10-Q 1 0001.txt FORM 10-Q SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 (Mark One) [X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended September 30, 2000 or [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934 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 HOUSTON, TEXAS 77019-2120 ----------------------------------- ---------- (Address of principal (Zip Code) executive offices) 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 Approximate aggregate market value of common stock held by non-affiliates of the registrant: $49,991,116 computed on the basis of $10.125 per share, closing price of the common stock on the New York Stock Exchange Inc. on November 10, 2000. For the purpose of calculating this amount only, all directors and executive officers of the registrant have been treated as affiliates. There were 6,414,804 shares of the registrant's common stock, $.001 par value, outstanding, as of November 10, 2000. The net asset value of a share at September 30, 2000 was $15.75. Documents incorporated by reference: None EQUUS II INCORPORATED (A Delaware Corporation) INDEX
PART I. FINANCIAL INFORMATION PAGE ---- Item 1. Financial Statements Balance Sheets - September 30, 2000 and December 31, 1999...................... 1 Statements of Operations - For the three months ended September 30, 2000 and 1999........ 2 - For the nine months ended September 30, 2000 and 1999 ........ 3 Statements of Changes in Net Assets - For the nine months ended September 30, 2000 and 1999 ........ 4 Statements of Cash Flows - For the nine months ended September 30, 2000 and 1999 ........ 5 Selected Per Share Data and Ratios - For the nine months ended September 30, 2000 and 1999 ........ 7 Schedule of Portfolio Securities - September 30, 2000 ........................................... 8 Notes to Financial Statements................................... 14 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations .......................... 20 Item 3. Quantitative and Qualitative Disclosure about Market Risk .... 25 PART II. OTHER INFORMATION Item 6. Exhibits and Reports on Form 8-K ............................. 25 SIGNATURE ..................................................................... 25
ii PART I. FINANCIAL INFORMATION ITEM 1. FINANCIAL STATEMENTS EQUUS II INCORPORATED BALANCE SHEETS SEPTEMBER 30, 2000 AND DECEMBER 31, 1999 (Unaudited)
2000 1999 ------------- ------------- Assets Investments in portfolio securities at fair value (cost $120,137,620 and $116,473,793, respectively) ...... $ 105,969,317 $ 115,373,205 Temporary cash investments, at cost which approximates fair value ................................. 60,041,662 50,334,180 Cash ......................................................... 5,514 5,485,502 Accounts receivable .......................................... 867 1,050,606 Accrued interest receivable .................................. 4,148,399 2,778,922 ------------- ------------- Total assets ....................................... 170,165,759 175,022,415 ------------- ------------- Liabilities and net assets Liabilities: Accounts payable ........................................ 391,935 696,501 Due to management company ............................... 452,606 507,094 Notes payable to bank ................................... 78,800,000 72,400,000 ------------- ------------- Total liabilities .................................. 79,644,541 73,603,595 ------------- ------------- Commitments and contingencies Net assets: Preferred stock, $.001 par value, 5,000,000 shares authorized, no shares outstanding .................... -- -- Common stock, $.001 par value, 25,000,000 shares authorized, 6,480,504 and 6,839,331 shares outstanding 6,481 6,839 Additional paid-in capital .............................. 99,253,248 102,676,963 Notes receivable from officers related to 731,662 shares of common stock ....................... (10,132,925) (10,132,925) Undistributed net investment income ..................... 849,817 -- Undistributed net capital gains ......................... 14,712,900 9,968,531 Unrealized depreciation of portfolio securities, net .... (14,168,303) (1,100,588) ------------- ------------- Total net assets ................................... $ 90,521,218 $ 101,418,820 ============= ============= Net assets per share ............................... $ 15.75 $ 16.61 ============= =============
The accompanying notes are an integral part of these financial statements 1 EQUUS II INCORPORATED STATEMENTS OF OPERATIONS FOR THE THREE MONTHS ENDED SEPTEMBER 30, 2000 AND 1999 (Unaudited)
2000 1999 ------------ ------------ Investment income: Income from portfolio securities .............................. $ 1,225,265 $ 1,196,829 Interest from temporary cash investments ...................... 44,291 10,020 Interest on notes receivable from officers .................... 26,079 -- ------------ ------------ Total investment income .................................. 1,295,635 1,206,849 ------------ ------------ Expenses: Management fees ............................................... 452,606 558,926 Director fees and expenses .................................... 58,164 70,617 Professional fees ............................................. 28,245 43,751 Administrative fees ........................................... 12,500 12,500 Mailing, printing and other expenses .......................... 41,605 18,078 Interest expense .............................................. 557,193 338,787 Franchise taxes ............................................... 7,840 8,880 ------------ ------------ Total expenses ........................................... 1,158,153 1,051,539 ------------ ------------ Net investment income .............................................. 137,482 155,310 ------------ ------------ Realized gain on sales of portfolio securities, net ................ 3,397,734 11,523,178 ------------ ------------ Unrealized appreciation (depreciation) of portfolio securities, net: End of period ................................................. (14,168,303) 9,878,277 Beginning of period ........................................... (2,873,741) 25,173,816 ------------ ------------ Unrealized depreciation during the period ..................... (11,294,562) (15,295,539) ------------ ------------ Total decrease in net assets from operations .................. $ (7,759,346) $ (3,617,051) ============ ============
The accompanying notes are an integral part of these financial statements 2 EQUUS II INCORPORATED STATEMENTS OF OPERATIONS FOR THE NINE MONTHS ENDED SEPTEMBER 30, 2000 AND 1999 (Unaudited)
2000 1999 ------------ ------------ Investment income: Income from portfolio securities .............................. $ 3,714,325 $ 3,657,716 Interest from temporary cash investments ...................... 98,888 46,386 Interest on notes receivable from officers .................... 75,238 -- Other income .................................................. 244,231 -- ------------ ------------ Total investment income .................................. 4,132,682 3,704,102 ------------ ------------ Expenses: Management fees ............................................... 1,456,650 1,672,319 Director fees and expenses .................................... 176,815 208,792 Professional fees ............................................. 68,405 163,427 Administrative fees ........................................... 37,500 37,500 Mailing, printing and other expenses .......................... 70,868 55,744 Interest expense .............................................. 1,351,162 1,826,036 Franchise taxes ............................................... 121,465 82,569 ------------ ------------ Total expenses ........................................... 3,282,865 4,046,387 ------------ ------------ Net investment income (loss) ....................................... 849,817 (342,285) ------------ ------------ Realized gain on sales of portfolio securities, net ................ 4,744,369 30,405,864 ------------ ------------ Unrealized appreciation (depreciation) of portfolio securities, net: End of period ................................................. (14,168,303) 9,878,277 Beginning of period ........................................... (1,100,588) 44,311,697 ------------ ------------ Unrealized depreciation during the period ..................... (13,067,715) (34,433,420) ------------ ------------ Total decrease in net assets from operations .................. $ (7,473,529) $ (4,369,841) ============ ============
