[Federal Register Volume 62, Number 73 (Wednesday, April 16, 1997)]
[Notices]
[Pages 18660-18662]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 97-9804]


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SECURITIES AND EXCHANGE COMMISSION

[Investment Company Act Rel. No. 22613; Investment Advisers Act Release 
No. 1628; 812-10388]


Equus II Incorporated, et al.; Notice of Application

April 10, 1997.
AGENCY: Securities and Exchange Commission (``SEC'').

ACTION: Notice of Application for Exemption under the Investment 
Company Act of 1940 (``Investment Company Act'') and the Investment 
Advisers Act of 1940 (``Advisers Act'').

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APPLICANTS: Equus II Incorporated (``Fund''), Equus Capital Corporation 
(``ECC''), the Equus Capital Management Corporation (``ECMC'').

RELEVANT INVESTMENT COMPANY ACT SECTIONS: Order requested under section 
6(c) granting an exemption from section 63.

RELEVANT ADVISERS ACT SECTIONS: Order requested under section 206A 
granting an exemption from section 205(a)(1).

SUMMARY OF APPLICATION: Applicants request an order to permit the Fund 
to pay and the adviser and subadviser to the Fund to receive 
performance compensation on the basis of cumulative realized and 
unrealized gains net of realized and unrealized losses on securities in 
the Fund's portfolio.

FILING DATES: The application was filed on October 10, 1996, and 
amended on March 20, 1997, and April 1, 1997. Applicants have agreed to 
file an amendment during the notice period, the substance of which is 
included in this notice.

HEARING OR NOTIFICATION OF HEARING: An order granting the application 
will be issued unless the SEC orders a hearing. Interested persons may 
request a hearing by writing to the SEC's Secretary and serving 
applicants with a copy of the request, personally or by mail. Hearing 
requests should be received by the SEC by 5:30 p.m. on May 5, 1997, and 
should be accompanied by proof of service on applicants, in the form of 
an affidavit or, for lawyers, a certificate of service. Hearing 
requests should state the nature of the writer's interest, the reason 
for the request, and the issues contested. Persons who wish to be 
notified of a hearing may request such notification by writing to the 
SEC's Secretary.

ADDRESSES: Secretary, SEC, 450 Fifth Street, N.W., Washington, D.C. 
20549. Applicants, 2929 Allen Parkway, Suite 2500, Houston, Texas 
77019.


[[Page 18661]]


FOR FURTHER INFORMATION CONTACT: Mercer E. Bullard, Branch Chief, at 
(202) 942-0564, or Elizabeth G. Osterman, Assistant Director, at (202) 
942-0564 (Division of Investment Management, Office of Investment 
Company Regulation).

SUPPLEMENTARY INFORMATION: The following is a summary of the 
application. The complete application may be obtained for a fee from 
the SEC's Public Reference Branch.

