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FORM 10-Q

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, DC 20549


QUARTERLY REPORT PURSUANT TO

SECTION 13 OR 15(d) OF


THE SECURITIES EXCHANGE ACT OF 1934




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|                                                      |  |                                    
|----------------------------------------------------- |  | -----------------------------------
|For The Quarterly Period
    Ended September 30, 2004 |  | Commission File Number:
    0-22832

ALLIED CAPITAL CORPORATION

(Exact Name of Registrant as Specified in its
Charter)

|                                                                     |  |                                                
|-------------------------------------------------------------------- |  | -----------------------------------------------
|                                                                    
|Maryland(State or Jurisdiction of
    Incorporation or Organization) |  | 52-1081052(IRS Employer
    Identification No.)

1919 Pennsylvania Avenue, N.W.

Washington, DC 20006


(Address of Principal Executive
Offices)


Registrants telephone number, including
area code: (202) 331-1112



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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 periods as 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 o

Indicate by check mark whether the registrant is an accelerated
filer (as defined in Rule 12b-2 of the Exchange Act)
YES x  NO o

On November 4, 2004, there were 132,943,090 shares
outstanding of the Registrants common stock, $0.0001 par
value.



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ALLIED CAPITAL CORPORATION

FORM 10-Q TABLE OF CONTENTS

|                              |                                                                                                   |                                                                                                                             |    |   
|----------------------------- | ------------------------------------------------------------------------------------------------- | --------------------------------------------------------------------------------------------------------------------------- | -- | --
|PART I. FINANCIAL INFORMATION |                                                                                                   |                                                                                                                            
|                              | Item 1. Financial Statements                                                                      |                                                                                                                             |   
|                              |                                                                                                   | Consolidated Balance Sheet as of
    September 30, 2004 (unaudited) and
    December 31, 2003                               |    | 1 
|                              |                                                                                                   | Consolidated Statement of Operations
    (unaudited)  For the Three and Nine Months Ended
    September 30, 2004 and 2003  |    | 2 
|                              |                                                                                                   | Consolidated Statement of Changes in Net Assets
    (unaudited)  For the Nine Months Ended
    September 30, 2004 and 2003 |    | 3 
|                              |                                                                                                   | Consolidated Statement of Cash Flows
    (unaudited)  For the Nine Months Ended
    September 30, 2004 and 2003            |    | 4 
|                              |                                                                                                   | Consolidated Statement of Investments as of
    September 30, 2004 (unaudited)                                              |    | 5 
|                              |                                                                                                   | Notes to Consolidated Financial Statements                                                                                  |    | 16
|                              |                                                                                                   | Report of Independent Registered Public
    Accounting Firm                                                                 |    | 42
|                              | Item 2. Managements Discussion
    and Analysis of Financial Condition and Results of Operations |                                                                                                                             | 43
|                              | Item 3. Quantitative and Qualitative
    Disclosures About Market Risk                            |                                                                                                                             | 85
|                              | Item 4. Controls and Procedures                                                                   |                                                                                                                             | 85
|                             
|PART II. OTHER INFORMATION    |                                                                                                   |                                                                                                                            
|                              | Item 1. Legal Proceedings                                                                         |                                                                                                                             | 87
|                              | Item 2. Unregistered Sales of Equity
    Securities and Use of Proceeds                           |                                                                                                                             | 87
|                              | Item 3. Defaults Upon Senior Securities                                                           |                                                                                                                             | 88
|                              | Item 4. Submission of Matters to a Vote
    of Security Holders                                   |                                                                                                                             | 88
|                              | Item 5. Other Information                                                                         |                                                                                                                             | 88
|                              | Item 6. Exhibits                                                                                  |                                                                                                                             | 88
|                              | Signatures                                                                                        |                                                                                                                             | 92





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##### 



PART I: FINANCIAL INFORMATION

Item 1.  Financial
Statements

ALLIED CAPITAL CORPORATION AND
SUBSIDIARIES

CONSOLIDATED BALANCE SHEET

|                                                                    |                                                                                                                                                                                                  |                                                                          |                                                                       |              |           |           |         |           |         |           | 
|------------------------------------------------------------------- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------ | ------------------------------------------------------------------------ | --------------------------------------------------------------------- | ------------ | --------- | --------- | ------- | --------- | ------- | --------- | 
|                                                                    |                                                                                                                                                                                                  | September 30,                                                            |                                                                       | December 31,
|                                                                    |                                                                                                                                                                                                  | 2004                                                                     |                                                                       | 2003        
|                                                                    |                                                                                                                                                                                                  |                                                                          |                                                                       |             
|(in thousands, except share and per share amounts)                  |                                                                                                                                                                                                  | (unaudited)                                                              |                                                                       |             
|ASSETS                                                             
|Portfolio at value:                                                 |                                                                                                                                                                                                  |                                                                          |                                                                       |              |           |           |         |          
|                                                                    | Private finance                                                                                                                                                                                  |                                                                          |                                                                       |              |           |           |         |           |        
|                                                                    |                                                                                                                                                                                                  | Companies more than 25% owned (cost:
    2004-$1,220,921; 2003-$755,024) |                                                                       | $            | 1,159,078 |           |         | $         | 900,317 |          
|                                                                    |                                                                                                                                                                                                  | Companies 5% to 25% owned (cost: 2004-$189,940;
    2003-$195,600)       |                                                                       |              | 179,736   |           |         |           | 218,305 |          
|                                                                    |                                                                                                                                                                                                  | Companies less than 5% owned (cost:
    2004-$762,454; 2003-$955,507)    |                                                                       |              | 692,171   |           |         |           | 784,050 |          
|                                                                    |                                                                                                                                                                                                  |                                                                          |                                                                       |              |           |           |         |          
|                                                                    |                                                                                                                                                                                                  |                                                                          | Total private finance (cost: 2004-$2,173,315;
    2003-$1,906,131)    |              |           | 2,030,985 |         |           |         | 1,902,672 | 
|                                                                    | Commercial real estate finance (cost:
    2004-$947,393; 2003-$694,929)                                                                                                                          |                                                                          |                                                                       | 949,024      |           |           |         | 681,927   |        
|                                                                    |                                                                                                                                                                                                  |                                                                          |                                                                       |              |           |           |         |          
|                                                                    |                                                                                                                                                                                                  |                                                                          | Total portfolio at value (cost: 2004-$3,120,708;
    2003-$2,601,060) |              |           | 2,980,009 |         |           |         | 2,584,599 | 
|                                                                    |                                                                                                                                                                                                  |                                                                          |                                                                       |              |           |           |         |          
|Deposits of proceeds from sales of borrowed
    Treasury securities |                                                                                                                                                                                                  |                                                                          | 270,662                                                               |              |           |           | 98,527  |          
|Accrued interest and dividends receivable                           |                                                                                                                                                                                                  |                                                                          | 73,551                                                                |              |           |           | 53,079  |          
|Other assets                                                        |                                                                                                                                                                                                  |                                                                          | 67,567                                                                |              |           |           | 69,498  |          
|Cash and cash equivalents                                           |                                                                                                                                                                                                  |                                                                          | 46,707                                                                |              |           |           | 214,167 |          
|                                                                    |                                                                                                                                                                                                  |                                                                          |                                                                       |              |           |           |         |          
|                                                                    |                                                                                                                                                                                                  |                                                                          | Total assets                                                          |              | $         | 3,438,496 |         |           | $       | 3,019,870 | 
|                                                                    |                                                                                                                                                                                                  |                                                                          |                                                                       |              |           |           |         |          
|LIABILITIES AND SHAREHOLDERS
    EQUITY                           
|Liabilities:                                                        |                                                                                                                                                                                                  |                                                                          |                                                                       |              |           |           |         |          
|                                                                    | Notes payable and debentures (maturing within one
    year of: September 30, 2004-$146,000; December 31, 2003-$221,000)                                                                          |                                                                          | $                                                                     | 840,478      |           |           | $       | 954,200   |        
|                                                                    | Revolving line of credit                                                                                                                                                                         |                                                                          |                                                                       | 327,250      |           |           |         |          |        
|                                                                    | Obligations to replenish borrowed Treasury
    securities                                                                                                                                        |                                                                          |                                                                       | 270,662      |           |           |         | 98,525    |        
|                                                                    | Accounts payable and other liabilities                                                                                                                                                           |                                                                          |                                                                       | 64,366       |           |           |         | 46,568    |        
|                                                                    |                                                                                                                                                                                                  |                                                                          |                                                                       |              |           |           |         |          
|                                                                    |                                                                                                                                                                                                  |                                                                          | Total liabilities                                                     |              |           | 1,502,756 |         |           |         | 1,099,293 | 
|                                                                    |                                                                                                                                                                                                  |                                                                          |                                                                       |              |           |           |         |          
|Commitments and contingencies                                       |                                                                                                                                                                                                  |                                                                          |                                                                       |              |           |           |         |          
|Preferred stock                                                     |                                                                                                                                                                                                  |                                                                          |                                                                      |              |           |           | 6,000   |          
|Shareholders equity:                                               |                                                                                                                                                                                                  |                                                                          |                                                                       |              |           |           |         |          
|                                                                    | Common stock, $0.0001 par value, 200,000,000
    shares authorized; 129,898,090 and 128,117,985 shares issued and
    outstanding at September 30, 2004, and December 31,
    2003, respectively |                                                                          |                                                                       | 13           |           |           |         | 13        |        
|                                                                    | Additional paid-in capital                                                                                                                                                                       |                                                                          |                                                                       | 2,022,979    |           |           |         | 1,985,652 |        
|                                                                    | Common stock held in deferred compensation trust                                                                                                                                                 |                                                                          |                                                                       | (9,969       | )         |           |         |          |        
|                                                                    | Notes receivable from sale of common stock                                                                                                                                                       |                                                                          |                                                                       | (5,592       | )         |           |         | (18,632   | )      
|                                                                    | Net unrealized appreciation (depreciation) on
    portfolio                                                                                                                                      |                                                                          |                                                                       | (159,439     | )         |           |         | (39,055   | )      
|                                                                    | Undistributed (distributions in excess of)
    earnings                                                                                                                                          |                                                                          |                                                                       | 87,748       |           |           |         | (13,401   | )      
|                                                                    |                                                                                                                                                                                                  |                                                                          |                                                                       |              |           |           |         |          
|                                                                    |                                                                                                                                                                                                  |                                                                          | Total shareholders equity                                            |              |           | 1,935,740 |         |           |         | 1,914,577 | 
|                                                                    |                                                                                                                                                                                                  |                                                                          |                                                                       |              |           |           |         |          
|                                                                    |                                                                                                                                                                                                  |                                                                          | Total liabilities and shareholders equity                            |              | $         | 3,438,496 |         |           | $       | 3,019,870 | 
|                                                                    |                                                                                                                                                                                                  |                                                                          |                                                                       |              |           |           |         |          
|Net asset value per common share                                    |                                                                                                                                                                                                  | $                                                                        | 14.90                                                                 |              |           | $         | 14.94   |          
|                                                                    |                                                                                                                                                                                                  |                                                                          |                                                                       |              |           |           |         |          

The accompanying notes are an integral part of
these consolidated financial statements.