The accompanying notes are an integral part of these financial statements 3 EQUUS II INCORPORATED STATEMENTS OF CHANGES IN NET ASSETS FOR THE NINE MONTHS ENDED SEPTEMBER 30, 2000 AND 1999 (Unaudited)
2000 1999 ------------- ------------- Operations: Net investment income (loss) .................... $ 849,817 $ (342,285) Realized gain on sales of portfolio securities, net .............................. 4,744,369 30,405,864 Unrealized depreciation of portfolio securities during period .................... (13,067,715) (34,433,420) ------------- ------------- Decrease in net assets from operations ............... (7,473,529) (4,369,841) ------------- ------------- Capital Transactions: Shares issued through exercise of stock options . -- 11,124,086 Notes receivable from sale of 654,358 shares of of common stock ................................. -- (11,124,086) Interest on non-recourse portion of officer notes 335,915 -- Repurchase shares of common stock ............... (3,759,988) -- ------------- ------------- Decrease in net assets from capital transactions ..... (3,424,073) -- ------------- ------------- Decrease in net assets ............................... (10,897,602) (4,369,841) Net assets at beginning of period .................... 101,418,820 116,155,028 ------------- ------------- Net assets at end of period .......................... $ 90,521,218 $ 111,785,187 ============= =============
The accompanying notes are an integral part of these financial statements 4 EQUUS II INCORPORATED STATEMENTS OF CASH FLOWS FOR THE NINE MONTHS ENDED SEPTEMBER 30, 2000 AND 1999 (Unaudited)
2000 1999 ------------- ------------- Cash flows from operating activities: Interest and dividends received ................... $ 2,031,259 $ 1,320,959 Cash paid to management company, directors, bank and suppliers ............................. (3,548,790) (4,101,095) ------------- ------------- Net cash used by operating activities .......... (1,517,531) (2,780,136) ------------- ------------- Cash flows from investing activities: Purchase of portfolio securities .................. (9,952,562) (18,521,639) Proceeds from sales of portfolio securities ....... 6,753,517 44,249,052 Principal payments from portfolio companies ....... 5,355,763 4,272,725 Advance to portfolio company ...................... -- (24,483) Repayment from portfolio company .................. 50,263 250,000 ------------- ------------- Net cash provided by investing activities ...... 2,206,981 30,225,655 ------------- ------------- Cash flows from financing activities: Advances from bank ................................ 230,000,000 156,850,000 Repayments to bank ................................ (223,600,000) (209,500,000) Repurchase of common stock ........................ (3,847,094) -- Payments received on officer notes ................ 991,161 -- Dividend payments ................................. (6,023) -- ------------- ------------- Net cash provided (used) by financing activities 3,538,044 (52,650,000) ------------- ------------- Net increase (decrease) in cash and cash equivalents ... 4,227,494 (25,204,481) Cash and cash equivalents at beginning of period ....... 55,819,682 60,253,990 ------------- ------------- Cash and cash equivalents at end of period ............. $ 60,047,176 $ 35,049,509 ============= =============
The accompanying notes are an integral part of these financial statements 5 EQUUS II INCORPORATED STATEMENTS OF CASH FLOWS FOR THE NINE MONTHS ENDED SEPTEMBER 30, 2000 AND 1999 (Unaudited) (Continued)
2000 1999 ------------ ------------ Reconciliation of decrease in net assets from operations to net cash used by operating activities: Decrease in net assets from operations ......................................... $ (7,473,529) $ (4,369,841) Adjustments to reconcile decrease in net assets from operations to net cash used by operating activities: Realized gain on sale of portfolio securities, net ........................ (4,744,369) (30,405,864) Unrealized depreciation of portfolio securities during period .............................................. 13,067,715 34,433,420 Accrued interest and dividends exchanged for portfolio securities .................................................. (1,067,861) (1,134,232) Increase in accrued interest receivable ................................... (1,033,562) (1,248,911) Amortization of commitment fee ............................................ -- 28,125 Decrease in accounts payable .............................................. (211,437) (60,984) Decrease in amount due to management company .............................. (54,488) (21,849) ------------ ------------ Net cash used by operating activities .......................................... $ (1,517,531) $ (2,780,136) ============ ============
The accompanying notes are an integral part of these financial statements 6 EQUUS II INCORPORATED SUPPLEMENTAL INFORMATION - SELECTED PER SHARE DATA AND RATIOS FOR THE NINE MONTHS ENDED SEPTEMBER 30, 2000 AND 1999 (Unaudited)
2000 1999 -------- -------- Investment income ........................................... $ 0.70 $ 0.75 Expenses .................................................... 0.56 0.82 -------- -------- Net investment income (loss) ................................ 0.14 (0.07) Realized gain on sale of portfolio securities, net .......... 0.80 6.13 Unrealized depreciation of portfolio securities during period (2.20) (6.95) -------- -------- Decrease in net assets from operations ...................... (1.26) (0.89) -------- -------- Capital Transactions: Effect of common stock repurchase ........................... 0.34 -- Interest on non-recourse portion of officer notes ........... 0.06 -- -------- -------- Increase in net assets from capital transactions ............ 0.40 -- -------- -------- Net decrease in net assets .................................. (0.86) (0.89) Net assets at beginning of period ........................... 16.61 23.45 -------- -------- Net assets at end of period ................................. $ 15.75 $ 22.56 ======== ======== Ratio of expenses before interest to average net assets ..... 2.01% 1.95% Ratio of expenses to average net assets ..................... 3.42% 3.55% Ratio of net investment income (loss) to average net assets . 0.89% (0.30)% Ratio of decrease in net assets from operations to average net assets .................................. (7.79)% (3.83)%
The accompanying notes are an integral part of these financial statements 7 EQUUS II INCORPORATED SCHEDULE OF PORTFOLIO SECURITIES SEPTEMBER 30, 2000 (Unaudited)
