<PAGE>
JUNE 30, 1996
-----------------------------
SPECIAL SITUATIONS SECOND
FUND III, L.P. QUARTER
REPORT
<PAGE>
SPECIAL SITUATIONS FUND III, L.P.
(A Limited Partnership)
STATEMENT OF FINANCIAL CONDITION
JUNE 30, 1996
(Unaudited)
- --------------------------------------------------------------------------------
ASSETS - NOTE 2
Investments, at value (cost $97,511,454) $124,071,799
Cash and cash equivalents 31,408,182
Receivable for investments sold 2,999,420
Organization costs, net 74,237
------------
Total Assets $158,553,638
------------
------------
LIABILITIES AND PARTNERS' CAPITAL
LIABILITIES
Payable for Units repurchased - Note 4 $12,726,302
Payable for investments purchased - Note 2 4,497,759
Securities sold short, at value (proceeds $4,624,012) - Note 10 3,748,334
Accrued expenses 111,038
Administrator's fee payable - Note 7 270,385
-----------
Total Liabilities 21,353,818
-----------
PARTNERS' CAPITAL - NOTES 1, 3 AND 4
Limited partners 124,627,306
Corporate general partner 8,280,293
Individual general partners 4,292,221
------------
Total Partners' Capital 137,199,820
------------
Total Liabilities and Partners' Capital $158,553,638
------------
------------
Net asset value per Limited Partners' Unit $ 25,000
------------
------------
- --------------------------------------------------------------------------------
See the accompanying Notes to the Financial Statements.
1
<PAGE>
SPECIAL SITUATIONS FUND III, L.P.
(A Limited Partnership)
PORTFOLIO OF INVESTMENTS
JUNE 30, 1996
(UNAUDITED)
SHARES COMMON STOCKS VALUE
- --------------------------------------------------------------------------------
86,900 Accom, Inc. $ 347,600
108,800 Accuhealth, Inc. (a) 231,200
25,100 Accuhealth, Inc. (Restricted) (a) -
179,000 Alteon Inc. 1,969,000
174,934 Applied Biometrics, Inc. 2,777,077
90,500 Applied Digital Access, Inc. 950,250
108,000 ARIAD Pharmaceuticals, Inc. 459,000
91,800 Asahi/America, Inc. 858,330
54,000 Avigen, Inc. 378,000
173,500 Bally Total Fitness Holding Corporation 759,062
271,686 Barringer Technologies, Inc. (a) 781,097
146,700 BioTransplant Incorporated 1,191,937
83,800 Blonder Tongue Laboratories, Inc. 1,277,950
144,000 Brookstone, Inc. 1,620,000
176,300 Byron Preiss Multimedia Company, Inc. (a) 1,057,800
80,400 C*ATS Software, Inc. 482,400
150,000 Caledonia Mining Corporation 618,750
300,039 Cardiac Control Systems, Inc. (a) 867,935
74,600 Carnegie Group, Inc. 652,750
185,000 Castelle 1,433,750
213,000 Ceradyne, Inc. 2,343,000
146,200 Cerion Technologies Inc. 1,425,450
455,000 Check Technology Corporation (a) 4,379,375
287,300 Chic By H.I.S, Inc. 1,508,325
109,100 Children's Broadcasting Corporation 763,700
74,500 Cinar Films, Inc. 1,620,375
136,500 Collaborative Clinical Research, Inc. 1,586,812
259,300 Commander Aircraft (a) 1,069,612
90,000 Community Care of America, Inc. 1,080,000
145,100 Computer Learning Centers, Inc. 3,119,650
193,150 Concentra Corporation 1,158,900
70,000 Conceptus, Inc. 1,190,000
2,200,000 Contempri Homes, Inc. 701,360
334,500 Country Wide Transport Services, Inc. (a) 62,719
164,062 CPAC, Inc. 1,681,641
44,000 Craig Consumer Electronics, Inc. 286,000
129,900 CytoTherapeutics, Inc. 1,445,137
132,900 Eagle Point Software Corporation 930,300
88,200 Edelbrock Corporation 1,543,500