1



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##### 



ALLIED CAPITAL CORPORATION AND
SUBSIDIARIES

CONSOLIDATED STATEMENT OF OPERATIONS

|                                                         |                                                           |                               |                                             |                     |         |        |         |         |        |         |         |          |         |         |         |         |         |         |  
|-------------------------------------------------------- | --------------------------------------------------------- | ----------------------------- | ------------------------------------------- | ------------------- | ------- | ------ | ------- | ------- | ------ | ------- | ------- | -------- | ------- | ------- | ------- | ------- | ------- | ------- | -
|                                                         |                                                           |                               |                                             |                    
|                                                         |                                                           | For the Three Months          |                                             | For the Nine Months
|                                                         |                                                           | Ended September 30,           |                                             | Ended September 30,
|                                                         |                                                           |                               |                                             |                    
|                                                         |                                                           | 2004                          |                                             | 2003                |         | 2004   |         | 2003   
|(in thousands, except per share amounts)                 |                                                           |                               |                                             |                     |         |        |         |        
|                                                         |                                                           |                               |                                             |                    
|                                                         |                                                           | (unaudited)                   |                                             | (unaudited)        
|Interest and Related Portfolio Income:                   |                                                           |                               |                                             |                     |         |        |         |         |        |         |         |          |         |         |         |        
|                                                         | Interest and dividends                                    |                               |                                             |                     |         |        |         |         |        |         |         |          |         |         |         |         |        
|                                                         |                                                           | Companies more than 25% owned |                                             | $                   | 27,242  |        |         | $       | 14,533 |         |         | $        | 59,112  |         |         | $       | 42,464  |        
|                                                         |                                                           | Companies 5% to 25% owned     |                                             |                     | 7,582   |        |         |         | 6,313  |         |         |          | 19,827  |         |         |         | 19,286  |        
|                                                         |                                                           | Companies less than 5% owned  |                                             |                     | 51,004  |        |         |         | 58,049 |         |         |          | 154,601 |         |         |         | 149,803 |        
|                                                         |                                                           |                               |                                             |                     |         |        |         |         |        |         |         |          |         |         |         |        
|                                                         |                                                           |                               | Total interest and dividends                |                     |         | 85,828 |         |         |        | 78,895  |         |          |         | 233,540 |         |         |         | 211,553 |  
|                                                         |                                                           |                               |                                             |                     |         |        |         |         |        |         |         |          |         |         |         |        
|                                                         | Loan prepayment premiums                                  |                               |                                             |                     |         |        |         |         |        |         |         |          |         |         |         |         |        
|                                                         |                                                           | Companies more than 25% owned |                                             |                     |        |        |         |         | 33     |         |         |          |        |         |         |         | 141     |        
|                                                         |                                                           | Companies 5% to 25% owned     |                                             |                     | 53      |        |         |         | 60     |         |         |          | 765     |         |         |         | 685     |        
|                                                         |                                                           | Companies less than 5% owned  |                                             |                     | 140     |        |         |         | 2,430  |         |         |          | 3,445   |         |         |         | 4,455   |        
|                                                         |                                                           |                               |                                             |                     |         |        |         |         |        |         |         |          |         |         |         |        
|                                                         |                                                           |                               | Total loan prepayment premiums              |                     |         | 193    |         |         |        | 2,523   |         |          |         | 4,210   |         |         |         | 5,281   |  
|                                                         |                                                           |                               |                                             |                     |         |        |         |         |        |         |         |          |         |         |         |        
|                                                         | Fees and other income                                     |                               |                                             |                     |         |        |         |         |        |         |         |          |         |         |         |         |        
|                                                         |                                                           | Companies more than 25% owned |                                             |                     | 7,611   |        |         |         | 4,382  |         |         |          | 20,406  |         |         |         | 14,395  |        
|                                                         |                                                           | Companies 5% to 25% owned     |                                             |                     | 934     |        |         |         | 229    |         |         |          | 1,404   |         |         |         | 459     |        
|                                                         |                                                           | Companies less than 5% owned  |                                             |                     | 2,297   |        |         |         | 2,841  |         |         |          | 6,568   |         |         |         | 7,526   |        
|                                                         |                                                           |                               |                                             |                     |         |        |         |         |        |         |         |          |         |         |         |        
|                                                         |                                                           |                               | Total fees and other income                 |                     |         | 10,842 |         |         |        | 7,452   |         |          |         | 28,378  |         |         |         | 22,380  |  
|                                                         |                                                           |                               |                                             |                     |         |        |         |         |        |         |         |          |         |         |         |        
|                                                         |                                                           |                               | Total interest and related portfolio income |                     |         | 96,863 |         |         |        | 88,870  |         |          |         | 266,128 |         |         |         | 239,214 |  
|                                                         |                                                           |                               |                                             |                     |         |        |         |         |        |         |         |          |         |         |         |        
|Expenses:                                                |                                                           |                               |                                             |                     |         |        |         |         |        |         |         |          |         |         |         |        
|                                                         | Interest                                                  |                               |                                             | 20,253              |         |        |         | 20,334  |        |         |         | 57,349   |         |         |         | 57,614  |        
|                                                         | Employee                                                  |                               |                                             | 10,817              |         |        |         | 9,480   |        |         |         | 28,710   |         |         |         | 26,859  |        
|                                                         | Individual performance award                              |                               |                                             | 3,079               |         |        |         |        |        |         |         | 9,461    |         |         |         |        |        
|                                                         | Administrative                                            |                               |                                             | 10,169              |         |        |         | 5,897   |        |         |         | 25,072   |         |         |         | 15,395  |        
|                                                         |                                                           |                               |                                             |                     |         |        |         |         |        |         |         |          |         |         |         |        
|                                                         |                                                           |                               | Total operating expenses                    |                     |         | 44,318 |         |         |        | 35,711  |         |          |         | 120,592 |         |         |         | 99,868  |  
|                                                         |                                                           |                               |                                             |                     |         |        |         |         |        |         |         |          |         |         |         |        
|Net investment income before income taxes                |                                                           |                               | 52,545                                      |                     |         |        | 53,159  |         |        |         | 145,536 |          |         |         | 139,346 |        
|Income tax benefit                                       |                                                           |                               | (200                                        | )                   |         |        | (449    | )       |        |         | (744    | )        |         |         | (1,530  | )      
|                                                         |                                                           |                               |                                             |                     |         |        |         |         |        |         |         |          |         |         |         |        
|Net investment income                                    |                                                           |                               | 52,745                                      |                     |         |        | 53,608  |         |        |         | 146,280 |          |         |         | 140,876 |        
|                                                         |                                                           |                               |                                             |                     |         |        |         |         |        |         |         |          |         |         |         |        
|Net Realized and Unrealized Gains (Losses):              |                                                           |                               |                                             |                     |         |        |         |         |        |         |         |          |         |         |         |        
|                                                         | Net realized gains (losses)                               |                               |                                             |                     |         |        |         |         |        |         |         |          |         |         |         |         |        
|                                                         |                                                           | Companies more than 25% owned |                                             |                     | (12,483 | )      |         |         | (114   | )       |         |          | 139,016 |         |         |         | 1,200   |        
|                                                         |                                                           | Companies 5% to 25% owned     |                                             |                     | 13,269  |        |         |         | (5,895 | )       |         |          | 48,965  |         |         |         | 10,793  |        
|                                                         |                                                           | Companies less than 5% owned  |                                             |                     | 514     |        |         |         | (429   | )       |         |          | (12,228 | )       |         |         | 38,448  |        
|                                                         |                                                           |                               |                                             |                     |         |        |         |         |        |         |         |          |         |         |         |        
|                                                         |                                                           |                               | Total net realized gains (losses)           |                     |         | 1,300  |         |         |        | (6,438  | )       |          |         | 175,753 |         |         |         | 50,441  |  
|                                                         | Net change in unrealized appreciation or
    depreciation |                               |                                             | 31,954              |         |        |         | (13,426 | )      |         |         | (120,384 | )       |         |         | (77,760 | )      
|                                                         |                                                           |                               |                                             |                     |         |        |         |         |        |         |         |          |         |         |         |        
|                                                         |                                                           |                               | Total net gains (losses)                    |                     |         | 33,254 |         |         |        | (19,864 | )       |          |         | 55,369  |         |         |         | (27,319 | )
|                                                         |                                                           |                               |                                             |                     |         |        |         |         |        |         |         |          |         |         |         |        
|Net increase in net assets resulting from
    operations |                                                           | $                             | 85,999                                      |                     |         | $      | 33,744  |         |        | $       | 201,649 |          |         | $       | 113,557 |        
|                                                         |                                                           |                               |                                             |                     |         |        |         |         |        |         |         |          |         |         |         |        
|Basic earnings per common share                          |                                                           | $                             | 0.67                                        |                     |         | $      | 0.28    |         |        | $       | 1.57    |          |         | $       | 0.99    |        
|                                                         |                                                           |                               |                                             |                     |         |        |         |         |        |         |         |          |         |         |         |        
|Diluted earnings per common share                        |                                                           | $                             | 0.66                                        |                     |         | $      | 0.28    |         |        | $       | 1.53    |          |         | $       | 0.98    |        
|                                                         |                                                           |                               |                                             |                     |         |        |         |         |        |         |         |          |         |         |         |        
|Weighted average common shares
    outstanding  basic   |                                                           |                               | 129,304                                     |                     |         |        | 118,855 |         |        |         | 128,812 |          |         |         | 113,985 |        
|                                                         |                                                           |                               |                                             |                     |         |        |         |         |        |         |         |          |         |         |         |        
|Weighted average common shares
    outstanding  diluted |                                                           |                               | 131,192                                     |                     |         |        | 120,906 |         |        |         | 131,487 |          |         |         | 115,228 |        
|                                                         |                                                           |                               |                                             |                     |         |        |         |         |        |         |         |          |         |         |         |        

The accompanying notes are an integral part of
these consolidated financial statements.