DATE OF PORTFOLIO COMPANY INITIAL INVESTMENT COST FAIR VALUE ----------------- ------------------ --------- ---------- A. C. Liquidating Corporation February 1985 -10% secured promissory notes $ 188,014 $ -- Allied Waste Industries, Inc. (NYSE - AW) March 1989 -900,000 shares of common stock 3,121,565 8,020,688 The Bradshaw Group May 2000 -1,335,000 shares of preferred stock 1,335,000 1,335,000 -Warrant to purchase 2,229,450 shares of common stock at $.01 through May 2008 1 1 Champion Window, Inc. March 1999 -1,400,000 shares of common stock 1,400,000 5,250,000 -20,000 shares of preferred stock 2,000,000 2,247,500 -12% subordinated promissory note 3,500,000 3,500,000 Container Acquisition, Inc. February 1997 -1,370,000 shares of common stock 1,370,000 2,870,000 -64,283 shares of preferred stock 6,428,300 6,428,300 -Conditional warrant to buy up to 370,588 shares of common stock at $0.01 per share through June 2003 1,000 1,000 The Drilltec Corporation August 1998 -140,000 shares of common stock 1,400,000 - -6,476 shares of preferred stock 6,245,000 - -Prime +9.75% promissory note 1,000,000 1,000,000 -Warrant to buy 10% of the common equity for $100 through September 2002 - - - - Drypers Corporation (OTCBB - DYPR) July 1991 -3,677,906 shares of common stock 9,328,556 805,577 Equicom, Inc. July 1997 -452,000 shares of common stock 141,250 - -657,611 shares of preferred stock 6,576,110 2,000,000 -10% promissory note 2,505,750 2,505,750 Equipment Support Services, Inc. December 1999 -35,000 shares of common stock 101,500 101,500 -35,000 shares of preferred stock 1,929,000 1,929,000 -8% promissory note 1,138,000 1,138,000
The accompanying notes are an integral part of these financial statements 8 EQUUS II INCORPORATED SCHEDULE OF PORTFOLIO SECURITIES SEPTEMBER 30, 2000 (UNAUDITED)
DATE OF PORTFOLIO COMPANY INITIAL INVESTMENT COST FAIR VALUE ----------------- ------------------ ----------- ---------- FS Strategies, Inc. June 2000 -110,000 shares of common stock $ 5,500,000 $ 5,500,000 GCS RE, Inc. February 1989 -1,000 shares of common stock 132,910 600,000 Hot & Cool Holdings, Inc. March 1996 -9% subordinated note 1,075,000 - -10% subordinated notes 2,200,000 - -12% promissory notes 2,500,000 - -19,665 shares of Series A 8% preferred stock 786,631 - -6,000 shares of Series B 8% preferred stock 300,000 - -Warrants to buy up to 14,942 shares of common stock at $0.01 per share through March 2006 - - -Warrants to buy up to 16,316 shares of common stock at $26.00 per share through April 2007 - - -Warrant to buy 10,000 shares of common stock at $0.01 through February 28, 2003 - - LG&E Energy Corp. (NYSE - LGE) July 1999 -17,739 shares of common stock 922,676 420,492 -Earnout on sale of CRC Holding Corp. 1,192,114 - NCI Building Systems, Inc. (NYSE - NCS) April 1989 -200,000 shares of common stock 159,784 2,925,000 Paracelsus Healthcare Corporation December 1990 (OTCBB - PLHC) -2,018,213 shares of common stock 5,278,748 59,620
The accompanying notes are an integral part of these financial statements 9 EQUUS II INCORPORATED SCHEDULE OF PORTFOLIO SECURITIES SEPTEMBER 30, 2000 (UNAUDITED)
DATE OF PORTFOLIO COMPANY INITIAL INVESTMENT COST FAIR VALUE ----------------- ------------------ ----------- ------------- Petrocon Engineering, Inc. September 1998 -12% promissory note $ 4,663,356 $ 4,663,356 -887,338 shares of common stock 635 635 -8% Series B junior subordinated promissory note 2,659,332 2,659,332 -Warrant to buy up to 1,552,571 shares of common stock at $0.01 per share through March 2009 - - Raytel Medical Corporation August 1997 (NASDAQ - RTEL) -33,073 shares of common stock 330,730 41,341 The ServiceMaster Company May 1999 (NYSE-SVM) -Warrant to buy up to 29,411 shares of common stock at $51 per share through September 2001 - - Sovereign Business Forms, Inc. August 1996 -15,659 shares of preferred stock 1,565,900 1,565,900 -15% promissory notes 2,717,461 2,717,461 -Warrant to buy 551,894 shares of of common stock at $1 per share through August 2006 - 1,062,891 -Warrant to buy 25,070 shares of common stock at $1.25 per share through October 2007 - 42,015 -Warrant to buy 273,450 shares of common stock at $1 per share through October 2009 - 526,637 Spectrum Management, LLC December 1999 -285,000 Units of Class A equity interest 2,850,000 2,850,000 Stephen L. LaFrance Holdings, Inc. September 1997 -2,498,452 shares of preferred stock 2,498,452 2,498,452 -Warrant to buy 269 shares of common stock for $0.01 per share through September 2007 - 6,000,000
The accompanying notes are an integral part of these financial statements 10 EQUUS II INCORPORATED SCHEDULE OF PORTFOLIO SECURITIES SEPTEMBER 30, 2000 (Unaudited)
DATE OF PORTFOLIO COMPANY INITIAL INVESTMENT COST FAIR VALUE ----------------- ------------------ ----- ---------- Sternhill Partners I, LP March 2000 -3% limited partnership interest $ 600,000 $ 700,000 Strategic Holdings, Inc. September 1995 -3,089,751 shares of common stock 3,088,389 844,791 -3,822,157 shares of Series B 3,820,624 3,820,624 preferred stock -15% promissory note 6,750,000 6,750,000 -Warrants to buy 225,000 shares of common stock at $0.4643 per share through August 2005 - - -Warrant to buy 100,000 shares of common stock at $1.50 per share through August 2005 - - -Warrant to buy 2,219,237 shares of common stock at $0.01 per share through November 2005 - 584,585 -1,000 shares of SMIP, Inc. common stock 150,000 150,000 -15% promissory note of SMIP, Inc. 175,000 175,000 Summit/DPC Partners, L.P. October 1995 -36.11% limited partnership interest 3,326,565 10,000,000 Travis International, Inc. December 1986 -98,761 shares of common stock 5,398 1,000,000 Tulsa Industries, Inc. December 1997 -27,500 shares of common stock 33,846 - -181,589 shares of Series A preferred stock 5,466,154 - -1,058 shares of Series B preferred stock 1,058,000 1,058,000 -Junior participation in promissory note 655,769 655,769 Turfgrass America, Inc. May 1999 -3,167,756 shares of common stock 600,000 600,000 -12% subordinated promissory note 3,565,000 3,565,000
The accompanying notes are an integral part of these financial statements 11 EQUUS II INCORPORATED SCHEDULE OF PORTFOLIO SECURITIES SEPTEMBER 30, 2000 (Unaudited)
DATE OF PORTFOLIO COMPANy INITIAL INVESTMENT COST FAIR VALUE ---------------- -------------------- ----- ----------- United Industrial Services, Inc. July 1998 -35,000 shares of preferred stock $ 3,500,000 $ 2,500,000 -Warrants to buy 63,637 shares of common stock at $0.01 through June 2008 100 100 Vanguard VII, L.P. June 2000 -1.3% limited partnership interest 300,000 300,000 ------------- ------------ Total $ 120,137,620 $105,969,317 ============= ============
The accompanying notes are an integral part of these financial statements 12 EQUUS II INCORPORATED SCHEDULE OF PORTFOLIO SECURITIES SEPTEMBER 30, 2000 (Continued) Substantially all of the Fund's portfolio securities are restricted from public sale without prior registration under the Securities Act of 1933. The Fund negotiates certain aspects of the method and timing of the disposition of the Fund's investment in each portfolio company, including registration rights and related costs. In connection with the investments in Allied Waste Industries, Inc., Champion Window, Inc., Container Acquisition, Inc., The Drilltec Corporation, Drypers Corporation, FS Strategies, Inc., Hot & Cool Holdings, Inc., Sovereign Business Forms, Inc., Strategic Holdings, Inc., Turfgrass America, Inc. and United Industrial Services, Inc. rights have been obtained to demand the registration of such securities under the Securities Act of 1933, providing certain conditions are met. The Fund does not expect to incur significant costs, including costs of any such registration, in connection with the future disposition of its portfolio securities. As defined in the Investment Company Act of 1940, at September 30, 2000, the Fund was considered to have a controlling interest in The Bradshaw Group, Champion Window, Inc., Container Acquisition, Inc., The Drilltec Corporation, Drypers Corporation, Equicom, Inc., FS Strategies, Inc., Sovereign Business Forms, Inc., Spectrum Management LLC, Strategic Holdings, Inc., Tulsa Industries, Inc. and United Industrial Services, Inc. The fair values of the Fund's investments in publicly traded securities include discounts from the closing market prices to reflect the estimated effects of restrictions on the sale of such securities at September 30, 2000. Such discounts, shown in the following table, total $495,963 or $0.08 per share as of September 30, 2000. DISCOUNT FROM MARKET VALUE ------------- Allied Waste Industries, Inc. ................................. $ 248,063 Drypers Corporation ........................................... 227,914 LG&E Energy Corporation ....................................... 