 2002, the Fund
invested $1,303,698 in Spectrum in exchange for a 16% senior subordinated
promissory note.
During 2002, the Fund invested an additional $330,000 in Sternhill
Partners I, L.P. pursuant to a $3,000,000 commitment made in March 2000.
$1,830,000 of such commitment has been funded through December 31, 2002. The
Fund has been notified by Sternhill that it does not expect to call on the Fund
for approximately $450,000 of the original commitment.
On April 29, 2002, the Fund invested an additional $1,571,000 in
CCI-ANI Finance, LLC, a limited liability company which acquired a subordinated
promissory note of Container Care International, Inc. ("Container Care"). The
note, with a face value of $2,000,000 plus accrued interest of $233,333, was
purchased for $1,850,000 from the former owner of Container Care.
On April 30, 2002, the Fund transferred its investment in Travis
International, Inc. ("Travis") to Milam Enterprises, LLC ("Milam"). The Fund
received $921,577 in cash and an interest in Milam, which was formed to hold
certain assets of Travis not included in the sale of its business operations and
to perform certain obligations which might arise pursuant to the sale of the
Travis business.
On May 8, 2002, the Fund received $878,667 from Jones Industrial
Services, Inc. for payment of a note receivable plus accrued interest and the
redemption of 18,887 warrants.
During the year ended December 31, 2002, ENG made principal payments on
its 9.5% promissory note of $220,000, reducing the note balance to $2,780,000.
During the year ended December 31, 2002, the Fund advanced $441,480 in
cash to Equicom, Inc. pursuant to a 10% promissory note.
During the year ended December 31, 2002, the Fund exchanged two 15%
promissory notes from The Bradshaw Group in the amount of $222,945 each for a
15% promissory note in the amount of $459,545, including $13,655 of accrued
interest.
For the year ended December 31, 2002, the original issue discount
accretion and interest on the discounted 15% promissory note from Doane Pet Care
Enterprises, Inc. amounted to $359,577, bringing the balance of the note to
$1,787,802 at December 31, 2002.
During the year ended December 31, 2002, the Fund received a 12%
promissory note from Turfgrass America, Inc. ("Turfgrass") in exchange for
accrued interest in the amount of $288,580. In addition, the original issue
discount was accreted on the 12% subordinated promissory note from
29
Turfgrass, bringing the note balance to $3,781,804 at December 31, 2002. The
original issue discount is being accreted over the life of the note.
During the year ended December 31, 2002, the Fund invested an
additional $208,144 in American Trenchless Technologies, LLC ("ATT") in a
preferred unit offering. On October 17, 2002, the Fund invested $300,000 in
Glendale, LLC, which was formed to invest in ATT in connection with a
restructuring of its debt and a recapitalization of its balance sheet.
During the year ended December 31, 2001, the Fund invested $15,386,789
in six new companies, including non-cash securities of $10,573,214 in three
companies as the result of a merger or sale of existing Portfolio Companies. In
addition, the Fund made follow-on investments of $8,709,395 in eleven portfolio
companies, including $2,332,847 in accrued interest and dividends received in
the form of additional portfolio securities and accretion of original issue
discount on a promissory note.
During the year ended December 31, 2000, the Fund invested $7,435,001
in four new companies and made follow-on investments of $4,968,405 in ten
portfolio companies. These follow-on investments included $1,209,344 in accrued
interest and dividends received in the form of additional portfolio securities
and accretion of original issue discount.
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,
2002, only ENG and NCS are publicly held. The others each have a small number of
shareholders and do not generally make financial information available to the
public. However, each company's operations and financial information are
reviewed by Management to determine the proper valuation of the Fund's
investment. See "Valuation".
New Accounting Pronouncements
In December 2002, SFAS No. 148, "Accounting for Stock-Based
Compensation--Transition and Disclosure--an amendment of FASB Statement No. 123"
was issued. SFAS 148 amends SFAS 123, "Accounting for Stock-Based Compensation",
to provide alternative methods of transition for a voluntary change to the fair
value based method of accounting for stock-based employee compensation. In
addition, this Statement amends the disclosure requirements of SFAS 123 to
require prominent disclosures in both annual and interim financial statements
about the method of accounting for stock-based employee compensation and the
effect of the method used on reported results. The provisions of SFAS 148 are
effective for financial statements for fiscal years ending after December 15,
2002. SFAS 148 does not change the provisions of SFAS 123 that permit entities
to continue to apply the intrinsic value method of Accounting Principles
Bulletin No. 25, "Accounting for Stock Issued to Employees". We continue to
account for stock-based compensation in accordance with the provisions of APB
No. 25. We have provided the disclosures required by SFAS 148.
In November 2002 FASB interpretation, or FIN 45, "Guarantor's
Accounting and Disclosure Requirements for Guarantees, Including Indirect
Guarantee of Indebtedness of Others" was issued. FIN 45 requires that upon
issuance of a guarantee, the guarantor must recognize a liability for the fair
value of the obligation it assumes under that guarantee. FIN 45's provisions for
initial recognition and measurement should be applied on a prospective basis to
guarantees issued or modified after December 31, 2002. The guarantor's previous
accounting for guarantees that were issued before the date of FIN
30
45's initial application may not be revised or restated to reflect the effect of
the recognition and measurement provisions of FIN 45. The disclosure
requirements are effective for financial statements of both interim and annual
periods that end after December 15, 2002, and have been adopted by the Fund.
Subsequent Events
Subsequent to December 31, 2002, the Fund repaid a net $59,950,000 of notes
payable to the bank, using the restricted temporary cash investments of
$58,000,000 held at year end.
On February 19, 2003, ENGlobal, Inc. made a principal payment on its 9.5%
promissory note of $110,000, reducing the note balance to $2,670,000.
On February 28, 2003, the Fund received $2,406,398 from Doane PetCare
Enterprises, Inc. for payment in full of its 15% promissory note.
On March 3, 2003, the Fund invested an additional $300,000 in Vanguard VII,
L.P. pursuant to a $3,000,000 commitment made in March 2000. $1,500,000 of such
commitment has now been funded.
On March 4, 2003, the Fund received $108,004 from Milam Enterprises, LLC,
realizing a capital gain of $106,092.
On March 7, 2003, the Fund advanced $75,000 to Equicom, Inc. pursuant to a
10% promissory note, thereby reducing the commitment to provide funding to
Equicom by a like amount.
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, a