2



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##### 



ALLIED CAPITAL CORPORATION AND
SUBSIDIARIES

CONSOLIDATED STATEMENT OF CHANGES IN NET
ASSETS

|                                           |                                                                      |                                                                          |           |          |          |   |           |          |          |  
|------------------------------------------ | -------------------------------------------------------------------- | ------------------------------------------------------------------------ | --------- | -------- | -------- | - | --------- | -------- | -------- | -
|                                           |                                                                      |                                                                         
|                                           |                                                                      | For the Nine Months                                                     
|                                           |                                                                      | Ended September 30,                                                     
|                                           |                                                                      |                                                                         
|                                           |                                                                      | 2004                                                                     |           | 2003    
|(in thousands, except per share amounts)   |                                                                      |                                                                          |           |         
|                                           |                                                                      |                                                                         
|                                           |                                                                      | (unaudited)                                                             
|Operations:                                |                                                                      |                                                                          |           |          |          |   |           |         
|                                           | Net investment income                                                |                                                                          | $         | 146,280  |          |   | $         | 140,876  |         
|                                           | Net realized gains                                                   |                                                                          |           | 175,753  |          |   |           | 50,441   |         
|                                           | Net change in unrealized appreciation or
    depreciation            |                                                                          |           | (120,384 | )        |   |           | (77,760  | )       
|                                           |                                                                      |                                                                          |           |          |          |   |           |         
|                                           |                                                                      | Net increase in net assets resulting from
    operations                 |           |          | 201,649  |   |           |          | 113,557  |  
|                                           |                                                                      |                                                                          |           |          |          |   |           |         
|Shareholder distributions:                 |                                                                      |                                                                          |           |          |          |   |           |         
|                                           | Common stock dividends                                               |                                                                          |           | (220,832 | )        |   |           | (196,159 | )       
|                                           | Preferred stock dividends                                            |                                                                          |           | (52      | )        |   |           | (155     | )       
|                                           |                                                                      |                                                                          |           |          |          |   |           |         
|                                           |                                                                      | Net decrease in net assets resulting from
    shareholder distributions  |           |          | (220,884 | ) |           |          | (196,314 | )
|                                           |                                                                      |                                                                          |           |          |          |   |           |         
|Capital share transactions:                |                                                                      |                                                                          |           |          |          |   |           |         
|                                           | Sale of common stock                                                 |                                                                          |           |         |          |   |           | 298,249  |         
|                                           | Issuance of common stock for portfolio investments                   |                                                                          |           | 3,227    |          |   |           |         |         
|                                           | Issuance of common stock upon the exercise of
    stock options      |                                                                          |           | 29,673   |          |   |           | 3,674    |         
|                                           | Issuance of common stock in lieu of cash
    distributions           |                                                                          |           | 4,399    |          |   |           | 4,959    |         
|                                           | Net decrease in notes receivable from sale of
    common stock       |                                                                          |           | 13,040   |          |   |           | 5,202    |         
|                                           | Purchase of common stock held in deferred
    compensation trust     |                                                                          |           | (10,152  | )        |   |           |         |         
|                                           | Distribution of common stock held in deferred
    compensation trust |                                                                          |           | 183      |          |   |           |         |         
|                                           | Other                                                                |                                                                          |           | 28       |          |   |           | 189      |         
|                                           |                                                                      |                                                                          |           |          |          |   |           |         
|                                           |                                                                      | Net increase in net assets resulting from capital
    share transactions |           |          | 40,398   |   |           |          | 312,273  |  
|                                           |                                                                      |                                                                          |           |          |          |   |           |         
|                                           |                                                                      | Total increase in net assets                                             |           |          | 21,163   |   |           |          | 229,516  |  
|Net assets at beginning of period          |                                                                      |                                                                          | 1,914,577 |          |          |   | 1,546,071 |         
|                                           |                                                                      |                                                                          |           |          |          |   |           |         
|Net assets at end of period                |                                                                      | $                                                                        | 1,935,740 |          |          | $ | 1,775,587 |         
|                                           |                                                                      |                                                                          |           |          |          |   |           |         
|Net asset value per common share           |                                                                      | $                                                                        | 14.90     |          |          | $ | 14.46     |         
|                                           |                                                                      |                                                                          |           |          |          |   |           |         
|Common shares outstanding at end of period |                                                                      |                                                                          | 129,898   |          |          |   | 122,766   |         
|                                           |                                                                      |                                                                          |           |          |          |   |           |         

The accompanying notes are an integral part of
these consolidated financial statements.

3



---



##### 



ALLIED CAPITAL CORPORATION AND
SUBSIDIARIES

CONSOLIDATED STATEMENT OF CASH FLOWS

|                                                         |                                                                   |                                                                                                                    |                                                         |          |            |          |        |          |          |        |  
|-------------------------------------------------------- | ----------------------------------------------------------------- | ------------------------------------------------------------------------------------------------------------------ | ------------------------------------------------------- | -------- | ---------- | -------- | ------ | -------- | -------- | ------ | -
|                                                         |                                                                   |                                                                                                                   
|                                                         |                                                                   | For the Nine Months                                                                                               
|                                                         |                                                                   | Ended September 30,                                                                                               
|                                                         |                                                                   |                                                                                                                   
|                                                         |                                                                   | 2004                                                                                                               |                                                         | 2003    
|(in thousands)                                           |                                                                   |                                                                                                                    |                                                         |         
|                                                         |                                                                   |                                                                                                                   
|                                                         |                                                                   | (unaudited)                                                                                                       
|Cash flows from operating activities:                    |                                                                   |                                                                                                                    |                                                         |          |            |          |        |         
|                                                         | Net increase in net assets resulting from
    operations          |                                                                                                                    | $                                                       | 201,649  |            |          | $      | 113,557  |         
|                                                         | Adjustments                                                       |                                                                                                                    |                                                         |          |            |          |        |          |         
|                                                         |                                                                   | Portfolio investments                                                                                              |                                                         |          | (1,056,213 | )        |        |          | (664,814 | )     
|                                                         |                                                                   | Principal collections related to investment
    repayments or sales                                                |                                                         |          | 542,513    |          |        |          | 501,528  |       
|                                                         |                                                                   | Change in accrued or reinvested interest and
    dividends                                                         |                                                         |          | (31,652    | )        |        |          | (39,983  | )     
|                                                         |                                                                   | Amortization of discounts and fees                                                                                 |                                                         |          | (5,929     | )        |        |          | (10,067  | )     
|                                                         |                                                                   | Changes in other assets and liabilities                                                                            |                                                         |          | 17,572     |          |        |          | 4,650    |       
|                                                         |                                                                   | Depreciation and amortization                                                                                      |                                                         |          | 1,266      |          |        |          | 1,233    |       
|                                                         |                                                                   | Notes and other securities received as
    consideration from sale of investments, net of principal
    repayments |                                                         |          | (44,515    | )        |        |          | (3,876   | )     
|                                                         |                                                                   | Realized losses                                                                                                    |                                                         |          | 65,828     |          |        |          | 14,228   |       
|                                                         |                                                                   | Net change in unrealized (appreciation) or
    depreciation                                                        |                                                         |          | 120,384    |          |        |          | 77,760   |       
|                                                         |                                                                   |                                                                                                                    |                                                         |          |            |          |        |         
|                                                         |                                                                   |                                                                                                                    | Net cash provided by (used in) operating
    activities |          |            | (189,097 | )      |          |          | (5,784 | )
|                                                         |                                                                   |                                                                                                                    |                                                         |          |            |          |        |         
|Cash flows from financing activities:                    |                                                                   |                                                                                                                    |                                                         |          |            |          |        |         
|                                                         | Sale of common stock                                              |                                                                                                                    |                                                         |         |            |          |        | 298,249  |         
|                                                         | Sale of common stock upon the exercise of stock
    options       |                                                                                                                    |                                                         | 29,673   |            |          |        | 3,674    |         
|                                                         | Collections of notes receivable from sale of
    common stock     |                                                                                                                    |                                                         | 13,040   |            |          |        | 5,202    |         
|                                                         | Borrowings under notes payable and debentures                     |                                                                                                                    |                                                         | 15,212   |            |          |        | 300,000  |         
|                                                         | Repayments on notes payable and debentures                        |                                                                                                                    |                                                         | (129,000 | )          |          |        | (140,000 | )       
|                                                         | Net borrowings under (repayments on) revolving
    line of credit |                                                                                                                    |                                                         | 327,250  |            |          |        | (204,250 | )       
|                                                         | Redemption of preferred stock                                     |                                                                                                                    |                                                         | (7,000   | )          |          |        |         |         
|                                                         | Purchase of common stock held in deferred
    compensation trust  |                                                                                                                    |                                                         | (10,152  | )          |          |        |         |         
|                                                         | Other financing activities                                        |                                                                                                                    |                                                         | (901     | )          |          |        | (4,669   | )       
|                                                         | Common stock dividends and distributions paid                     |                                                                                                                    |                                                         | (216,433 | )          |          |        | (194,382 | )       
|                                                         | Preferred stock dividends paid                                    |                                                                                                                    |                                                         | (52      | )          |          |        | (155     | )       
|                                                         |                                                                   |                                                                                                                    |                                                         |          |            |          |        |         
|                                                         |                                                                   |                                                                                                                    | Net cash provided by (used in) financing
    activities |          |            | 21,637   |        |          |          | 63,669 |  
|                                                         |                                                                   |                                                                                                                    |                                                         |          |            |          |        |         
|Net increase (decrease) in cash and cash
    equivalents |                                                                   |                                                                                                                    | (167,460                                                | )        |            |          | 57,885 |         
|Cash and cash equivalents at beginning of period         |                                                                   |                                                                                                                    | 214,167                                                 |          |            |          | 11,186 |         
|                                                         |                                                                   |                                                                                                                    |                                                         |          |            |          |        |         
|Cash and cash equivalents at end of period               |                                                                   | $                                                                                                                  | 46,707                                                  |          |            | $        | 69,071 |         
|                                                         |                                                                   |                                                                                                                    |                                                         |          |            |          |        |         

The accompanying notes are an integral part of
these consolidated financial statements.