13,005 Paracelsus Healthcare Corporation ............................. 6,981 ------------- Total discount .......................................... $ 495,963 ============= Income was earned in the amount of $2,444,997 and $3,216,189 for the nine months ended September 30, 2000 and 1999, respectively, on portfolio securities of companies in which the Fund has a controlling interest. As defined in the Investment Company Act of 1940, all of the Fund's investments are in eligible portfolio companies. The Fund provides significant managerial assistance to all of the portfolio companies in which it has invested, except Equipment Support Services, Inc., LG&E Energy Corp., Raytel Medical Corporation, Sternhill Partners I, L.P., Summit/DPC Partners, L.P. and Vanguard VII, L.P. The Fund provides significant managerial assistance to portfolio companies that comprise 86% of the total value of the investments in portfolio companies at September 30, 2000. The accompanying notes are an integral part of these financial statements 13 EQUUS II INCORPORATED NOTES TO FINANCIAL STATEMENTS SEPTEMBER 30, 2000, AND 1999 (1) ORGANIZATION AND BUSINESS PURPOSE Equus II Incorporated (the "Fund"), a Delaware corporation with perpetual existence, was formed by Equus Investments II, L.P. (the "Partnership") on August 16, 1991. On July 1, 1992, the Partnership was reorganized and all of the assets and liabilities of the Partnership were transferred to the Fund in exchange for shares of common stock of the Fund. The shares of the Fund trade on the New York Stock Exchange under the symbol EQS. The Fund seeks to achieve capital appreciation by making investments in equity and equity-oriented securities issued by privately-owned companies in transactions negotiated directly with such companies. The Fund seeks to invest primarily in companies which intend to acquire other businesses, including leveraged buyouts. The Fund may also invest in recapitalizations of existing businesses or special situations from time to time. The Fund's investments in Portfolio Companies consist principally of equity securities such as common and preferred stock, but also include other equity-oriented securities such as debt convertible into common or preferred stock or debt combined with warrants, options or other rights to acquire common or preferred stock. Current income is not a significant factor in the selection of investments. The Fund elected to be treated as a business development company under the Investment Company Act of 1940, as amended. (2) MANAGEMENT The Fund has entered into a management agreement with Equus Capital Management Corporation, a Delaware corporation (the "Management Company"). Pursuant to such agreement, the Management Company performs certain services, including certain management and administrative services necessary for the operation of the Fund. The Management Company receives a management fee at an annual rate of 2% of the net assets of the Fund, paid quarterly in arrears. The Management Company also receives compensation for providing certain investor communication services, of which $37,500 is included in the accompanying Statements of Operations for each of the nine months ended September 30, 2000 and 1999. The Management Company is controlled by a privately-owned corporation. As compensation for services rendered to the Fund, each director who is not an officer of the Fund receives an annual fee of $25,000 paid quarterly in arrears, a fee of $3,000 for each meeting of the Board of Directors attended in person, a fee of $1,500 for participation in each telephonic meeting of the Board of Directors and for each committee meeting attended ($500 for each committee meeting if attended on the same day as a Board Meeting), and reimbursement of all out-of-pocket expenses relating to attendance at such meetings. In addition, each director who is not an officer of the Fund is granted incentive stock options to purchase shares of the Fund's stock from time to time. (See Note 10). Certain officers and directors of the Fund serve as directors of Portfolio Companies, and may receive and retain fees, including non-employee director stock options, from such Portfolio Companies in consideration for such service. 14 (3) SIGNIFICANT ACCOUNTING POLICIES Valuation of Investments - Portfolio investments are carried at fair value with the net change in unrealized appreciation or depreciation included in the determination of net assets. Investments in companies whose securities are publicly traded are valued at their quoted market price, less a discount to reflect the estimated effects of restrictions on the sale of such securities ("Valuation Discount"), if applicable. Cost is used to approximate fair value of other investments until significant developments affecting an investment provide a basis for use of an appraisal valuation. Thereafter, portfolio investments are carried at appraised values as determined quarterly by the Management Company, subject to the approval of the Board of Directors. Appraisal valuations are based upon such factors as the Portfolio Company's earnings, cash flow and net worth, the market prices for similar securities of comparable companies and an assessment of the company's future financial prospects. In the case of unsuccessful operations, the appraisal may be based upon liquidation value. Appraisal valuations are necessarily subjective. The fair market values of debt securities, which are generally held to maturity, are determined on the basis of the terms of the debt securities and the financial conditions of the issuer. Because of the inherent uncertainty of the valuation of portfolio securities which do not have readily ascertainable market values, amounting to $103,002,976 (including $9,306,377 in publicly-traded securities, net of a $495,963 Valuation Discount) and $111,571,919 (including $17,228,705 in publicly-traded securities, net of a $2,554,017 Valuation Discount) at September 30, 2000 and December 31, 1999, respectively, the Fund's estimate of fair value may significantly differ from the fair value that would have been used had a ready market existed for the securities. Appraised values do not reflect brokers' fees or other normal selling costs or management incentive fees which might become payable on disposition of such investments. On a daily basis, the Fund adjusts its net asset value for the changes in the value of its publicly held securities and material changes in the value of its private securities and reports those amounts to Lipper Analytical Services, Inc. Weekly and daily net asset values appear in various publications, including BARRON'S and THE WALL STREET JOURNAL and on the Fund's website at www.equuscap.com. Investment Transactions - Investment transactions are recorded on the accrual method. Realized gains and losses on investments sold are computed on a specific identification basis. Cash Flows - For purposes of the Statements of Cash Flows, the Fund considers all highly liquid temporary cash investments purchased with an original maturity of three months or less to be cash equivalents. Income Taxes - No provision for federal income taxes has been made in the accompanying financial statements as the Fund has qualified for pass-through treatment as a "regulated investment company" under Subchapter M of the Internal Revenue Code of 1986. As such, all net income is allocable to the stockholders for inclusion in their respective tax returns. Net capital losses are not allocable to the shareholders but can be carried over to offset future earnings of the Fund. (4) BOOK TO TAX RECONCILIATION The Fund accounts for dividends in accordance with Statement of Position 93-2 which relates to the amounts distributed by the Fund as net investment income or net capital gains, which are often not equal to the corresponding income or gains shown in the Fund's financial statements. The Internal Revenue