211,800 Ellett Brothers, Inc. 1,323,750
290,000 EP MedSystems, Inc. 1,595,000
- --------------------------------------------------------------------------------
2
<PAGE>
PORTFOLIO OF INVESTMENTS (CONTINUED)
JUNE 30, 1996
(UNAUDITED)
SHARES COMMON STOCKS (CONTINUED) VALUE
- --------------------------------------------------------------------------------
125,200 Exactech, Inc. 1,001,600
130,400 EZCORP, Inc. 880,200
97,500 Flamel Technologies S.A. 786,094
272,940 Fourth Shift Corporation 1,808,227
68,500 Fusion Medical Technologies, Inc. 483,781
56,500 Grand Prix Association of Long Beach, Inc. 536,750
123,700 Gynecare, Inc. 974,137
96,300 Health Power, Inc. 698,175
95,868 Hirsch International Corp. 1,833,471
10,700 Hoenig Group Inc. 42,800
35,400 Hooper Holmes, Inc. 469,050
121,100 InSite Vision Incorporated 696,325
75,000 ISG Technologies, Inc. 318,750
578,000 Jos. A. Bank Clothiers, Inc. (a) 2,673,250
988,800 Kurzweil Applied Intelligence, Inc. (Restricted)(a) 1,977,600
76,000 KVH Industries, Inc. 693,500
40,100 La Jolla Pharmaceutical Company 220,550
185,846 LifeRate Systems, Inc. (a) 1,417,076
162,000 Lincoln Logs, Ltd. (a) 50,625
287,000 Little Switzerland, Inc. 1,506,750
209,500 Lunn Industries, Inc. 288,062
139,000 Maverick Tube Corporation 1,633,250
71,000 Meadow Valley Corporation 417,125
105,500 Medallion Financial Corp. 1,318,750
235,400 Medical Graphics Corporation (a) 1,934,694
375,000 Mednet International, Ltd. 1,896,750
1,151,000 Memorex Telex N.V. ADR 1,438,750
455,000 MicroFrame, Inc. (a) 881,562
69,400 Micrografx, Inc. 1,014,975
126,200 Mizar, Inc. 820,300
70,000 Movado Group, Inc. 1,619,500
224,400 National Picture & Frame Company 2,412,300
60,000 Northland Cranberries, Inc. 1,800,000
289,000 Oakhurst Capital, Inc. (a) 334,156
143,000 Odetics, Inc. 2,180,750
91,100 Open Plan Systems, Inc. 1,093,200
234,700 Osteotech, Inc. (a) 1,701,575
- --------------------------------------------------------------------------------
3
<PAGE>
PORTFOLIO OF INVESTMENTS (CONTINUED)
JUNE 30, 1996
(UNAUDITED)
SHARES COMMON STOCKS (CONTINUED) VALUE
- --------------------------------------------------------------------------------
300,000 PC Etcetera, Inc. (Restricted) (a) -
64,500 Penn Treaty American Corp. 1,386,750
61,700 Photran Corporation 617,000
92,500 PixTech 624,375
64,000 Plasma & Materials Technologies, Inc. 960,000
50,000 Pomeroy Computer Resources 750,000
83,600 Raytel Medical Corporation 1,065,900
320,000 Ringer Corporation 760,000
42,400 Rochester Medical Corporation 784,400
303 Royal International Optical Corporation 227,250
127,600 SoftQuad International, Inc. 707,781
54,800 Software Spectrum, Inc. 1,274,100
139,500 SONUS Pharmaceuticals, Inc. 2,824,875
319,000 Specs Music 518,375
289,000 Steel City Products, Inc. 18,062
150,000 Targeted Genetics Corporation 712,500
204,600 Total Containment, Inc. (a) 716,100
253,800 Trans World Entertainment Corp. 1,729,012
110,000 Travis Boats & Motors, Inc. 1,003,750
112,900 Tridex Corporation 1,213,675
75,100 Triple P N.V. 459,987
85,300 Tripos, Inc. 746,375
66,200 Tuesday Morning Corporation 885,425
181,000 Ultimate Electronics, Inc. 950,250
183,300 ULTRADATA Corporation 1,420,575
18,000 Ultrafem, Inc. 355,500
218,500 Vacation Break U.S.A., Inc. 2,813,148
194,300 Vanguard Airlines, Inc. 1,748,700