4



---



##### 



ALLIED CAPITAL CORPORATION AND
SUBSIDIARIES

CONSOLIDATED STATEMENT OF
INVESTMENTS

|                                                                                                                                                                                                                                                                                                                                         |                       |                                                       |                                    |                    |         |         |  |   |         |         | 
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- | --------------------- | ----------------------------------------------------- | ---------------------------------- | ------------------ | ------- | ------- |  | - | ------- | ------- | 
|                                                                                                                                                                                                                                                                                                                                         |                       |                                                       |                                    |                   
|                                                                                                                                                                                                                                                                                                                                         |                       |                                                       |                                    | September 30, 2004
|                                                                                                                                                                                                                                                                                                                                         |                       |                                                       |                                    |                   
|Private Finance                                                                                                                                                                                                                                                                                                                          |                       |                                                       |                                    |                   
|Portfolio Company                                                                                                                                                                                                                                                                                                                        |                       |                                                       |                                    | (unaudited)       
|(in thousands, except number of shares)                                                                                                                                                                                                                                                                                                  |                       | Investment(1)(2)                                      |                                    | Cost               |         | Value  
|                                                                                                                                                                                                                                                                                                                                         |                       |                                                       |                                    |                    |         |        
|Companies More Than 25% Owned                                                                                                                                                                                                                                                                                                            |                       |                                                       |                                    |                    |         |         |  |  
|                                                                                                                                                                                                                                                                                                                                        
|ACE Products, Inc.                                                                                                                                                                                                                                                                                                                       |                       | Loan (20.5%, Due 7/09)                                |                                    | $                  | 17,164  |         |  | $ | 50      |        
|                                                                                                                                                                                                                                                                                                                                         | (Industrial Products) |                                                       | Common Stock (5,000 shares)        |                    |         |        |  |   |         |        | 
|                                                                                                                                                                                                                                                                                                                                        
|Acme Paging, L.P.(4)                                                                                                                                                                                                                                                                                                                     |                       | Loan (6.8%, Due 12/07  1/08)                         |                                    |                    | 4,631   |         |  |   | 2,398   |        
|                                                                                                                                                                                                                                                                                                                                         | (Telecommunications)  |                                                       | Equity Interests                   |                    |         | 13,274  |  |   |         | 1,742   | 
|                                                                                                                                                                                                                                                                                                                                         |                       | Common Stock (4,656 shares)                           |                                    |                    | 27      |         |  |   |        |        
|                                                                                                                                                                                                                                                                                                                                        
|Advantage Sales & Marketing, Inc.                                                                                                                                                                                                                                                                                                        |                       | Loan (12.0%, Due 9/09)                                |                                    |                    | 59,714  |         |  |   | 59,714  |        
|                                                                                                                                                                                                                                                                                                                                         | (Business Services)   |                                                       | Debt Securities (18.5%, Due 12/09) |                    |         | 124,386 |  |   |         | 124,386 | 
|                                                                                                                                                                                                                                                                                                                                         |                       | Common Stock (18,957,011 shares)                      |                                    |                    | 73,472  |         |  |   | 73,472  |        
|                                                                                                                                                                                                                                                                                                                                        
|Alaris Consulting, LLC                                                                                                                                                                                                                                                                                                                   |                       | Loan (16.5%, Due 12/05  12/07)                       |                                    |                    | 22,990  |         |  |   | 4,812   |        
|                                                                                                                                                                                                                                                                                                                                         | (Business Services)   |                                                       | Equity Interests                   |                    |         | 5,165   |  |   |         |        | 
|                                                                                                                                                                                                                                                                                                                                         |                       | Guaranty ($1,100)                                     |                                    |                    |         |         |  |   |         |        
|                                                                                                                                                                                                                                                                                                                                        
|American Healthcare Services, Inc.                                                                                                                                                                                                                                                                                                       |                       | Loan (0.2%, Due 12/04  12/05)                        |                                    |                    | 17,676  |         |  |   | 4,663   |        
|                                                                                                                                                                                                                                                                                                                                         | (Healthcare Services) |                                                       | Debt Securities (29.3%, Due 5/06)  |                    |         | 17,311  |  |   |         |        | 
|                                                                                                                                                                                                                                                                                                                                         |                       | Common Stock (7,956,704 shares)                       |                                    |                    | 1,000   |         |  |   |        |        
|                                                                                                                                                                                                                                                                                                                                         |                       | Guaranty ($824)                                       |                                    |                    |         |         |  |   |         |        
|                                                                                                                                                                                                                                                                                                                                        
|Avborne, Inc.(6)                                                                                                                                                                                                                                                                                                                         |                       | Loan (25.0%, Due 8/07)                                |                                    |                    | 1,269   |         |  |   | 1,269   |        
|                                                                                                                                                                                                                                                                                                                                         | (Business Services)   |                                                       | Preferred Stock (12,500 shares)    |                    |         | 14,138  |  |   |         | 4,212   | 
|                                                                                                                                                                                                                                                                                                                                         |                       | Common Stock (27,500 shares)                          |                                    |                    |        |         |  |   |        |        
|                                                                                                                                                                                                                                                                                                                                         |                       | Standby Letter of Credit ($6,978)                     |                                    |                    |         |         |  |   |         |        
|                                                                                                                                                                                                                                                                                                                                        
|Avborne Heavy Maintenance, Inc.(6)                                                                                                                                                                                                                                                                                                       |                       | Preferred Stock (1,568 shares)                        |                                    |                    |        |         |  |   |        |        
|                                                                                                                                                                                                                                                                                                                                         | (Business Services)   |                                                       | Common Stock (2,750 shares)        |                    |         |        |  |   |         |        | 
|                                                                                                                                                                                                                                                                                                                                        
|Business Loan Express, LLC                                                                                                                                                                                                                                                                                                               |                       | Debt Securities (25.0%, Due 12/08)                    |                                    |                    | 43,426  |         |  |   | 43,426  |        
|                                                                                                                                                                                                                                                                                                                                         | (Financial Services)  |                                                       | Class A Equity Interests           |                    |         | 52,278  |  |   |         | 52,278  | 
|                                                                                                                                                                                                                                                                                                                                         |                       | Class B Equity Interests                              |                                    |                    | 66,161  |         |  |   | 104,676 |        
|                                                                                                                                                                                                                                                                                                                                         |                       | Class C Equity Interests                              |                                    |                    | 109,340 |         |  |   | 151,704 |        
|                                                                                                                                                                                                                                                                                                                                         |                       | Guaranty ($101,585  See Note 3)                      |                                    |                    |         |         |  |   |         |        
|                                                                                                                                                                                                                                                                                                                                         |                       | Standby Letters of Credit
    ($35,550   See Note 3) |                                    |                    |         |         |  |   |         |        
|                                                                                                                                                                                                                                                                                                                                        
|Callidus Capital Corporation                                                                                                                                                                                                                                                                                                             |                       | Loan (12.0%, Due 12/06)                               |                                    |                    | 1,335   |         |  |   | 1,335   |        
|                                                                                                                                                                                                                                                                                                                                         | (Financial Services)  |                                                       | Debt Securities (18.0%, Due 10/08) |                    |         | 3,877   |  |   |         | 3,877   | 
|                                                                                                                                                                                                                                                                                                                                         |                       | Common Stock (10 shares)                              |                                    |                    | 1,871   |         |  |   | 1,871   |        
|                                                                                                                                                                                                                                                                                                                                        
|Chickasaw Sales & Marketing, Inc.                                                                                                                                                                                                                                                                                                        |                       | Preferred Stock (1,000,000 shares)                    |                                    |                    | 1,000   |         |  |   |        |        
|                                                                                                                                                                                                                                                                                                                                         | (Consumer Services)   |                                                       | Common Stock (37,000 shares)       |                    |         | 2,812   |  |   |         |        | 
|                                                                                                                                                                                                                                                                                                                                        
|(1)Interest
    rates represent the weighted average annual stated interest rate
    on loans and debt securities, which are presented by nature of
    indebtedness for a single issuer. The maturity dates represent
    the earliest and the latest maturity dates.                                                                  
|(2)Common
    stock, preferred stock, warrants, options, and equity interests
    are generally non-income producing and restricted.                                                                                                                                                                                                    
|(3)Public
    company.                                                                                                                                                                                                                                                                                                                  
|(4)Non-U.S. company
    or principal place of business outside the U.S.                                                                                                                                                                                                                                                                 
|(5)Non-registered
    investment company.                                                                                                                                                                                                                                                                                               
|(6)During
    the third quarter of 2004, Avborne, Inc. transferred certain
    equity securities in Avborne Heavy Maintenance, Inc. to its
    lenders in exchange for a reduction in contractual interest on
    the Companys loan to Avborne, Inc. Avborne, Inc. and
    Avborne Heavy Maintenance, Inc. remain affiliated companies.



The accompanying notes are an integral part of
these consolidated financial statements.


5



---



##### 



|                                                                                                                                                                                                                                                                       |                        |                                            |                                              |                    |        |        |  |   |        |        | 
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- | ---------------------- | ------------------------------------------ | -------------------------------------------- | ------------------ | ------ | ------ |  | - | ------ | ------ | 
|                                                                                                                                                                                                                                                                       |                        |                                            |                                              |                   
|                                                                                                                                                                                                                                                                       |                        |                                            |                                              | September 30, 2004
|                                                                                                                                                                                                                                                                       |                        |                                            |                                              |                   
|Private Finance                                                                                                                                                                                                                                                        |                        |                                            |                                              |                   
|Portfolio Company                                                                                                                                                                                                                                                      |                        |                                            |                                              | (unaudited)       
|(in thousands, except number of shares)                                                                                                                                                                                                                                |                        | Investment(1)(2)                           |                                              | Cost               |        | Value 
|                                                                                                                                                                                                                                                                       |                        |                                            |                                              |                    |        |       
|Fairchild Industrial Products                                                                                                                                                                                                                                          |                        | Loan (8.5%, Due 7/09)                      |                                              | $                  | 7,409  |        |  | $ | 7,409  |       
|                                                                                                                                                                                                                                                                       | Company                |                                            | Debt Securities (12.0%, Due 7/09)            |                    |        | 3,938  |  |   |        | 3,938  | 
|                                                                                                                                                                                                                                                                       | (Industrial Products)  |                                            | Common Stock (1,000 shares)                  |                    |        | 2,841  |  |   |        | 72     | 
|                                                                                                                                                                                                                                                                      
|Financial Pacific Company                                                                                                                                                                                                                                              |                        | Loan (17.4%, Due 2/12  8/12)              |                                              |                    | 68,124 |        |  |   | 68,124 |       
|                                                                                                                                                                                                                                                                       | (Financial Services)   |                                            | Preferred Stock (9,950 shares)               |                    |        | 9,950  |  |   |        | 9,950  | 
|                                                                                                                                                                                                                                                                       |                        |                                            | Common Stock (14,735 shares)                 |                    |        | 14,780 |  |   |        | 14,780 | 
|                                                                                                                                                                                                                                                                      
|ForeSite Towers, LLC                                                                                                                                                                                                                                                   |                        | Equity Interests                           |                                              |                    | 18,640 |        |  |   | 21,393 |       
|                                                                                                                                                                                                                                                                       | (Tower Leasing)        |                                            |                                              |                    |        |        |  |   |        |        | 
|                                                                                                                                                                                                                                                                      
|GAC Investments, Inc.                                                                                                                                                                                                                                                  |                        | Loan (10.0%, Due 9/10)                     |                                              |                    | 11,000 |        |  |   | 7,527  |       
|                                                                                                                                                                                                                                                                       | (Broadcasting & Cable) |                                            | Common Stock (99 shares)                     |                    |        | 43,350 |  |   |        |       | 
|                                                                                                                                                                                                                                                                       |                        |                                            | Guaranty ($800)                              |                    |        |        |  |   |        |        | 
|                                                                                                                                                                                                                                                                       |                        | Standby Letter of Credit ($200)            |                                              |                    |        |        |  |   |        |       
|                                                                                                                                                                                                                                                                      
|Global Communications, LLC                                                                                                                                                                                                                                             |                        | Loan (17.0%, Due 12/03)                    |                                              |                    | 2,755  |        |  |   | 2,755  |       
|                                                                                                                                                                                                                                                                       | (Business Services)    |                                            | Debt Securities (12.9%, Due
    9/02  9/05) |                    |        | 18,042 |  |   |        | 18,042 | 
|                                                                                                                                                                                                                                                                       |                        | Preferred Equity Interest                  |                                              |                    | 14,067 |        |  |   | 19,433 |       
|                                                                                                                                                                                                                                                                       |                        | Options                                    |                                              |                    | 1,639  |        |  |   | 2,242  |       
|                                                                                                                                                                                                                                                                      
|Gordian Group, Inc.                                                                                                                                                                                                                                                    |                        | Loan (15.0%, Due 6/07  3/09)              |                                              |                    | 11,120 |        |  |   | 11,120 |       
|                                                                                                                                                                                                                                                                       | (Business Services)    |                                            | Common Stock (1,000 shares)                  |                    |        | 3,742  |  |   |        | 2,960  | 
|                                                                                                                                                                                                                                                                      
|HealthASPex, Inc.                                                                                                                                                                                                                                                      |                        | Preferred Stock (1,000,000 shares)         |                                              |                    | 700    |        |  |   | 700    |       
|                                                                                                                                                                                                                                                                       | (Business Services)    |                                            | Preferred Stock (1,451,380 shares)           |                    |        | 4,900  |  |   |        | 1,752  | 
|                                                                                                                                                                                                                                                                       |                        | Common Stock (1,451,380 shares)            |                                              |                    | 4      |        |  |   |       |       
|                                                                                                                                                                                                                                                                      
|HMT, Inc.                                                                                                                                                                                                                                                              |                        | Debt Securities (13.3%, Due 12/08)         |                                              |                    | 9,280  |        |  |   | 9,280  |       
|                                                                                                                                                                                                                                                                       | (Energy Services)      |                                            | Preferred Stock (554,052 shares)             |                    |        | 2,488  |  |   |        | 2,488  | 
|                                                                                                                                                                                                                                                                       |                        | Common Stock (300,000 shares)              |                                              |                    | 3,000  |        |  |   | 4,625  |       
|                                                                                                                                                                                                                                                                       |                        | Warrants                                   |                                              |                    | 1,155  |        |  |   | 1,781  |       
|                                                                                                                                                                                                                                                                      
|Housecall Medical Resources, Inc.                                                                                                                                                                                                                                      |                        | Loan (16.7%, Due 11/07  11/09)            |                                              |                    | 15,516 |        |  |   | 15,516 |       
|                                                                                                                                                                                                                                                                       | (Healthcare Services)  |                                            | Common Stock (864,000 shares)                |                    |        | 86     |  |   |        | 36,652 | 
|                                                                                                                                                                                                                                                                      
|Impact Innovations Group, LLC                                                                                                                                                                                                                                          |                        | Equity Interests in Affiliate (See Note 3) |                                              |                    |       |        |  |   | 772    |       
|                                                                                                                                                                                                                                                                       | (Business Services)    |                                            |                                              |                    |        |        |  |   |        |        | 
|                                                                                                                                                                                                                                                                      
|Jakel, Inc.                                                                                                                                                                                                                                                            |                        | Loan (15.5%, Due 3/08)                     |                                              |                    | 3,873  |        |  |   | 3,873  |       
|                                                                                                                                                                                                                                                                       | (Industrial Products)  |                                            | Debt Securities (15.5%, Due 3/08)            |                    |        | 8,245  |  |   |        | 8,245  | 
|                                                                                                                                                                                                                                                                       |                        |                                            | Preferred Stock (6,460 shares)               |                    |        | 6,460  |  |   |        | 2,871  | 
|                                                                                                                                                                                                                                                                       |                        |                                            | Common Stock (158,061 shares)                |                    |        | 9,347  |  |   |        |       | 
|                                                                                                                                                                                                                                                                       |                        |                                            | Standby Letter of Credit ($1,222)            |                    |        |        |  |   |        |        | 
|                                                                                                                                                                                                                                                                      
|Legacy Partners Group, LLC                                                                                                                                                                                                                                             |                        | Loan (14.0%, Due 5/09)                     |                                              |                    | 4,034  |        |  |   | 4,034  |       
|                                                                                                                                                                                                                                                                       | (Financial Services)   |                                            | Debt Securities (18.0%, Due 5/09)            |                    |        | 2,832  |  |   |        | 2,832  | 
|                                                                                                                                                                                                                                                                       |                        | Equity Interests                           |                                              |                    | 2,286  |        |  |   | 2,286  |       
|                                                                                                                                                                                                                                                                      
|(1)Interest
    rates represent the weighted average annual stated interest rate
    on loans and debt securities, which are presented by nature of
    indebtedness for a single issuer. The maturity dates represent
    the earliest and the latest maturity dates.
|(2)Common
    stock, preferred stock, warrants, options, and equity interests
    are generally non-income producing and restricted.                                                                                                                                  
|(3)Public
    company.                                                                                                                                                                                                                                                
|(4)Non-U.S. company
    or principal place of business outside the U.S.                                                                                                                                                                                               
|(5)Non-registered
    investment company.                                                                                                                                                                                                                             