Service approved the Fund's request, effective October 31, 1998, to change its year-end for determining capital gains for federal income tax purposes from December 31 to October 31, which allows current year dividends to be paid prior to the end of the calendar year. The Fund had undistributed capital gains (losses) of $9,946,780 and $(6,558,635) for the period from November 1, 1999 to December 31, 15 1999 and November 1, 1998 to December 31, 1998, respectively. The Fund realized net capital gains of $4,744,369 and $30,405,864 for the nine months ended September 30, 2000 and 1999, respectively. Therefore, for tax purposes, the Fund had net capital gains of $14,691,149 and $23,847,229 for the eleven months ended September 30, 2000 and 1999 respectively. The Fund had net investment income for tax purposes of $557,298 for the nine months ended September 30, 2000. In addition, the Fund had $21,751 of capital gains and $108,174 of net investment income from 1999 that was declared as a dividend in August 2000 for distribution in December 2000. The following is a reconciliation of the difference in the Fund's net realized gain or loss on the sale of portfolio securities for book and tax purposes. (See Note 12 for losses realized subsequent to September 30, 2000.) 2000 1999 ------------ ------------ Net realized gain on the sales of portfolio securities, book ............. $ 4,744,369 $ 30,405,864 Undistributed 1999 net capital gains ........ 9,946,780 -- Undistributed 1998 net capital losses ....... -- (6,558,635) ------------ ------------ Net realized gain on the sales of portfolio securities, tax .............. $ 14,691,149 $ 23,847,229 ============ ============ (5) DIVIDENDS The Fund declared undistributed capital gains of $21,751 from 1999 and undistributed net investment income of $108,174 from 1999 as a dividend in August 2000 to be distributed in December 2000. The Fund declared no dividends during the nine months ended September 30, 1999. The Fund has adopted a policy to make dividend distributions of at least $0.60 per share on an annual basis. In the event that taxable income, including realized capital gains, exceeds $0.60 per share in any year, additional dividends may be declared to distribute such excess. See Note 12. (6) TEMPORARY CASH INVESTMENTS Temporary cash investments, which represent the short-term utilization of cash prior to investment in securities of portfolio companies, distributions to the shareholders or payment of expenses and notes payable, consist of $60,041,662 in money market accounts with Bank of America, N.A. earning interest at a range of 4.82% to 5.00 % per annum at September 30, 2000. (7) ACCOUNTS RECEIVABLE At December 31, 1999, the accounts receivable balance was $1,050,606, and primarily consisted of $991,161 in principal due on the notes receivable from officers that were issued to the Fund upon exercise of their stock options. The $991,161 was received in January 2000. In addition, $38,818 was included in receivables due from two portfolio companies as reimbursement for expenses related to such investments. The $38,818 of receivables was reimbursed to the Fund by September 2000. 16 (8) PORTFOLIO SECURITIES During the nine months ended September 30, 2000, the Fund invested $7,435,001 in four new companies and made follow-on investments of $3,585,422 in eight companies, including $1,067,861 in accrued interest and dividends received in the form of additional portfolio securities and accretion of original issue discount on a promissory note. In addition, the Fund realized a net capital gain of $4,744,369 during the nine months ended September 30, 2000. During the nine months ended September 30, 1999, the Fund invested $14,619,898 in four new companies and made follow-on investments of $7,280,660 in eleven portfolio companies, including $1,134,232 in accrued interest and dividends received in the form of additional portfolio securities and accretion of original issue discount on a promissory note. In addition, the Fund realized a net capital gain of $30,405,864 during the nine months ended September 30, 1999. (9) NOTES PAYABLE TO BANK The Fund has a $100,000,000 line of credit promissory note with Bank of America N.A., with interest payable at 1/2% over the rate earned in its money market account. The Fund had $60,000,000 and $50,000,000 outstanding on such note at September 30, 2000 and December 31, 1999, respectively that was secured by $60,000,000 and $50,000,000 of the Fund's temporary cash investments. The line of credit promissory note expires July 1, 2001. The Fund has a $40,000,000 revolving line of credit with Bank of America, N.A. that expired on July 1, 2000. The Fund had $18,800,000 and $22,400,000 outstanding under such line of credit at September 30, 2000 and December 31, 1999, respectively, which is secured by the Fund's investments in portfolio securities. The interest rate ranges from prime -1/2% to prime +1/4% or LIBOR + 1.65%. The Fund also pays interest at the rate of 1/4% per annum on the unused portion of the line of credit. On July 1, 2000, the revolving line of credit was reduced to $32,500,000 and the maturity date was extended to July 1, 2001. The average daily balances outstanding on the Fund's notes payable during the nine months ended September 30, 2000 and 1999, were $20,399,903 and $30,246,154, respectively. (10) STOCK OPTION PLAN Shareholders have approved the Equus II Incorporated 1997 Stock Incentive Plan ("Stock Incentive Plan"), which authorizes the Fund to issue options to the directors and officers of the Fund in an aggregate amount of up to 20% of the outstanding shares of common stock of the Fund. The Stock Incentive Plan also provides that each director who is not an officer of the Fund is, on the first business day following each annual meeting, granted an incentive stock option ("Director Options") to purchase 2,000 shares of the Fund's common stock. On May 10, 2000, options to acquire an aggregate total of 12,000 shares for $9.94 per share were issued to the directors. Under the Stock Incentive Plan, options to purchase 306,773 and 296,773 shares of the Fund's common stock with a weighted average exercise price of $18.71 and $17.66 per share were outstanding at September 30, 2000 and 1999, respectively. Outstanding options at September 30, 2000 have exercise prices ranging from $9.94 to $27.44 and expire in May 2007 through May 2010. No options were exercised during the nine months ended September 30, 2000. On September 30, 1999, options to purchase 654,358 shares of common stock of the Fund were exercised by the officers of the Fund for $17 per share. The exercise price of $11,124,086 was paid in the form of promissory notes from the officers 17 to the Fund. The notes bear interest at 5.42% per annum, have limited recourse and are due on or before September 30, 2008. The notes are secured by the 654,358 shares, including any proceeds or dividends paid thereon. During 1999, a dividend of $4.25 per share was paid by the Fund. As a result of this dividend, 135,608 additional shares were issued to the officers and pledged to the Fund. In addition, principal payments of $991,161, representing 58,304 shares, were made on the notes. As a result of the additional shares issued and payments made, the notes are secured by 789,966 shares of common stock and the outstanding note balance is $10,132,925 at September 30, 2000. The notes receivable, as well as 731,662 of such shares of pledged common stock, are not included in the Fund's net asset value per share. The shares of stock financed by the notes from the officers will be included in the net asset value per share as the shares are paid for or released from collateral. Shares may be released as payments on the notes are made or as the value of the collateral increases. Generally accepted accounting principles require that the options issued to the officers be accounted for using variable plan accounting due to