180,000 Western Transmedia Company, Inc. 337,500
--------------
118,994,269
--------------
SHARES PREFERRED STOCKS VALUE
- --------------------------------------------------------------------------------
425,000 Accuhealth, Inc. convertible preferred (a) 850,000
105,000 Biocircuits Corporation Series A convertible preferred 176,400
160,764 Celerity Systems, Inc. Series A convertible preferred 272,521
79,296 Celerity Systems, Inc. Series B convertible preferred 155,420
--------------
1,454,341
--------------
--------------
AMOUNT CORPORATE BONDS VALUE
- --------------------------------------------------------------------------------
560,000 Children's Broadcasting Corporation
due 7-8-96 560,000
250,000 Celerity Systems, Inc.
10% note, due 11-30-96 250,000
150,000 Lincoln Logs, Ltd., convertible subordinated,
debentures, due 6-30-98 150,000
--------------
960,000
--------------
--------------
- --------------------------------------------------------------------------------
4
<PAGE>
PORTFOLIO OF INVESTMENTS (CONTINUED)
JUNE 30, 1996
(UNAUDITED)
WARRANTS WARRANTS VALUE
- --------------------------------------------------------------------------------
350,000 ATS Medical, Inc. 3/2/97 $ 262,500
27,500 Barringer Technologies, Inc. 5/9/98 -
153,500 Bryon Preiss Multimedia Company, Inc. 5/11/99 249,437
127,551 Celerity Systems, Inc. Series B 3/31/97 -
43,125 Children's Broadcasting Corporation 1/8/2001 -
733,334 Contempri Homes, Inc. 4/11/97 -
250,000 Country Wide Transport Services, Inc. 1/15/97 -
160,644 IBAH, Inc. 8/10/2000 910,851
78,500 Meadow Valley Corporation 10/16/2000 117,750
126,436 PC Etcetera, Inc. 3/15/99 -
25,000 PC Etcetera, Inc. (Restricted) 3/15/99 -
75,000 Prologic Management System, Inc. 3/14/99 56,250
71,000 Semiconductor Laser International Corp. 3/19/2000 213,000
57,000 Solar-Mates, Inc. 9/29/99 114,000
179,000 Superior Energy Services, Inc. Class A 7/6/97 22,375
295,000 Versus Technology, Inc. Class A 2/15/95 -
--------------
1,946,163
--------------
--------------
SHARES UNITS VALUE
- --------------------------------------------------------------------------------
229,167 Barringer Technologies, Inc. (Restricted) (a) 550,000
133,621 MicroFrame, Inc. (Restricted) 167,026
--------------
717,026
--------------
Total Investments $ 124,071,799
--------------
--------------
SECURITIES SOLD SHORT
SHARES COMMON STOCK VALUE
- --------------------------------------------------------------------------------
5,000 Cerner Corporation $ 106,875
22,500 Cygnus Therapeutic Systems 343,125
7,500 Daka International, Inc. 176,250
18,000 Edmark Corporation 360,000
15,200 First Merchants Acceptance Corporation 300,200
39,500 Hawaiian Airlines, Inc. 197,500
2,500 Heartport, Inc. 75,625
39,400 Isolyser Company, Inc. 472,800
26,300 Micron Technology, Inc. 680,512
6,000 Morrow Snowboards, Inc. 63,000
15,000 QUEST Medical, Inc. 106,875
7,500 Segue Software, Inc. 223,125
17,000 SoftKey International, Inc. 321,937
40,700 SyQuest Technology, Inc. 320,510
--------------
Total Securities Sold Short $ 3,748,334
--------------
--------------
- --------------------------------------------------------------------------------
(a) Affiliated company under the Investment Company Act of 1940,
inasmuch as the Fund owns more than 5% of the voting securities
of the issuer.