The accompanying notes are an integral part of
these consolidated financial statements.


6



---



##### 



|                                        |                       |                                    |                                    |                    |        |        |           |   |        |        | 
|--------------------------------------- | --------------------- | ---------------------------------- | ---------------------------------- | ------------------ | ------ | ------ | --------- | - | ------ | ------ | 
|                                        |                       |                                    |                                    |                   
|                                        |                       |                                    |                                    | September 30, 2004
|                                        |                       |                                    |                                    |                   
|Private Finance                         |                       |                                    |                                    |                   
|Portfolio Company                       |                       |                                    |                                    | (unaudited)       
|(in thousands, except number of shares) |                       | Investment(1)(2)                   |                                    | Cost               |        | Value 
|                                        |                       |                                    |                                    |                    |        |       
|Litterer Beteiligungs-GmbH(4)           |                       | Debt Securities (8.0%, Due 3/07)   |                                    | $                  | 1,452  |        |           | $ | 1,452  |       
|                                        | (Business Services)   |                                    | Equity Interest                    |                    |        | 1,159  |           |   |        | 245    | 
|                                       
|Mercury Air Centers, Inc.               |                       | Loan (13.8%, Due 4/09)             |                                    |                    | 53,508 |        |           |   | 53,508 |       
|                                        | (Business Services)   |                                    | Common Stock (50,000 shares)       |                    |        | 30,416 |           |   |        | 30,416 | 
|                                        |                       |                                    | Standby Letters of Credit ($1,322) |                    |        |        |           |   |        |        | 
|                                       
|MVL Group, Inc.                         |                       | Loan (12.2%, Due 10/07  7/09)     |                                    |                    | 16,591 |        |           |   | 16,591 |       
|                                        | (Business Services)   |                                    | Debt Securities (14.4%, Due 7/09)  |                    |        | 17,395 |           |   |        | 17,395 | 
|                                        |                       | Common Stock (648,661 shares)      |                                    |                    | 643    |        |           |   | 6,100  |       
|                                       
|Pennsylvania Avenue Investors, L.P. (5) |                       | Equity Interests                   |                                    |                    | 264    |        |           |   | 264    |       
|                                        | (Private Equity Fund) |                                    |                                    |                    |        |        |           |   |        |        | 
|                                       
|Powell Plant Farms, Inc.                |                       | Loan (15.0%, Due 1/05)             |                                    |                    | 23,142 |        |           |   | 23,142 |       
|                                        | (Consumer Products)   |                                    | Debt Securities (20.0%, Due 6/03)  |                    |        | 19,224 |           |   |        | 10,725 | 
|                                        |                       | Preferred Stock (1,483 shares)     |                                    |                    |       |        |           |   |       |       
|                                        |                       | Warrants                           |                                    |                    |       |        |           |   |       |       
|                                       
|Redox Brands, Inc.                      |                       | Loan (19.0%, Due 12/07)            |                                    |                    | 3,274  |        |           |   | 3,274  |       
|                                        | (Consumer Products)   |                                    | Debt Securities (16.0%, Due 3/08)  |                    |        | 10,562 |           |   |        | 10,562 | 
|                                        |                       | Preferred Stock (2,726,444 shares) |                                    |                    | 7,903  |        |           |   | 12,021 |       
|                                        |                       | Warrants                           |                                    |                    | 584    |        |           |   | 511    |       
|                                        |                       | Guaranty ($125)                    |                                    |                    |        |        |           |   |        |       
|                                       
|Staffing Partners Holding               |                       | Debt Securities (15.0%, Due 10/05) |                                    |                    | 6,084  |        |           |   | 6,084  |       
|                                        | Company, Inc.         |                                    | Preferred Stock (439,600 shares)   |                    |        | 4,968  |           |   |        | 2,863  | 
|                                        | (Business Services)   |                                    | Common Stock (69,773 shares)       |                    |        | 50     |           |   |        |       | 
|                                        |                       | Warrants                           |                                    |                    | 10     |        |           |   |       |       
|                                       
|Startec Global Communications           |                       | Loan (10.0%, Due 5/07  5/09)      |                                    |                    | 16,522 |        |           |   | 16,522 |       
|                                        | Corporation           |                                    | Common Stock (19,180,000 shares)   |                    |        | 37,255 |           |   |        | 11,548 | 
|                                        | (Telecommunications)  |                                    |                                    |                    |        |        |           |   |        |        | 
|                                       
|STS Operating, Inc.                     |                       | Preferred Stock (5,769,424 shares) |                                    |                    | 6,818  |        |           |   | 6,818  |       
|                                        | (Industrial Products) |                                    | Common Stock (3,000,000 shares)    |                    |        | 3,177  |           |   |        | 5,700  | 
|                                        |                       |                                    | Options                            |                    |        |       |           |   |        |       | 
|                                       
|Total
    companies more than 25% owned |                       | $                                  | 1,220,921                          |                    |        | $      | 1,159,078 |  
|                                       
|Companies 5% to 25% Owned              
|                                       
|Air Evac Lifeteam                       |                       | Debt Securities (12.4%, Due 7/10)  |                                    | $                  | 39,062 |        |           | $ | 39,062 |       
|                                        | (Healthcare)          |                                    | Equity Interests                   |                    |        | 3,000  |           |   |        | 3,000  | 
|                                       
|Aspen Pet Products, Inc.                |                       | Loans (19.0%, Due 6/08)            |                                    |                    | 18,499 |        |           |   | 18,499 |       
|                                        | (Consumer Products)   |                                    | Preferred Stock (2,655 shares)     |                    |        | 2,154  |           |   |        | 1,249  | 
|                                        |                       | Common Stock (1,400 shares)        |                                    |                    | 140    |        |           |   |       |       
|                                        |                       | Warrants                           |                                    |                    |       |        |           |   |       |       
|                                       
|Becker Underwood, Inc.                  |                       | Loan (14.5%, Due 8/12)             |                                    |                    | 22,886 |        |           |   | 22,886 |       
|                                        | (Industrial Products) |                                    | Common Stock (4,364 shares)        |                    |        | 5,000  |           |   |        | 5,000  | 
|                                       

|                                                                                                                                                                                                                                                                       |  |  |  |  |  |  |  |  |  | 
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- |  |  |  |  |  |  |  |  |  | 
|(1)Interest
    rates represent the weighted average annual stated interest rate
    on loans and debt securities, which are presented by nature of
    indebtedness for a single issuer. The maturity dates represent
    the earliest and the latest maturity dates.
|(2)Common
    stock, preferred stock, warrants, options, and equity interests
    are generally non-income producing and restricted.                                                                                                                                  
|(3)Public
    company.                                                                                                                                                                                                                                                
|(4)Non-U.S. company
    or principal place of business outside the U.S.                                                                                                                                                                                               
|(5)Non-registered
    investment company.                                                                                                                                                                                                                             



The accompanying notes are an integral part of
these consolidated financial statements.