the limited recourse provision of such notes. Additionally, the dividends paid on the non-recourse portion of the notes are required to be recorded as compensation expense in the statements of operations, and interest recorded on the non-recourse portion of the notes is required to be recorded as an increase to additional paid-in capital. Accordingly, for the nine months ended September 30, 2000, interest of $335,915 was credited to additional paid-in capital. Additionally, the limited recourse notes receivable from the officers are required to be recorded as a reduction of net assets. As of September 30, 2000 and December 31, 1999, the accrued interest on the notes receivable from the officers was $491,260 and $153,622, respectively. If the notes and the shares were included in the Fund's balance sheet, the net asset value would have been $17.51 per share at September 30, 2000. As of September 30, 2000 and 1999, all outstanding options, except the 12,000 Director Options issued in 2000, were "out of the money" and would not have had a dilutive effect on net assets per share if exercised, assuming the Fund would use the proceeds from the exercise of such options to purchase shares at the market price pursuant to the treasury stock method. (11) COMMITMENTS AND CONTINGENCIES The Fund has made a commitment to invest, under certain circumstances, up to an additional $150,000 in Equicom, Inc., $500,000 in Sovereign Business Forms, Inc.,$2,400,000 in Sternhill Partners I, L.P., $750,000 in Tulsa Industries, Inc. and $2,700,000 in Vanguard VII, L.P. The Fund and certain of the portfolio companies are involved in asserted claims and have the possibility for unasserted claims which may ultimately affect the fair value of the Fund's portfolio investments. In the opinion of management, the financial position or operating results of the Fund will not be materially affected by these claims. During 2000, the Fund completed the 300,000 share purchase program announced in 1999 with the repurchase of 191,127 shares for $1,976,152. On May 11, 2000 the Fund announced it would purchase up to an additional 400,000 shares of common stock in open market transactions over the next six months, subject to market conditions and limitations. As of September 30, 2000, the Fund had repurchased 167,700 shares of the 400,000 shares for $1,783,861, $28,827 of which is included in accounts payable at September 30, 2000. The 167,700 shares were repurchased at an average discount of 36.8% from net asset value. (12) SUBSEQUENT EVENTS Subsequent to September 30, 2000, the Fund repaid a net $62,550,000 of notes payable to the bank. 18 Subsequent to September 30, 2000, the Fund repurchased an additional 65,700 shares of common stock for $673,865. On October 10, 2000, Drypers Corporation ("DYPR") filed a voluntary petition for reorganization pursuant to Chapter 11 of the U.S. Bankruptcy Code due to increased pressure on cash flows, a termination of its license agreement with Procter & Gamble, and other matters. Subsequent to September 30, 2000, the Fund sold 1,703,200 shares of DYPR common stock for $83,002, realizing a capital loss of $7,270,848. As of September 15, 2000, Paracelsus Healthcare Corporation ("PLS") filed a voluntary petition for reorganization pursuant to Chapter 11 of the U.S. Bankruptcy Code. On October 27, 2000, the Fund sold 173,868 shares of common stock for $4,460, realizing a capital loss of $974,839. In addition to the DYPR and PLS capital losses, the Fund realized the following capital losses subsequent to September 30, 2000 for the tax year ended October 31, 2000: o sale of 17,739 common shares of LG&E Energy Corporation for $434,808, realizing a capital loss of $487,868; o sale of Hot & Cool Holdings, Inc. preferred shares for $1, realizing a capital loss of $1,086,631; and o the write-off of 140,000 shares of common stock and 6,476 shares of preferred stock of The Drilltec Corporation, realizing a capital loss of $7,645,000. In November 2000, the Fund declared a dividend of $0.60 per share, the majority of which will be a return of capital. The dividend will be paid to the shareholders of record on November 20, 2000. Shareholders may elect to receive the dividend in cash, or it may be paid by the issuance of additional shares of common stock. Payment of the dividend will occur on or before December 29, 2000. 19 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. LIQUIDITY AND CAPITAL RESOURCES At September 30, 2000, the Fund had $105,969,317 of its assets invested in portfolio securities of 29 companies, and has committed to invest up to an additional $6,500,000 in five of such companies. Current temporary cash investments, anticipated future investment income, proceeds from borrowings, and proceeds from the sale of existing portfolio securities are believed to be sufficient to finance these commitments. At September 30, 2000, the Fund had $18,800,000 outstanding on a $32,500,000 revolving line of credit loan from a bank. Net cash used by operating activities was $1,517,531 and $2,780,136 for the nine months ended September 30, 2000 and 1999, respectively. At September 30, 2000, the Fund had $60,041,662 of its total assets of $170,165,759 invested in temporary cash investments consisting of money market securities. This amount includes proceeds of $60,000,000 from a $100,000,000 note payable to a bank that is utilized to enable the Fund to achieve adequate diversification to maintain its pass-through tax status as a regulated investment company. Such amount was repaid to the bank on October 2, 2000. The Fund has the ability to borrow funds and issue forms of senior securities representing indebtedness or stock, such as preferred stock, subject to certain restrictions. Net investment income and net realized gains from the sales of portfolio investments are intended to be distributed at least annually, to the extent such amounts are not reserved for payment of contingencies or to make follow-on or new investments. Management believes that the availability under its line of credit, as well as the ability to sell its investments in publicly traded securities, are adequate to provide payment for any expenses and contingencies of the Fund. The Fund reserves the right to retain net long-term capital gains in excess of net short-term capital losses for reinvestment or to pay contingencies and expenses. Such retained amounts, if any, will be taxable to the Fund as long-term capital gains and stockholders will be able to claim their proportionate share of the federal income taxes paid by the Fund on such gains as a credit against their own federal income tax liabilities. Stockholders will also be entitled to increase the adjusted tax basis of their Fund shares by the difference between their undistributed capital gains and their tax credit. The Fund may repurchase its shares, subject to the restrictions of the Investment Company Act. On May 11, 2000, the Board of Directors approved a program to purchase up to 400,000 shares of the Fund's common stock, pursuant to which the Fund repurchased 167,700 shares for $1,783,861 through September 30, 2000. Such stock was repurchased at an average discount of 36.8% from net asset value. RESULTS OF OPERATIONS INVESTMENT INCOME AND EXPENSE Net investment income (loss) after all expenses amounted to $849,817 and $(342,285) for the nine months ended September 30, 2000 and 1999, respectively. The increase in net investment income in 2000 is due to a decrease in interest expense, professional fees and other expenses and an increase in other income. Interest expense decreased to $1,351,162 in 2000 from $1,826,036 in 1999 due to a decrease in the average daily balances outstanding on the lines of credit to $20,399,903 during the nine months ended September 30, 2000 from $29,513,553 during the comparable period in 1999. In the 20 second quarter of 2000, the Fund received a refund of legal fees that had been previously paid in conjunction with the lawsuit related to Champion Healthcare Corporation and Paracelsus Healthcare Corporation. The other income recorded in 2000 is a fee received in conjunction with the Fund's investment in FS Strategies, Inc. 