Equus Total Return: Bad Management Of A Valuable Fund

Investment Thesis

Equus Total Return (NYSE:EQS) is a micro-cap BDC sitting on some valuable assets that are up for sale at a discount. Recent developments increase the odds that a merger or an acquisition will come about soon, unlocking the value of these assets.

A deal is expected to result in a 112% capital appreciation and materialize in the next nine to twelve months.

What is New?

Insider Ownership

In a private transaction, on July 20th, 2020, MVC Capital, through Tokarz Group, sold 3,228,024 shares to John hardy, EQS’s CEO.

The trade increased the ownership of the CEO more than 540%. His holdings now stand at ~28% of total shares outstanding. This is important because it aligns the CEO’s interest with that of shareholders.

Liquidity Problems

The current cash balance now stands at $2.3 million. This is not enough to cover EQS annual expenses, which stood at $3.7 million and $4 million in 2019 and 2018, respectively.

The company’s cash dropped like a stone in the past five years. Management compensation constitutes the highest expense and is paid mostly in cash.

Now that the company is almost out of cash, the next step will most likely be the sale of assets.

Data by YCharts

EQS Portfolio

The arbitrage opportunity here depends on the difference between market and book value of the assets.

The analysis below assesses the accuracy of book value estimates and adjusts them in light of more conservative calculations, in order to create a healthy margin of error to investors.

The bulk of the company’s assets are found in its investment portfolio. The portfolio book value is $65 million but includes a $27 million US treasury bills investments.

The first thing to do is to exclude the treasury investments because they don’t have a significant effect on shareholders’ returns either now or in case of liquidation. Funds for this investment are borrowed from a brokerage firm and used to meet regulatory requirements related to the company’s RIC status.

The book value of the EQS portfolio, excluding the US treasury bills, is $38 million. Here is what that portfolio looked like as of June 30th, 2020.

Source: Table created by the author. The data is sourced from EQS financial statements.

Below is an analysis of each portfolio company individually.

Equus Energy

Equus Energy is a wholly-owned subsidiary of EQS. I value this company at ZERO because of the following reasons:

  1. Equus Energy was profitable in only two out of the seven past years.
  2. Recessionary pressures on oil prices do not bode well for the company’s value.

Source: Graph created by the author. Data sourced from EQS financial statements.

PalletOne

PalletOne is the largest pallet manufacturer in the US, with ~$500 million in annual sales. EQS owns approximately 19% of the company’s equity. The reported fair value on EQS’s balance sheet is $27.5 million, valuing PalletOne at ~$1.5 billion.

I think this valuation is reasonable as it translates to a 3x P/S ratio. The company will not have a problem selling PalletOne at the reported book value of $27 million.

MVC Capital

MVC shares are traded on the NYSE, under the symbol MVC, so there won’t be a problem in either valuating or disposing of this investment.

EQS owns 578,596 shares valued at $4,628,768, based on the October 2nd, 2020, market close. This is compared to $3,778,000 million reported on the latest financial statement.

I will use the market value of the securities when estimating EQS’s NAV.

5th Element Tracking, LLC

5th Element Tracking is a tech holding company that has three tech startups in its portfolio.

  1. Spectrum Management (Blue tracks)
  2. LP Innovations
  3. The Pharma Compliance Group

I value this company at ZERO compared to the $975,000 reported fair value on the balance sheet. The investment in 5th Element is in the form of a promissory note. The note is non-income producing and was due in 2018, but has never been paid.

While the underlying companies seem legitimate and functional, the company might have a hard time selling the note. For the sake of being conservative in estimating the fair value of EQS, I won’t include the note in the NAV calculation.

Adjusted Net Asset Value

Based on the adjustments above, the fair value of the company’s portfolio is $32,128,768, and the adjusted NAV is $35,843,000 million. Adjusted NAV per share is $2.65 (based on 13,518,146 shares outstanding).

The current price is $1.25, opening an opportunity of 112% capital appreciation.

Management Team

EQS’s ineffective management is the main risk for shareholders. The company’s CEO and CFO have disappointed shareholders for years. Despite the small size of EQS portfolio, the management failed to dispose of the assets in a way that would unlock value to shareholders.

Despite being in the BDC business, where buying and selling of private companies’ debt and equity is a normal course of business, John A Hardy, the company’s CEO was only able to find one buyer for the company’s assets, since the failed MVC deal. This is a demonstration of lack of talent, especially given the small size of the portfolio.

L’Sheryl D. Hudson, the company’s CFO, doesn’t own any stock in the company but has been sitting on a defunct BDC for years. The CFO relies heavily on outsourced professional services to manage the company’s accounts. The company spent $974,000 and $1.3 million on professional services in 2019 and 2018, respectively.

Despite their ineffectiveness and lack of talent as demonstrated by years of disappointing investors, and inability to find a buyer for obviously valuable assets, John A Hardy and L’Sheryl D. Hudson pocketed $1.2 million of the $1.7 million management compensation in 2019 (see page 10 of the 2020 proxy statement).

Summary

Equus Total Return is a micro-cap BDC sitting on some valuable assets that are up for sale at a discount. Recent developments created a stick-and-carrot dynamics that will push the management to make a deal to unlock the value of EQS within less than 12 months.

The most conservative estimates of EQS assets point to an opportunity of more than 100% capital appreciation.

Management’s ineffectiveness and lack of talent might mean that a deal might take longer than anticipated.

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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: This is not investment advice. All information contained herein is for informational purposes only.

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