7



---



##### 



|                                        |                       |                                          |                                        |                    |        |       |         |   |        |       | 
|--------------------------------------- | --------------------- | ---------------------------------------- | -------------------------------------- | ------------------ | ------ | ----- | ------- | - | ------ | ----- | 
|                                        |                       |                                          |                                        |                   
|                                        |                       |                                          |                                        | September 30, 2004
|                                        |                       |                                          |                                        |                   
|Private Finance                         |                       |                                          |                                        |                   
|Portfolio Company                       |                       |                                          |                                        | (unaudited)       
|(in thousands, except number of shares) |                       | Investment(1)(2)                         |                                        | Cost               |        | Value
|                                        |                       |                                          |                                        |                    |        |      
|Border Foods, Inc.                      |                       | Loan (13.0%, Due 12/10)                  |                                        | $                  | 3,000  |       |         | $ | 3,000  |      
|                                        | (Consumer Products)   |                                          | Debt Securities (13.0%, Due 12/10)     |                    |        | 9,495 |         |   |        | 9,495 | 
|                                        |                       | Preferred Stock (50,919 shares)          |                                        |                    | 2,000  |       |         |   | 2,000  |      
|                                        |                       | Common Stock (1,810 shares)              |                                        |                    | 45     |       |         |   |       |      
|                                        |                       | Warrants                                 |                                        |                    | 665    |       |         |   |       |      
|                                       
|The Debt Exchange Inc.                  |                       | Preferred Stock (921,875 shares)         |                                        |                    | 1,250  |       |         |   | 1,332  |      
|                                        | (Business Services)   |                                          |                                        |                    |        |       |         |   |        |       | 
|                                       
|EDM Consulting, LLC                     |                       | Debt Securities (8.0%, Due 1/05)         |                                        |                    | 1,800  |       |         |   | 210    |      
|                                        | (Business Services)   |                                          | Equity Interests                       |                    |        | 250   |         |   |        |      | 
|                                       
|GFC Holdings, LLC                       |                       | Warrants                                 |                                        |                    | 800    |       |         |   | 1,075  |      
|                                        | (Business Services)   |                                          |                                        |                    |        |       |         |   |        |       | 
|                                       
|Liberty-Pittsburgh Systems, Inc.        |                       | Debt Securities (17.0%, Due 4/06)        |                                        |                    | 3,972  |       |         |   | 1,419  |      
|                                        | (Business Services)   |                                          | Common Stock (123,929 shares)          |                    |        | 142   |         |   |        |      | 
|                                       
|MasterPlan, Inc.                        |                       | Loan (12.0%, Due on demand)              |                                        |                    | 959    |       |         |   | 1,204  |      
|                                        | (Business Services)   |                                          | Common Stock (1,350 shares)            |                    |        | 42    |         |   |        | 1,000 | 
|                                       
|MedBridge Healthcare, LLC               |                       | Loan (4.0%, Due 8/09  8/14)             |                                        |                    | 9,311  |       |         |   | 9,311  |      
|                                        | (Healthcare)          |                                          | Convertible Debenture (2.0%, Due 8/09) |                    |        | 2,737 |         |   |        | 2,250 | 
|                                       
|MortgageRamp, Inc.                      |                       | Common Stock (772,000 shares)            |                                        |                    | 3,860  |       |         |   | 1,320  |      
|                                        | (Business Services)   |                                          |                                        |                    |        |       |         |   |        |       | 
|                                       
|Nexcel Synthetics, LLC                  |                       | Loan (14.5%, Due 6/09)                   |                                        |                    | 10,118 |       |         |   | 10,118 |      
|                                        | (Consumer Products)   |                                          | Equity Interests                       |                    |        | 1,690 |         |   |        | 827   | 
|                                       
|Packaging Advantage Corporation         |                       | Debt Securities (18.5%, Due 4/08)        |                                        |                    | 14,731 |       |         |   | 14,731 |      
|                                        | (Business Services)   |                                          | Common Stock (232,168 shares)          |                    |        | 2,386 |         |   |        | 1,160 | 
|                                        |                       | Warrants                                 |                                        |                    | 963    |       |         |   | 468    |      
|                                       
|Pres Air Trol LLC                       |                       | Debt Securities (12.0%, Due 4/10)        |                                        |                    | 6,220  |       |         |   | 6,220  |      
|                                        | (Industrial Products) |                                          | Equity Interests                       |                    |        | 1,323 |         |   |        | 1,323 | 
|                                       
|Progressive International               |                       | Loan (16.0%, Due 12/09)                  |                                        |                    | 7,182  |       |         |   | 7,182  |      
|                                        | Corporation           |                                          | Preferred Stock (500 shares)           |                    |        | 500   |         |   |        | 729   | 
|                                        | (Consumer Products)   |                                          | Common Stock (197 shares)              |                    |        | 13    |         |   |        |      | 
|                                        |                       | Warrants                                 |                                        |                    |       |       |         |   |       |      
|                                       
|Total Foam, Inc.                        |                       | Debt Securities (12.0%, Due 6/96  1/99) |                                        |                    | 139    |       |         |   | 70     |      
|                                        | (Industrial Products) |                                          | Common Stock (164 shares)              |                    |        | 10    |         |   |        |      | 
|                                       
|Universal Environmental Services,       |                       | Loan (13.5%, Due 2/09)                   |                                        |                    | 12,096 |       |         |   | 12,096 |      
|                                        | LLC                   |                                          | Equity Interests                       |                    |        | 1,500 |         |   |        | 1,500 | 
|                                        | (Business Services)   |                                          |                                        |                    |        |       |         |   |        |       | 
|                                       
|Total
    companies 5% to 25% owned     |                       | $                                        | 189,940                                |                    |        | $     | 179,736 |  
|                                       
|Companies Less Than 5% Owned           
|                                       
|Alderwoods Group, Inc. (3)              |                       | Common Stock (357,568 shares)            |                                        | $                  | 5,006  |       |         | $ | 3,515  |      
|                                        | (Consumer Services)   |                                          |                                        |                    |        |       |         |   |        |       | 
|                                       

|                                                                                                                                                                                                                                                                       |  |  |  |  |  |  |  |  |  | 
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- |  |  |  |  |  |  |  |  |  | 
|(1)Interest
    rates represent the weighted average annual stated interest rate
    on loans and debt securities, which are presented by nature of
    indebtedness for a single issuer. The maturity dates represent
    the earliest and the latest maturity dates.
|(2)Common
    stock, preferred stock, warrants, options, and equity interests
    are generally non-income producing and restricted.                                                                                                                                  
|(3)Public
    company.                                                                                                                                                                                                                                                
|(4)Non-U.S. company
    or principal place of business outside the U.S.                                                                                                                                                                                               
|(5)Non-registered
    investment company.                                                                                                                                                                                                                             



The accompanying notes are an integral part of
these consolidated financial statements.


8



---



##### 



|                                               |                       |                                    |                                   |                    |        |       |  |   |        |       | 
|---------------------------------------------- | --------------------- | ---------------------------------- | --------------------------------- | ------------------ | ------ | ----- |  | - | ------ | ----- | 
|                                               |                       |                                    |                                   |                   
|                                               |                       |                                    |                                   | September 30, 2004
|                                               |                       |                                    |                                   |                   
|Private Finance                                |                       |                                    |                                   |                   
|Portfolio Company                              |                       |                                    |                                   | (unaudited)       
|(in thousands, except number of shares)        |                       | Investment(1)(2)                   |                                   | Cost               |        | Value
|                                               |                       |                                    |                                   |                    |        |      
|American Barbecue & Grill, Inc.                |                       | Warrants                           |                                   | $                  | 125    |       |  | $ |       |      
|                                               | (Retail)              |                                    |                                   |                    |        |       |  |   |        |       | 
|                                              
|Anthony, Inc.                                  |                       | Loan (12.1%, Due 9/11  9/12)      |                                   |                    | 14,428 |       |  |   | 14,428 |      
|                                               | (Industrial Products) |                                    |                                   |                    |        |       |  |   |        |       | 
|                                              
|Apogen Technologies, Inc.                      |                       | Debt Securities (13.0%, Due 1/10)  |                                   |                    | 4,981  |       |  |   | 4,981  |      
|                                               | (Business Services)   |                                    | Preferred Stock (270,008 shares)  |                    |        | 2,700 |  |   |        | 2,700 | 
|                                               |                       | Common Stock (1,256,452 shares)    |                                   |                    | 50     |       |  |   | 1,896  |      
|                                               |                       | Warrants                           |                                   |                    |       |       |  |   | 4      |      
|                                              
|Aviation Technologies, Inc.                    |                       | Loan (17.0%, Due 5/11)             |                                   |                    | 20,837 |       |  |   | 20,837 |      
|                                               | (Industrial Products) |                                    |                                   |                    |        |       |  |   |        |       | 
|                                              
|Benchmark Medical, Inc.                        |                       | Debt Securities (14.0%, Due 12/08) |                                   |                    | 13,618 |       |  |   | 13,618 |      
|                                               | (Healthcare Services) |                                    | Warrants                          |                    |        | 18    |  |   |        | 18    | 
|                                              
|Camden Partners Strategic Fund II,
    L.P.(5) |                       | Limited Partnership Interest       |                                   |                    | 2,463  |       |  |   | 2,985  |      
|                                               | (Private Equity Fund) |                                    |                                   |                    |        |       |  |   |        |       | 
|                                              
|Catterton Partners V, L.P.(5)                  |                       | Limited Partnership Interest       |                                   |                    | 873    |       |  |   | 721    |      
|                                               | (Private Equity Fund) |                                    |                                   |                    |        |       |  |   |        |       | 
|                                              
|CBS Personnel Holdings, Inc.                   |                       | Loan (15.5%, Due 12/09)            |                                   |                    | 19,900 |       |  |   | 19,900 |      
|                                               | (Business Services)   |                                    |                                   |                    |        |       |  |   |        |       | 
|                                              
|Colibri Holding Corporation                    |                       | Debt Securities (12.5%, Due 9/08)  |                                   |                    | 3,508  |       |  |   | 3,508  |      
|                                               | (Consumer Products)   |                                    | Preferred Stock (459 shares)      |                    |        | 523   |  |   |        | 736   | 
|                                               |                       | Common Stock (3,362 shares)        |                                   |                    | 1,250  |       |  |   | 609    |      
|                                               |                       | Warrants                           |                                   |                    | 290    |       |  |   | 141    |      
|                                              
|Community Education
    Centers, Inc.          |                       | Loan (15.0%, Due 12/10)            |                                   |                    | 22,972 |       |  |   | 22,972 |      
|                                               | (Education Services)  |                                    |                                   |                    |        |       |  |   |        |       | 
|                                              
|Component Hardware Group, Inc.                 |                       | Preferred Stock (18,000 shares)    |                                   |                    | 2,553  |       |  |   | 2,553  |      
|                                               | (Industrial Products) |                                    | Common Stock (2,000 shares)       |                    |        | 200   |  |   |        | 600   | 
|                                              
|Cooper Natural Resources, Inc.                 |                       | Debt Securities (15.0%, Due 7/04)  |                                   |                    | 1,500  |       |  |   | 1,500  |      
|                                               | (Industrial Products) |                                    | Preferred Stock (6,316 shares)    |                    |        | 1,427 |  |   |        |      | 
|                                               |                       | Warrants                           |                                   |                    | 832    |       |  |   |       |      
|                                              
|Coverall North America, Inc.                   |                       | Loan (20.0%, Due 7/08)             |                                   |                    | 15,918 |       |  |   | 17,159 |      
|                                               | (Business Services)   |                                    | Debt Securities (20.0%, Due 7/08) |                    |        | 8,229 |  |   |        | 8,871 | 
|                                              
|CTT Holdings                                   |                       | Loan (0%, Due 3/10)                |                                   |                    | 1,125  |       |  |   | 1,125  |      
|                                               | (Consumer Products)   |                                    |                                   |                    |        |       |  |   |        |       | 
|                                              
|DCS Business Services, Inc.                    |                       | Debt (15.8%, Due 7/10)             |                                   |                    | 21,349 |       |  |   | 21,349 |      
|                                               | (Business Services)   |                                    | Preferred Stock (478,816 shares)  |                    |        | 1,239 |  |   |        | 2,457 | 
|                                              
|Drilltec Patents & Technologies                |                       | Loan (10.0%, Due 8/06)             |                                   |                    | 10,918 |       |  |   |       |      
|                                               | Company, Inc.         |                                    | Debt Securities (14.5%, Due 8/06) |                    |        | 1,500 |  |   |        |      | 
|                                               | (Energy Services)     |                                    |                                   |                    |        |       |  |   |        |       | 
|                                              