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 $1,456,650 and $1,672,319 during the nine months ended September 30, 2000 and 1999, respectively. The decrease in management fees during the nine months ended September 30, 2000 was due to the decrease in net assets. Shareholders have approved the Equus II Incorporated 1997 Stock Incentive Plan ("Stock Incentive Plan") which authorizes the Fund to issue options to the directors and officers of the Fund in an aggregate amount of up to 20% of the outstanding shares of common stock of the Fund The Stock Incentive Plan also provides that each director who is not an officer of the Fund is, on the first business day following each annual meeting, granted an incentive stock option ("Director Options") to purchase 2,000 shares of the Fund's common stock. Under the Stock Incentive Plan, options to purchase 306,773 and 296,773 shares of the Fund's common stock with a weighted average exercise price of $18.71 and $17.66 per share were outstanding at September 30, 2000 and 1999, respectively. Outstanding options at September 30, 2000 have exercise prices ranging from $9.94 to $27.44 and expire in May 2007 through May 2010. On September 30, 1999, options to purchase 654,358 shares of common stock of the Fund were exercised by the officers of the Fund for $17 per share. The exercise price of $11,124,086 was paid in the form of promissory notes from the officers to the Fund. The notes bear interest at 5.42% per annum, have limited recourse and are due on or before September 30, 2008. The notes are secured by the 654,358 shares, including any proceeds or dividends paid thereon. During 1999, a dividend of $4.25 per share was paid. As a result of the dividend, 135,608 additional shares were issued to the officers and pledged to the Fund. In addition, principal payments of $991,161, representing 58,304 shares, were made on the notes. As a result of the additional shares issued and payments made, the notes are secured by 789,966 shares of common stock and the outstanding note balance is $10,132,925 at September 30, 2000. The notes receivable, as well as 731,662 of such shares of common stock, are not included in the Fund's net asset value per share. The shares of stock financed by the notes from the officers will be included in the net asset value per share as the shares are paid for or released from collateral. Shares may be released as payments on the notes are made or as the value of the collateral increases. Generally accepted accounting principles require that the options issued to the officers be accounted for using variable plan accounting due to the limited recourse provision of such notes. Additionally, the dividends paid on the non-recourse portion of the notes are required to be recorded as compensation expense in the statements of operations, and interest recorded on the non-recourse portion of the notes is required to be recorded as an increase to additional paid-in capital. Accordingly, for the nine months ended September 30, 2000, interest of $335,915 was credited to additional paid-in capital. Additionally, the limited recourse notes receivable from the officers are required to be recorded as a reduction of net assets. As of September 30, 2000 and December 31, 1999, the accrued interest on the notes receivable from the officers was $491,260 and $153,622, respectively. If the notes and the shares were included in the Fund's balance sheet, the net asset value would have been $17.51 per share at September 30, 2000. As of September 30, 2000 and 1999, all outstanding options, except the 12,000 Director Options issued in 2000, were "out of the money" and would not have had a dilutive effect on net assets per share if exercised, assuming the Fund would use the proceeds from the exercise of such options to repurchase shares at the market price pursuant to the treasury stock method. 21 REALIZED GAINS AND LOSSES ON SALES OF PORTFOLIO SECURITIES During the nine months ended September 30, 2000, the Fund realized net capital gains of $4,744,369 as a result of additional compensation related to the previous sale of three Portfolio Companies. 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 $653,697 as a result of additional compensation from the escrow account related to the 1999 sale of HTD Corporation. The Fund also wrote off a receivable from Restaurant Development Group realizing a capital loss of $8,315. In addition, during the quarter, the Fund received proceeds from Video Rental of Pennsylvania, Inc. in the amount of $3,722,349 for repayment of the outstanding notes payable and $250,000 for redemption of the common and preferred stock and did not realize a capital gain. The Fund also received proceeds from Equus Video Corporation and realized a capital loss of $5,919. In addition, the Fund sold 237,364 shares of LG&E Energy Corp ("LGE") common stock for $5,759,059 realizing a capital gain of $2,399,812. Also, as a result of the earn out related to the sale of CRC Holding, the Fund received cash of $994,458 and 17,739 shares of LGE and realized the $994,458 as a capital gain. During the nine months ended September 30, 1999, the Fund realized net capital gains of $30,405,864 from the sale of securities of seven Portfolio Companies, as follows: o 54,334 shares of United Rentals, Inc. for $1,738,036, realizing a capital gain of $1,737,639; o 134,472 common shares of United States Filter Corporation for $3,884,978 realizing a capital gain of $2,324,700; o 100,000 shares of Allied Waste Industries commons stock for $1,832,122 realizing a capital gain of $1,357,966; o 1,125,000 shares of American Residential Services, Inc. for $6,468,750 realizing a capital gain of $3,468,478; o 149,337 shares of Travis International for $6,668,987, including a $479,849 promissory note, realizing a capital gain of $6,114,095; o its investment in HTD Corporation for $12,877,114, realizing a capital gain of $3,341,546; and o its investment in CRC Holdings, realizing a capital gain of $12,128,572. The Fund sold CRC Holdings to LGE and received $12,128,572 in cash and 121,504 shares of LGE common stock. An additional 115,860 shares of LGE stock are being held in escrow to secure contractual representations and warranties. In addition, LGE has committed to pay up to an additional $11.7 million to the Fund if the CRC business sold to LGE achieves certain levels of financial performances through March 31, 2002. The Fund also realized a capital gain as a result of the receipt of $654,570 in additional compensation from the escrow account related to the 1998 sale of WMW Industries, Inc. In addition, Atlas Acquisition paid $128,298 in principal on its outstanding junior participation note and the Fund realized a loss of $721,702 on the remaining balance of the note. 22 DEPRECIATION OF PORTFOLIO SECURITIES Net unrealized depreciation on investments increased $13,067,715 during the nine months ended September 30, 2000, from $1,100,588 to $14,168,303. Such net increase resulted from increases in the estimated fair value of securities of seven of the Fund's Portfolio Companies aggregating $10,530,498, decreases in the estimated fair value of securities of ten of the Fund's Portfolio Companies aggregating $20,476,333 and the transfer of $3,121,880 in net unrealized appreciation to net realized loss from the sale of securities of two Portfolio Companies. Net unrealized appreciation on investments decreased $34,443,420 during the nine months ended September 30, 1999, from $44,311,697 to $9,878,277. Such net decrease resulted from decreases in the estimated fair value of securities of six of the Fund's Portfolio Companies aggregating $17,156,508, an increase in the estimated fair value of securities