5
<PAGE>
SPECIAL SITUATIONS FUND III, L.P.
(A Limited Partnership)
STATEMENT OF OPERATIONS
FOR THE SIX MONTHS ENDED JUNE 30, 1996
(UNAUDITED)
- --------------------------------------------------------------------------------
INCOME
Net realized gains on investments 37,186,500
Net unrealized gains on investments 6,419,599
---------------
Net gains on investment portfolio 43,606,099
Interest 308,865
Dividends 19,955
Other income 19,460
---------------
Total income 43,954,379
---------------
EXPENSES
Administrator's fee - Note 7 488,843
Professional fees 112,000
Independent general partners' fees 15,000
Amortization of organization costs 14,847
Other 43,493
---------------
Total expenses 674,183
---------------
Net income 43,280,196
---------------
---------------
- --------------------------------------------------------------------------------
See the accompanying Notes to the Financial Statements.
6
<PAGE>
SPECIAL SITUATIONS FUND III, L.P.
(A Limited Partnership)
STATEMENT OF CHANGES IN PARTNERS' CAPITAL
(INFORMATION SUBSEQUENT TO DECEMBER 31, 1995 IS UNAUDITED)
<TABLE>
<CAPTION>
Per Limited Corporate Individual
Partners' Limited General General
Unit Partners Partner Partners Total
------------ --------------- ----------------- ---------------- ----------------
<S> <C> <C> <C> <C> <C>
YEAR ENDED
DECEMBER 31, 1995:
BALANCE
DECEMBER 31, 1994 67,221,191 4,452,038 3,659,674 75,332,903
Capital contributions 5,086,487 - - 5,086,487
Transfers 1,408 (592,189) 590,781 -
Allocation of net income:
Corporate General
Partner (20%) - 7,038,906 - 7,038,906
Partners (80%) 24,817,741 1,917,684 1,420,198 28,155,623
Repurchases (3,538,213) (6,850,000) - (10,388,213)
----------- --------- --------- ----------
BALANCE,
DECEMBER 31, 1995 25,000 93,588,614 5,966,439 5,670,653 105,225,706
---------
---------
SIX MONTHS ENDED
JUNE 30, 1996:
Capital contributions 1,419,291 - 929 1,420,220
Transfers - (210,828) 210,828 -
Allocation of net income:
Corporate General
Partner (20%) - 8,656,039 - 8,656,039
Partners (80%) 8,117 30,845,703 1,868,643 1,909,811 34,624,157
-----------
-----------
Repurchases - Note 4 (1,226,302) (8,000,000) (3,500,000) (12,726,302)
----------- --------- --------- ----------
BALANCE,
JUNE 30, 1996 25,000 124,627,306 8,280,293 4,292,221 137,199,820
----------- ----------- --------- --------- ------------
----------- ----------- --------- --------- ------------
</TABLE>
See Note 4 for changes in Units outstanding.
- -------------------------------------------------------------------------------
See the accompanying Notes to the Financial Statements.
7
<PAGE>
SPECIAL SITUATIONS FUND III, L.P.
(A Limited Partnership)
NOTES TO THE FINANCIAL STATEMENTS
(INFORMATION SUBSEQUENT TO DECEMBER 31, 1995 IS UNAUDITED)
NOTE 1 - GENERAL:
Special Situations Fund III, L.P. (the "Fund") was organized under the
Delaware Revised Uniform Limited Partnership Act on October 18, 1993,
and commenced investment operations on January 1, 1994. The Fund is a
closed-end interval fund registered under the Investment Company Act
of 1940. Commencing December 31, 1994, the Fund, as an interval fund,
allows investors to semi-annually redeem or acquire units of the Fund
("Units") (see Note 4). The Fund will continue until December 31,
2010 unless further extended or sooner terminated as provided for in
the Agreement of Limited Partnership (the "Agreement").