|                                                                                                                                                                                                                                                                       |  |  |  |  |  |  |  |  |  | 
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- |  |  |  |  |  |  |  |  |  | 
|(1)Interest
    rates represent the weighted average annual stated interest rate
    on loans and debt securities, which are presented by nature of
    indebtedness for a single issuer. The maturity dates represent
    the earliest and the latest maturity dates.
|(2)Common
    stock, preferred stock, warrants, options, and equity interests
    are generally non-income producing and restricted.                                                                                                                                  
|(3)Public
    company.                                                                                                                                                                                                                                                
|(4)Non-U.S. company
    or principal place of business outside the U.S.                                                                                                                                                                                               
|(5)Non-registered
    investment company.                                                                                                                                                                                                                             



The accompanying notes are an integral part of
these consolidated financial statements.


9



---



##### 



|                                        |                        |                                            |                                          |                    |        |       |  |   |        |       | 
|--------------------------------------- | ---------------------- | ------------------------------------------ | ---------------------------------------- | ------------------ | ------ | ----- |  | - | ------ | ----- | 
|                                        |                        |                                            |                                          |                   
|                                        |                        |                                            |                                          | September 30, 2004
|                                        |                        |                                            |                                          |                   
|Private Finance                         |                        |                                            |                                          |                   
|Portfolio Company                       |                        |                                            |                                          | (unaudited)       
|(in thousands, except number of shares) |                        | Investment(1)(2)                           |                                          | Cost               |        | Value
|                                        |                        |                                            |                                          |                    |        |      
|eCentury Capital Partners, L.P.(5)      |                        | Limited Partnership Interest               |                                          | $                  | 4,375  |       |  | $ |       |      
|                                        | (Private Equity Fund)  |                                            |                                          |                    |        |       |  |   |        |       | 
|                                       
|Elexis Beta GmbH(4)                     |                        | Options                                    |                                          |                    | 426    |       |  |   | 50     |      
|                                        | (Industrial Products)  |                                            |                                          |                    |        |       |  |   |        |       | 
|                                       
|E-Talk Corporation                      |                        | Preferred Stock (133 shares)               |                                          |                    | 10,009 |       |  |   |       |      
|                                        | (Business Services)    |                                            | Common Stock (8,656 shares)              |                    |        |      |  |   |        |      | 
|                                       
|Frozen Specialties, Inc.                |                        | Debt Securities (16.0%, Due 5/08)          |                                          |                    | 10,535 |       |  |   | 10,535 |      
|                                        | (Consumer Products)    |                                            | Warrants                                 |                    |        | 435   |  |   |        | 435   | 
|                                       
|Garden Ridge Corporation
    (Retail)   |                        | Debt Securities (12.9%, Due 12/05  12/07) |                                          |                    | 27,271 |       |  |   | 16,500 |      
|                                        |                        |                                            | Preferred Stock (1,130 shares)           |                    |        | 1,130 |  |   |        |      | 
|                                        |                        | Common Stock (847,800 shares)              |                                          |                    | 613    |       |  |   |       |      
|                                       
|Geotrace Technologies, Inc.             |                        | Debt Securities (12.0%, Due 6/09)          |                                          |                    | 16,212 |       |  |   | 16,212 |      
|                                        | (Energy Services)      |                                            | Warrants                                 |                    |        | 2,350 |  |   |        | 2,350 | 
|                                       
|Ginsey Industries, Inc.                 |                        | Loans (12.5%, Due 3/06)                    |                                          |                    | 4,696  |       |  |   | 4,696  |      
|                                        | (Consumer Products)    |                                            | Convertible Debentures (12.5%, Due 3/06) |                    |        | 500   |  |   |        | 654   | 
|                                        |                        | Warrants                                   |                                          |                    |       |       |  |   | 1,646  |      
|                                       
|Grant Broadcasting Systems II           |                        | Warrants                                   |                                          |                    | 87     |       |  |   | 2,400  |      
|                                        | (Broadcasting & Cable) |                                            |                                          |                    |        |       |  |   |        |       | 
|                                       
|Griffith Energy, Inc.                   |                        | Loan (16.3%, Due 3/11)                     |                                          |                    | 16,926 |       |  |   | 16,926 |      
|                                        | (Energy Services)      |                                            |                                          |                    |        |       |  |   |        |       | 
|                                       
|Grotech Partners, VI, L.P.(5)           |                        | Limited Partnership Interest               |                                          |                    | 4,330  |       |  |   | 2,693  |      
|                                        | (Private Equity Fund)  |                                            |                                          |                    |        |       |  |   |        |       | 
|                                       
|Haven Eldercare of New England, LLC     |                        | Loans (9.3%, Due 10/05)                    |                                          |                    | 46,666 |       |  |   | 46,666 |      
|                                        | (Healthcare Services)  |                                            |                                          |                    |        |       |  |   |        |       | 
|                                       
|HealthMarket, Inc.                      |                        | Debt Securities (12.0%, Due 3/08)          |                                          |                    | 10,189 |       |  |   | 10,189 |      
|                                        | (Health Insurance)     |                                            | Warrants                                 |                    |        | 439   |  |   |        | 500   | 
|                                       
|The Hillman Companies, Inc.(3)          |                        | Loan (13.5%, Due 9/11)                     |                                          |                    | 42,556 |       |  |   | 42,556 |      
|                                        | (Consumer Products)    |                                            |                                          |                    |        |       |  |   |        |       | 
|                                       
|Homax Holdings, Inc.                    |                        | Debt (12.0%, Due 8/10)                     |                                          |                    | 10,079 |       |  |   | 10,079 |      
|                                        | (Consumer Products)    |                                            | Warrants                                 |                    |        | 927   |  |   |        | 1,159 | 
|                                       
|Icon International, Inc.                |                        | Common Stock (25,707 shares)               |                                          |                    | 76     |       |  |   |       |      
|                                        | (Business Services)    |                                            |                                          |                    |        |       |  |   |        |       | 
|                                       
|Interline Brands, Inc.                  |                        | Preferred Stock (199,313 shares)           |                                          |                    | 1,849  |       |  |   | 2,987  |      
|                                        | (Business Services)    |                                            | Common Stock (15,615 shares)             |                    |        | 139   |  |   |        |      | 
|                                        |                        | Warrants                                   |                                          |                    | 1,181  |       |  |   |       |      
|                                       
|International Fiber Corporation         |                        | Debt Securities (14.0%, Due 6/12)          |                                          |                    | 20,898 |       |  |   | 20,898 |      
|                                        | (Industrial Products)  |                                            | Preferred Stock (25,000 shares)          |                    |        | 2,500 |  |   |        | 2,500 | 
|                                       

|                                                                                                                                                                                                                                                                       |  |  |  |  |  |  |  |  |  | 
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- |  |  |  |  |  |  |  |  |  | 
|(1)Interest
    rates represent the weighted average annual stated interest rate
    on loans and debt securities, which are presented by nature of
    indebtedness for a single issuer. The maturity dates represent
    the earliest and the latest maturity dates.
|(2)Common
    stock, preferred stock, warrants, options, and equity interests
    are generally non-income producing and restricted.                                                                                                                                  
|(3)Public
    company.                                                                                                                                                                                                                                                
|(4)Non-U.S. company
    or principal place of business outside the U.S.                                                                                                                                                                                               
|(5)Non-registered
    investment company.                                                                                                                                                                                                                             



The accompanying notes are an integral part of
these consolidated financial statements.