Applicants' Representations

    1. The Fund, a Delaware corporation, is the successor to Equus 
Investments II, L.P., a Delaware limited partnership (``Partnership''). 
The Fund has elected to be a business development company (``BDC'') 
pursuant to section 54(a) of the Investment Company Act. The Fund's 
investment objective is to achieve capital appreciation by making 
equity and equity-oriented investments in growth capital, leveraged 
buyouts or recapitalizations of existing companies or divisions thereof 
and subsequently disposing of such investments.
    2. As an investor primarily in private securities, the Fund holds 
such securities until a portfolio company can be taken public or 
acquired by another company or other investors. The Fund's holding 
period generally exceeds five years and the Fund has held certain 
investments for more than nine years. The nature of venture capital 
investing is such that bad investments typically surface earlier than 
successful investments, and the ultimate success of the Fund may be 
dependent upon realizing substantial gains in a relatively small number 
of investments. The nature of the Fund's investments is such that the 
Fund's unrealized appreciation generally exceeds its unrealized 
depreciation.
    3. At December 31, 1996, the Fund had total net assets of 
$103,223,308 and 4,300,682 shares of common stock of the Fund issued 
and outstanding. The shares of the Fund are listed for trading on the 
American Stock Exchange (``AMEX''). Since the listing of the Fund's 
shares on the AMEX, the Fund's shares have traded at a discount to the 
Fund's net asset value. At December 31, 1996, the closing sale price of 
the Fund's shares was $16.125 and the net asset value of the Fund was 
$24.00 per share, for a discount of approximately 33%.
    4. ECMC and ECC, both registered investment advisers under the 
Advisers Act, provide investment advisory services to the Fund. ECC is 
a wholly owned subsidiary of ECMC, which is in turn controlled by Equus 
Corporation International, a privately owned corporation engaged in a 
variety of investment activities. Certain directors and officers of 
ECMC and ECC are also directors and/or officers of the Fund.
    5. ECMC serves the Fund's management company and, pursuant to a 
management agreement between the Fund and ECMC, performs, or arranges 
for third parties to perform, the management, administrative, 
investment advisory, and other services necessary for the operation of 
the Fund. Such management and administrative services include providing 
the Fund with office space, equipment, facilities, and supplies; 
keeping and maintaining the books and records of the Fund; preparing 
accounting, management, and other reports; and providing such other 
managerial and administrative services as may be necessary to identify, 
structure, monitor, and dispose of the Fund's investments. ECMC entered 
into a sub-adviser agreement with ECC, pursuant to which ECC provides 
certain investment advisory services to the Fund, including approving 
the Fund's quarterly net asset valuations and arranging for necessary 
financing for the Fund or its leverage transactions.
    6. ECMC receives (1) a management fee at an annual rate of 2% of 
the net assets of the Fund, paid quarterly in arrears, (2) compensation 
for providing certain investor communication services at the rate of 
$50,000 per year, and (3) incentive compensation equal to 20% of the 
net realized capital gains of the Fund less unrealized capital 
depreciation, computed on a cumulative basis over the life of the Fund 
and its predecessors. ECC is entitled to a fee from ECMC equal to one-
half of the incentive compensation that ECMC receives from the Fund, 
paid quarterly in arrears. If, at the end of any quarter or upon 
termination of the Fund, net payments previously made to ECMC exceed 
20% of the Fund's cumulative net realized capital gains less unrealized 
capital depreciation, ECMC is required to repay such excess.
    7. At December 31, 1996, the Fund had accrued a deferred management 
company incentive fee (``Deferred Fee'') of $10,784,028. This amount 
represents the unpaid computed incentive compensation fee on the excess 
of unpaid realized and unrealized appreciation of the Fund's 
investments over unrealized depreciation at December 31, 1996, and 
would be payable to ECMC upon sale of the Fund's investments at their 
current net asset values as of such date.
    8. The Fund is managed by a board of directors, a majority of whom 
are not ``interested persons'' of the Fund, as defined in the 
Investment Company Act (``Independent Directors''). At its February 
1995 meeting, the board of directors established a committee to review 
ways for the Fund to enhance shareholder value (``Committee''). The 
Committee reviewed and the Fund's board of directors approved a 
proposal to end the payment of incentive compensation to ECMC and ECC 
and to substitute in its place a stock option plan for the directors 
and officers of the Fund. The stock option plan adopted by the board of 
directors would comply with the provisions of section 61(a)(3)(B) of 
the Investment Company Act.\1\
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    \1\ The Fund has filed an application requesting relief from 
section 61(a)(3)(B) of the Act to permit it to offer the stock 
option plan as it applies to directors of the Fund who are neither 
officers or employees of the Fund (File No. 812-10574).
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    9. The board of directors does not wish to penalize ECMC and ECC by 
terminating the incentive compensation provisions of their management 
agreements prematurely. The board of directors therefore proposes that, 
upon termination of the incentive compensation provisions of the 
current management agreement with ECMC, ECMC be vested with the amount 
of the Deferred Fee as of the effective date of termination 
(``Valuation Date''). The Fund has set the Valuation Date as March 31, 
1997, contingent on approval of the stock option plan and the payment 
of the Deferred Fee in shares of the Fund's common stock by the 
shareholders of the Fund and the issuance of an exemptive order by the 
SEC. The proposal to pay the Deferred Fee in shares of the Fund's 
common stock will be submitted to the shareholders of the Fund for 
approval at a special shareholders meeting.
    10. For purposes of determining the Deferred Fee, the investment 
portfolio of the Fund will be appraised by an independent appraiser 
selected by the Independent Directors, the cost of which will be borne 
one-half by ECMC and one-half by the Fund. All unrealized capital gains 
and losses of the Fund will be deemed realized at that time. ECMC will 
be paid the Deferred Fee in shares of the Fund's common stock valued at 
the net asset value of such shares on the Valuation Date. The appraisal 
will take into account the difficulties of determining the fair market 
value of the Fund's investments and provide for an independent analysis 
of such value.
    11. The payment of the Deferred Fee in shares of the Fund's common 
stock valued at net asset value would result in ECMC receiving shares 
with a market value substantially less than the amount of the Deferred 
Fee. For example, if the

[[Page 18662]]

Deferred Fee at December 31, 1996, of $10,784,028 had been paid in 
shares at the net asset value of such shares at December 31, 1996 
($24.00), the Fund would have issued 449,334 shares with an aggregate 
current market value on that date of $7,245,511, or $16.125 per share, 
a discount of approximately 33%.
    12. The shares of Fund's common stock issued in payment of the 
Deferred Fee will not be registered under the Securities Act of 1933 
(``Securities Act''). Consequently, they will be restricted from resale 
for a minimum of one year as ``restricted securities'' under rule 
144(d) under the Securities Act and will be subject to the volume 
limitations on the amount of securities that may be sold thereafter. 
Under Rule 144(e), based on the 4,300,682 shares of Fund's common stock 
outstanding on December 31, 1996, and assuming that approximately 
450,000 shares are issued to ECMC in payment of the deferred fee, ECMC 
could sell approximately 47,500 shares (1% of the shares of common 
stock outstanding) every three months after it has held the shares for 
one year.\2\ Thus, without taking into account the average weekly 
trading volume of the shares (which did not exceed 47,500 shares in a 
recent four calendar week period), it would take more than three years 
for ECMC to realize the total value of the Deferred Fee after receiving 
the shares representing payment of the Fee.
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    \2\ Rule 144(e) provides that, after the one-year holding period 
has expired, a holder of restricted securities that is an affiliate 
of the issuer may not sell, in any three-month period, more than the 
greater of (1) 1% of the issuer's outstanding shares or (2) the 
average weekly reported volume of trading in the shares over the 
preceding four calendar weeks.
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Applicants' Legal Analysis