The Agreement provides for not less than three "Individual General
Partners" and a "Corporate General Partner". The General Partners, as
a group, must own not less than one percent (1%) of the Fund's
outstanding Units.
The Corporate General Partner and Investment Adviser is MGP Advisers
Limited Partnership ("MGP"), of which the General Partner is AWM
Investment Company, Inc. ("AWM"). Austin W. Marxe, an Individual
General Partner of the Fund and a limited partner of MGP owns directly
and indirectly 75% of MGP and AWM. Mr. Marxe is primarily
responsible for managing the Fund's investments and performing certain
administrative services on its behalf.
The Fund seeks long-term capital appreciation by investing primarily
in equity securities and securities with equity features of publicly
traded companies which possess a technological, market or product
niche, which may be, for various reasons, undervalued, or with
prospects of going private or being acquired.
NOTE 2 - ACCOUNTING POLICIES:
Securities traded on a securities exchange or on the NASDAQ System are
valued at the last sales price. Other securities traded in the
over-the-counter market are valued at the average of the bid and asked
prices on the last trading day. Securities for which market
quotations are not available are valued at fair value as determined in
good faith by the Individual General Partners. Securities
transactions are recorded on trade date. Realized gains and losses on
sales of securities are determined using the specific identification
cost method. Dividend income is recorded on the ex-dividend date, and
interest income is recorded on the accrual basis.
8
<PAGE>
SPECIAL SITUATIONS FUND III, L.P.
(A Limited Partnership)
NOTES TO THE FINANCIAL STATEMENTS
(INFORMATION SUBSEQUENT TO DECEMBER 31, 1995 IS UNAUDITED)
NOTE 2 - ACCOUNTING POLICIES (CONTINUED):
The preparation of financial statements in conformity with generally
accepted accounting principles requires management to make estimates
and assumptions that affect the reported amounts of assets and
liabilities and disclosure of contingent assets and liabilities at the
date of the financial statements and the reported amounts of revenues
and expenses during the reporting period. Actual results could differ
from those estimates.
Cash and cash equivalents include cash held in money market funds.
Organization costs are amortized over a sixty month period.
NOTE 3 - ALLOCATION OF ACCOUNTING PROFITS AND LOSSES:
Profits are allocated; first, to MGP to the extent of any previous net
losses allocated to MGP in excess of the other Partners' capital
balances; next, to the Partners in proportion to the number of Units
held by each to the extent of net losses previously allocated to them;
and, thereafter, 80% to the Partners in proportion to the number of
Units held by each and 20% to MGP.
Losses are allocated to the Partners in proportion to the number of
Units held by each, provided, however, that losses in excess of an
Individual General Partner's or a Limited Partner's capital balance
will be allocated to MGP.
NOTE 4 - PARTNER CAPITAL ACCOUNT TRANSACTIONS:
All net income allocated to Partners will be reinvested. In order to
maintain a $25,000 price per Unit, the number of Units held by each
Partner at the close of each fiscal period (generally June 30 and
December 31, commencing December 31, 1994), is adjusted to equal the
Partner's capital account divided by $25,000.
As of each fiscal period, the Fund will offer to repurchase at least
10% and no more than 25% of the outstanding Units. The repurchase
request deadline will generally be June 16, and December 17, of each
year.
9
<PAGE>
SPECIAL SITUATIONS FUND III, L.P.
(A Limited Partnership)
NOTES TO THE FINANCIAL STATEMENTS
(INFORMATION SUBSEQUENT TO DECEMBER 31, 1995 IS UNAUDITED)
NOTE 4 - PARTNER CAPITAL ACCOUNT TRANSACTIONS (CONTINUED):
In May 1996, the Fund offered to repurchase up to 599.7045 Units (10%
of its outstanding Units at June 30, 1996) at $25,000 per Unit.