of seven Portfolio Companies of $7,105,937, and the transfer of $24,382,849 in net unrealized appreciation to net realized gains from the sale of investments in seven Portfolio Companies and the write-off of one Portfolio Company. DIVIDENDS The Fund declared undistributed capital gain of $21,751 from 1999 and undistributed net investment income of $108,174 from 1999 as a dividend in August 2000 to be distributed in December 2000. The Fund declared no dividends for the nine months ended September 30, 1999. PORTFOLIO INVESTMENTS During the nine months ended September 30, 2000, the Fund invested $7,435,001 in four new companies and made follow-on investments of $3,585,422 in eight portfolio companies, including $1,067,861 in accrued interest and dividends received in the form of additional portfolio securities and accretion of original issue discount on a promissory note. During 2000, the Fund advanced $476,000 to The Drilltec Corporation pursuant to a prime + 9.75% promissory note, $514,996 to Equicom, Inc. pursuant to a 10% promissory note and $500,000 to Hot & Cool Holdings, Inc. pursuant to a 12% promissory note. During the nine months ended September 30, 2000, the Fund received an additional 4,593 and 1,011 shares of preferred stock of Container Acquisition, Inc and Sovereign Business Forms, Inc. ("Sovereign") in payment of $459,300 and $101,100 in dividends, respectively. In addition, Sovereign elected to convert $417,461 of accrued interest into the balance of the 15% promissory notes due to the Fund. On February 28, 2000, the Fund invested an additional $726,565 in Summit/DPC Partners to allow the partnership to purchase additional shares of Doane Pet Care Enterprises, Inc. common stock. On March 15, 2000, the Fund committed to invest up to $3,000,000 in Sternhill Partners I, L.P., a fund formed to invest in private, early-stage, emerging-growth companies involved in information technology and, on limited occasions, life science technologies. $600,000 of such commitment has been funded through September 30, 2000. As of September 30, 2000, the original issue discount accretion on the discounted 12% subordinated promissory note due from Turfgrass America, Inc. ("Turfgrass") amounted to $90,000, bringing the balance of the note to $3,565,000 at September 30, 2000. The original issue discount is being accreted over the life of the note. 23 During the second quarter of 2000, the Fund committed to invest up to $3,000,000 in Vanguard VII, L.P., a fund formed to invest in seed and early stage communications, internet and life sciences technology companies. The Fund's investment consists of a 1.4% limited partnership interest. $300,000 of this commitment has been funded through September 30, 2000. During May 2000, the Fund invested $1,335,001 in The Bradshaw Group, a company that provides innovative printing solutions primarily for customers in need of high speed mass printings. The Fund's investment consists of 8% redeemable preferred stock and a warrant to acquire 2,229,450 shares of common stock at $0.01 per share through May 2008. During June 2000, the Fund invested $5,500,000 in FS Strategies, Inc., a company formed to acquire the stock of Initial Staffing Services ("Initial") and EESIS, Inc. ("EESIS"). Initial provides temporary staffing and permanent placement services. EESIS is a web based human resources solutions provider. The Fund's investment consists of 110,000 shares of common stock. SUBSEQUENT EVENTS Subsequent to September 30, 2000, the Fund repaid a net $62,550,000 of notes payable to the bank. Subsequent to September 30, 2000, the Fund repurchased an additional 65,700 shares of common stock for $673,865. On October 10, 2000, Drypers Corporation ("DYPR") filed a voluntary petition for reorganization pursuant to Chapter 11 of the U.S. Bankruptcy Code due to increased pressure on cash flows, a termination of its license agreement with Procter & Gamble, and other matters. Subsequent to September 30, 2000, the Fund sold 1,703,200 shares of DYPR common stock for $83,002, realizing a capital loss of $7,270,848. As of September 15, 2000, Paracelsus Healthcare Corporation ("PLS") filed a voluntary petition for reorganization pursuant to Chapter 11 of the U.S. Bankruptcy Code. On October 27, 2000, the Fund sold 173,868 shares of common stock for $4,460, realizing a capital loss of $974,839. In addition to the DYPR and PLS capital losses, the Fund realized the following capital losses subsequent to September 30, 2000 for the tax year ended October 31, 2000: o sale of 17,739 common shares of LG&E Energy Corporation for $434,808, realizing a capital loss of $487,868; o sale of Hot & Cool Holdings, Inc. preferred shares for $1, realizing a capital loss of $1,086,631; and o the write-off of 140,000 shares of common stock and 6,476 shares of preferred stock of the Drilltec Corporation, realizing a capital loss of $7,645,000. In November 2000, the Fund declared a dividend of $0.60 per share, the majority of which will be a return of capital. The dividend will be paid to the shareholders of record on November 20, 2000. Shareholders may elect to receive the dividend in cash, or it may be paid by the issuance of additional shares of common stock. Payment of the dividend will occur on or before December 29, 2000. 24 ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK The Fund is subject to financial market risks, including changes in interest rates with respect to its investments in debt securities and its outstanding debt payable, as well as changes in marketable equity security prices. The Fund does not use derivative financial instruments to mitigate any of these risks. The return on the Fund's investments is generally not affected by foreign currency fluctuations. The Fund's investment in portfolio securities consists of some fixed rate debt securities. Since the debt securities are generally priced at a fixed rate, changes in interest rates do not directly impact interest income. In addition, changes in market interest rates are not typically a significant factor in the Fund's determination of fair value of these debt securities. The Fund's debt securities are generally held to maturity and their fair values are determined on the basis of the terms of the debt security and the financial condition of the issuer. The Fund's liabilities consist of debt payable to a financial institution. The revolving credit facilities are priced at floating rates of interest, with a basis of LIBOR or prime rate at the Fund's option. As a result of the floating rate, a change in interest rates could result in either an increase or decrease in the Fund's interest expense. A portion of the Fund's investment portfolio consists of debt and equity investments in private companies. The Fund would anticipate no impact on these investments from modest changes in public market equity prices. However, should significant changes in market equity prices occur, there could be a longer-term effect on valuations of private companies, which could affect the carrying value and the amount and timing of gains realized on these investments. A portion of the Fund's investment portfolio also consists of common stocks and warrants to purchase common stock in publicly traded companies. These investments are directly exposed to equity price risk, in that a hypothetical ten percent change in these equity prices would result in a similar percentage change in the fair value of these securities. ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K. (a) EXHIBITS 10. Material Contracts (b) REPORTS ON FORM 8-K No reports on Form 8-K were filed by the Fund during the period for which this report is filed. SIGNATURE Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has caused this report to be signed by the undersigned, thereunto duly authorized. Date: November 14, 2000 EQUUS II INCORPORATED /S/NOLAN LEHMANN Nolan Lehmann President and Principal Financial and Accounting Officer 25