    1. Section 63 of the Investment Company Act provides that section 
23 of the Act shall apply to a BDC to the same extent as if it were a 
registered closed-end investment company, with certain exceptions. 
Section 23(a) prohibits registered closed-end companies from issuing 
their securities for services. Applicants believe that, to the extent 
that the payment of the Deferred Fee in shares of the Fund's common 
stock represents the issuance of such shares for services, the payment 
may be deemed to violate section 23(a).
    2. Section 205(a)(1) of the Advisers Act generally prohibits an 
investment adviser from having an advisory agreement that provides for 
it to receive compensation on the basis of a share of capital gains 
upon or capital appreciation of a client's funds. Section 205(b)(3) of 
the Advisers Act provides that section 205(a)(1) shall not apply to an 
agreement between an investment adviser and a BDC for the adviser to 
receive a limited performance fee based on realized gains computed net 
of realized and unrealized losses, provided that, among other things, 
the BDC does not also have outstanding any option issued pursuant to 
section 61(a)(3) of the Investment Company Act.\3\ Applicants believe 
that, to the extent that the calculation of the Deferred Fee provides 
that all unrealized capital appreciation or gains be deemed realized, 
such calculation may be deemed to violate section 205(a)(1).
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    \3\ Section 61(a)(3) permits a BDC to issue options pursuant to 
an executive compensation plan provided that certain requirements 
are satisfied.
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    3. Section 6(c) of the Investment Company Act and section 206A of 
the Advisers Act provide that the SEC may exempt any person or 
transaction from any provision of the Investment Company Act and the 
Advisers Act if such exemption is appropriate in the public interest 
and consistent with the protection of investors and the purposes fairly 
intended by the policy and provisions of each Act. Applicants believe 
that these standards are satisfied for the reasons stated below.
    4. Applicants contend that payment of the Deferred Fee in shares of 
the Fund's common stock is beneficial to the Fund and its shareholders 
because it will permit the Fund to retain cash otherwise required to 
pay the Deferred Fee and assist in better aligning management's 
compensation with the Fund's shareholders' objective of increasing the 
market value of the Fund's shares. Applicants believe that the loss of 
the accrued incentive compensation by ECC and ECMC would not be in the 
best interest of the Fund because it would penalize the very persons 
for whom the board of directors wishes to create incentives.
    5. Applicants argue that elimination of the Deferred Fee also will 
significantly reduce expenses and the expense ratio of the Fund. By 
eliminating the Deferred Fee, applicants note that the expenses of the 
Fund would have been reduced from $10,857,087 to $3,310,381 for the 
year ended December 31, 1996, and the expense ratio of the Fund would 
have been reduced from 13.1% to 4.0% for 1996.
    6. Applicants believe that Congress may have excluded unrealized 
gains from the calculation of performance fees under section 205(b)(3) 
in part because it was concerned about the possible overcompensation of 
the BDC's adviser resulting from overvaluation of the BDC's portfolio 
securities. Applicants assert that this concern will be addressed by 
basing the Deferred Fee on a valuation of the Fund's portfolio 
securities provided by an independent appraiser selected by the 
Independent Directors.
    7. Applicants state that Congress permitted the payment of 
incentive compensation under section 205(b)(3) only if the BDC did not 
also have a stock option plan. Applicants believe that this condition 
may have arisen from a concern that management might be paid twice with 
respect to the same capital gains. Applicants note that the Fund 
proposes to issue to directors and officers of the Fund stock options 
exercisable at the market price on the date of issuance. Applicants 
therefore believe there would be a risk that management may receive 
additional compensation based on the same capital gain if the shares of 
common stock issued in payment of the Deferred Fee were issued at 
market value and the subsequent realization of a capital gain 
previously deemed realized in determining the Deferred Fee reduced the 
market discount on the Fund's net asset value. Applicants assert that 
payment of the Deferred Fee in shares of common stock at net asset 
value eliminates this risk because ECMC and ECC would not receive any 
benefit from the current market discount on the Fund's net asset value.

Applicants' Condition

    Applicants agree that any order of the SEC granting the requested 
relief will be subject to the condition that the shares of the Fund's 
common stock to be issued in payment of the Deferred Fee will be valued 
at the net asset value of such shares on the same date as of which the 
Deferred Fee is determined.

    For the SEC, by the Division of Investment Management, under 
delegated authority.
Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 97-9804 Filed 4-15-97; 8:45 am]
BILLING CODE 8010-01-M