509.0521 Units were tendered for repurchase.
The Fund also has the right to sell additional Units at each fiscal
period. As of July 1, 1996, the Fund sold 250.4 additional Units at
$25,000 each.
Changes in Units outstanding:
<TABLE>
<CAPTION>
Corporate Individual
Limited General General
Partners Partner Partners Total
---------- ---------- ---------- -----------
<S> <C> <C> <C> <C>
Balance, December 31, 1994 2,688.8476 178.0815 146.3870 3,013.3161
Additional units sold 203.4595 - - 203.4595
Transfers 0.0563 (23.6876) 23.6313 -
Allocation of additional units 992.7096 358.2636 56.8079 1,407.7811
Repurchases (141.5285) (274.0000) - (415.5285)
----------- ---------- -------- -----------
Balance, December 31, 1995 3,743.5445 238.6575 226.8262 4,209.0282
Additional units sold 56.7716 - 0.0372 56.8088
Transfers - (8.4331) 8.4331 -
Allocation of additional units 1,233.8281 420.9873 76.3924 1,731.2078
Repurchases (49.0521) (320.0000) (140.0000) (509.0521)
----------- ---------- -------- -----------
Balance, June 30, 1996 4,985.0921 331.2117 171.6889 5,487.9927
----------- ---------- -------- -----------
----------- ---------- -------- -----------
</TABLE>
NOTE 5 - PURCHASES AND SALES OF SECURITIES:
Purchases and sales of securities for the six months ended June 30,
1996 aggregated $159,796,044 and $184,735,414, respectively.
10
<PAGE>
SPECIAL SITUATIONS FUND III, L.P.
(A Limited Partnership)
NOTES TO THE FINANCIAL STATEMENTS
(INFORMATION SUBSEQUENT TO DECEMBER 31, 1995 IS UNAUDITED)
NOTE 6 - INCOME TAXES:
No provision for income taxes has been made in the accompanying
financial statements as each Partner is individually responsible for
reporting income or loss based upon the respective share of the Fund's
income and expenses reported for income tax purposes.
NOTE 7 - RELATED PARTY TRANSACTIONS:
AWM is the administrator of the Fund. The administrator's fee is
computed monthly at an annual rate of .75% of the average net assets.
The Fund pays each Independent General Partner an annual fee of
$10,000.
NOTE 8 - SUPPLEMENTARY FINANCIAL INFORMATION:
<TABLE>
<CAPTION>
Six Months
Ended Years Ended
June 30, December 31,
-------------------
1996 1995 1994
---- ---- ----
<S> <C> <C> <C>
Ratio of total expenses to average net
assets 1.05%* 1.18% 1.19%
Ratio of net income to average net
assets 67.60%* 38.09% 11.18%
Portfolio turnover rate 141.2% 245.2% 233.4%
Average commission rate paid $.0406
* Annualized
</TABLE>
11
<PAGE>
SPECIAL SITUATIONS FUND III, L.P.
(A Limited Partnership)
NOTES TO THE FINANCIAL STATEMENTS
(INFORMATION SUBSEQUENT TO DECEMBER 31, 1995, IS UNAUDITED
NOTE 9 - RETURN ON PARTNER INVESTMENT:
At June 30, 1996, the value of a $25,000 investment made at each
respective subscription date is as follows:
Subscription Date Value
----------------- ------
January 1, 1994 $49,057
January 1, 1995 $44,848
July 1, 1995 $39,711
January 1, 1996 $33,117
NOTE 10 - SECURITIES SOLD SHORT:
The Partnership is subject to certain inherent risks arising from
its activities of selling securities short. The ultimate cost to
the Partnership to acquire these securities may exceed the liability
reflected in the financial statements. In addition, the Partnership
is required to maintain collateral with the broker to secure these
short positions.
12