10



---



##### 



|                                               |                        |                                           |                                 |                    |        |       |  |   |        |       | 
|---------------------------------------------- | ---------------------- | ----------------------------------------- | ------------------------------- | ------------------ | ------ | ----- |  | - | ------ | ----- | 
|                                               |                        |                                           |                                 |                   
|                                               |                        |                                           |                                 | September 30, 2004
|                                               |                        |                                           |                                 |                   
|Private Finance                                |                        |                                           |                                 |                   
|Portfolio Company                              |                        |                                           |                                 | (unaudited)       
|(in thousands, except number of shares)        |                        | Investment(1)(2)                          |                                 | Cost               |        | Value
|                                               |                        |                                           |                                 |                    |        |      
|Love Funding Corporation                       |                        | Preferred Stock (26,000 shares)           |                                 | $                  | 359    |       |  | $ | 442    |      
|                                               | (Financial Services)   |                                           |                                 |                    |        |       |  |   |        |       | 
|                                              
|MedAssets, Inc.                                |                        | Preferred Stock (227,865 shares)          |                                 |                    | 2,049  |       |  |   | 2,685  |      
|                                               | (Business Services)    |                                           | Warrants                        |                    |        | 136   |  |   |        | 30    | 
|                                              
|Mercury Air Group, Inc.(3)                     |                        | Warrants                                  |                                 |                    | 427    |       |  |   |       |      
|                                               | (Business Services)    |                                           |                                 |                    |        |       |  |   |        |       | 
|                                              
|Mid-Atlantic Venture Fund IV, L.P.
    (5)     |                        | Limited Partnership Interest              |                                 |                    | 5,850  |       |  |   | 2,710  |      
|                                               | (Private Equity Fund)  |                                           |                                 |                    |        |       |  |   |        |       | 
|                                              
|Midview Associates, L.P.                       |                        | Warrants                                  |                                 |                    |       |       |  |   |       |      
|                                               | (Housing)              |                                           |                                 |                    |        |       |  |   |        |       | 
|                                              
|Mogas Energy, LLC                              |                        | Debt Securities (9.5%, Due 3/12  4/12)   |                                 |                    | 16,153 |       |  |   | 16,153 |      
|                                               | (Energy Services)      |                                           | Warrants                        |                    |        | 1,774 |  |   |        | 2,300 | 
|                                              
|Nobel Learning Communities,                    |                        | Preferred Stock (1,214,356 shares)        |                                 |                    | 2,764  |       |  |   | 2,764  |      
|                                               | Inc.(3)                |                                           | Warrants                        |                    |        | 575   |  |   |        |      | 
|                                               | (Education)            |                                           |                                 |                    |        |       |  |   |        |       | 
|                                              
|Norstan Apparel Shops, Inc.
    (Retail)       |                        | Debt Securities (17.8%, Due 12/07  9/08) |                                 |                    | 12,960 |       |  |   | 6,298  |      
|                                               |                        |                                           | Common Stock (29,663 shares)    |                    |        | 4,750 |  |   |        |      | 
|                                               |                        | Warrants                                  |                                 |                    | 655    |       |  |   |       |      
|                                              
|Novak Biddle Venture Partners III,
    L.P.(5) |                        | Limited Partnership Interest              |                                 |                    | 979    |       |  |   | 723    |      
|                                               | (Private Equity Fund)  |                                           |                                 |                    |        |       |  |   |        |       | 
|                                              
|Oahu Waste Services, Inc.                      |                        | Debt Securities (12.0%, Due 9/08)         |                                 |                    | 8,691  |       |  |   | 8,691  |      
|                                               | (Business Services)    |                                           | Stock Appreciation Rights       |                    |        | 239   |  |   |        | 445   | 
|                                              
|Onyx Television GmbH (4)                       |                        | Preferred Units                           |                                 |                    | 201    |       |  |   |       |      
|                                               | (Broadcasting & Cable) |                                           |                                 |                    |        |       |  |   |        |       | 
|                                              
|Opinion Research Corporation(3)                |                        | Loan (13.1%, Due 11/07  5/09)            |                                 |                    | 21,449 |       |  |   | 21,449 |      
|                                               | (Business Services)    |                                           | Warrants                        |                    |        | 996   |  |   |        | 340   | 
|                                              
|Oriental Trading Company, Inc.                 |                        | Common Stock (13,820 shares)              |                                 |                    | 10     |       |  |   | 4,600  |      
|                                               | (Consumer Products)    |                                           |                                 |                    |        |       |  |   |        |       | 
|                                              
|Polaris Pool Systems, Inc.                     |                        | Debt Securities (12.0%, Due 9/07)         |                                 |                    | 11,250 |       |  |   | 11,250 |      
|                                               | (Consumer Products)    |                                           | Warrants                        |                    |        | 1,145 |  |   |        | 2,700 | 
|                                              
|RadioVisa Corporation                          |                        | Loan (15.5%, Due 12/08)                   |                                 |                    | 25,482 |       |  |   | 25,482 |      
|                                               | (Broadcasting & Cable) |                                           |                                 |                    |        |       |  |   |        |       | 
|                                              
|Resun Leasing, Inc.                            |                        | Loan (15.5%, Due 11/07)                   |                                 |                    | 30,000 |       |  |   | 30,000 |      
|                                               | (Business Services)    |                                           |                                 |                    |        |       |  |   |        |       | 
|                                              
|S.B. Restaurant Company                        |                        | Debt Securities (15.0%, Due 11/08)        |                                 |                    | 12,072 |       |  |   | 12,072 |      
|                                               | (Retail)               |                                           | Preferred Stock (54,125 shares) |                    |        | 135   |  |   |        | 135   | 
|                                               |                        | Warrants                                  |                                 |                    | 619    |       |  |   | 619    |      
|                                              

|                                                                                                                                                                                                                                                                       |  |  |  |  |  |  |  |  |  | 
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- |  |  |  |  |  |  |  |  |  | 
|(1)Interest
    rates represent the weighted average annual stated interest rate
    on loans and debt securities, which are presented by nature of
    indebtedness for a single issuer. The maturity dates represent
    the earliest and the latest maturity dates.
|(2)Common
    stock, preferred stock, warrants, options, and equity interests
    are generally non-income producing and restricted.                                                                                                                                  
|(3)Public
    company.                                                                                                                                                                                                                                                
|(4)Non-U.S. company
    or principal place of business outside the U.S.                                                                                                                                                                                               
|(5)Non-registered
    investment company.                                                                                                                                                                                                                             



The accompanying notes are an integral part of
these consolidated financial statements.


11



---



##### 



|                                        |                        |                                    |                                   |                    |        |       |  |   |        |       | 
|--------------------------------------- | ---------------------- | ---------------------------------- | --------------------------------- | ------------------ | ------ | ----- |  | - | ------ | ----- | 
|                                        |                        |                                    |                                   |                   
|                                        |                        |                                    |                                   | September 30, 2004
|                                        |                        |                                    |                                   |                   
|Private Finance                         |                        |                                    |                                   |                   
|Portfolio Company                       |                        |                                    |                                   | (unaudited)       
|(in thousands, except number of shares) |                        | Investment(1)(2)                   |                                   | Cost               |        | Value
|                                        |                        |                                    |                                   |                    |        |      
|SBBUT, LLC                              |                        | Equity Interests                   |                                   | $                  | 85     |       |  | $ | 85     |      
|                                        | (Consumer Products)    |                                    |                                   |                    |        |       |  |   |        |       | 
|                                       
|Soff-Cut Holdings, Inc.                 |                        | Preferred Stock (300 shares)       |                                   |                    | 300    |       |  |   |       |      
|                                        | (Industrial Products)  |                                    | Common Stock (2,000 shares)       |                    |        | 200   |  |   |        |      | 
|                                       
|SPP Mezzanine Fund, L.P.(5)             |                        | Limited Partnership Interest       |                                   |                    | 1,127  |       |  |   | 956    |      
|                                        | (Private Equity Fund)  |                                    |                                   |                    |        |       |  |   |        |       | 
|                                       
|SunStates Refrigerated Services,        |                        | Loans (9.2%, Due 9/97  1/05)      |                                   |                    | 4,466  |       |  |   | 1,500  |      
|                                        | Inc.                   |                                    | Debt Securities (10.0%, Due 1/03) |                    |        | 2,445 |  |   |        |      | 
|                                        | (Warehouse Facilities) |                                    |                                   |                    |        |       |  |   |        |       | 
|                                       
|Sydran Food Services II, L.P.           |                        | Debt Securities (25.0%, Due 12/08) |                                   |                    | 14,318 |       |  |   | 50     |      
|                                        | (Retail)               |                                    | Equity Interests                  |                    |        | 3,747 |  |   |        |      | 
|                                        |                        | Warrants                           |                                   |                    | 162    |       |  |   |       |      
|                                       
|United Site Services, Inc.              |                        | Loan (16.0%, Due 12/10)            |                                   |                    | 26,919 |       |  |   | 26,919 |      
|                                        | (Business Services)    |                                    |                                   |                    |        |       |  |   |        |       | 
|                                       
|Universal Tax Systems, Inc.             |                        | Loan (14.5%, Due 7/11)             |                                   |                    | 18,410 |       |  |   | 18,410 |      
|                                        | (Business Services)    |                                    |                                   |                    |        |       |  |   |        |       | 
|                                       
|Updata Venture Partners II,
    L.P.(5) |                        | Limited Partnership Interest       |                                   |                    | 3,375  |       |  |   | 3,376  |      
|                                        | (Private Equity Fund)  |                                    |                                   |                    |        |       |  |   |        |       | 
|                                       
|U.S. Security Holdings, Inc.            |                        | Warrants                           |                                   |                    | 826    |       |  |   | 2,000  |      
|                                        | (Business Services)    |                                    |                                   |                    |        |       |  |   |        |       | 
|                                       
|Venturehouse-Cibernet Investors, LLC    |                        | Equity Interest                    |                                   |                    | 34     |       |  |   | 34     |      
|                                        | (Business Services)    |                                    |                                   |                    |        |       |  |   |        |       | 
|                                       
|Venturehouse Group, LLC(5)              |                        | Equity Interest                    |                                   |                    | 598    |       |  |   | 3      |      
|                                        | (Private Equity Fund)  |                                    |                                   |                    |        |       |  |   |        |       | 
|                                       
|VICORP Restaurants, Inc.                |                        | Warrants                           |                                   |                    | 33     |       |  |   | 25     |      
|                                        | (Retail)               |                                    |                                   |                    |        |       |  |   |        |       | 
|                                       
|Walker Investment Fund II, LLLP(5)      |                        | Limited Partnership Interest       |                                   |                    | 1,330  |       |  |   | 357    |      
|                                        | (Private Equity Fund)  |                                    |                                   |                    |        |       |  |   |        |       | 
|                                       
|Wear Me Apparel Corporation             |                        | Debt Securities (15.0%, Due 12/10) |                                   |                    | 48,729 |       |  |   | 48,729 |      
|                                        | (Consumer Products)    |                                    | Warrants                          |                    |        | 1,219 |  |   |        | 2,300 | 
|                                       
|Weston Solutions, Inc.                  |                        | Loan (17.3%, Due 6/10)             |                                   |                    | 7,319  |       |  |   | 7,319  |      
|                                        | (Business Services)    |                                    |                                   |                    |        |       |  |   |        |       | 
|                                       
|Wilshire Restaurant Group, Inc.         |                        | Debt Securities (20.0%, Due 6/07)  |                                   |                    | 18,566 |       |  |   | 17,468 |      
|                                        | (Retail)               |                                    | Warrants                          |                    |        | 735   |  |   |        |      | 
|                                       
|Wilton Industries, Inc.                 |                        | Loan (19.3%, Due 6/08)             |                                   |                    | 7,200  |       |  |   | 7,200  |      
|                                        | (Consumer Products)    |                                    |                                   |                    |        |       |  |   |        |       | 
|                                       

|                                                                                                                                                                                                                                                                       |  |  |  |  |  |  |  |  |  | 
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- |  |  |  |  |  |  |  |  |  | 
|(1)Interest
    rates represent the weighted average annual stated interest rate
    on loans and debt securities, which are presented by nature of
    indebtedness for a single issuer. The maturity dates represent
    the earliest and the latest maturity dates.
|(2)Common
    stock, preferred stock, warrants, options, and equity interests
    are generally non-income producing and restricted.                                                                                                                                  
|(3)Public
    company.                                                                                                                                                                                                                                                
|(4)Non-U.S. company
    or principal place of business outside the U.S.                                                                                                                                                                                               
|(5)Non-registered
    investment company.                                                                                                                                                                                                                             



The accompanying notes are an integral part of
these consolidated financial statements.


12



---



##### 



|                                                    |                     |                           |                                    |                    |       |        |           |   |       |        | 
|--------------------------------------------------- | ------------------- | ------------------------- | ---------------------------------- | ------------------ | ----- | ------ | --------- | - | ----- | ------ | 
|                                                    |                     |                           |                                    |                   
|                                                    |                     |                           |                                    | September 30, 2004
|                                                    |                     |                           |                                    |                   
|Private Finance                                     |                     |                           |                                    |                   
|Portfolio Company                                   |                     |                           |                                    | (unaudited)       
|(in thousands, except number of shares)             |                     | Investment(1)(2)          |                                    | Cost               |       | Value 
|                                                    |                     |                           |                                    |                    |       |       
|Woodstream Corporation                              |                     | Loan (14.0%, Due 11/10)   |                                    | $                  | 255   |        |           | $ | 255   |       
|                                                    | (Consumer Products) |                           | Debt Securities (14.0%, Due 11/10) |                    |       | 16,826 |           |   |       | 16,826 | 
|                                                    |                     | Common Stock (180 shares) |                                    |                    | 1,800 |        |           |   | 2,450 |       
|                                                    |                     | Warrants                  |                                    |                    | 587   |        |           |   | 800   |       
|                                                   
|Other companies                                     |                     | Other investments         |                                    |                    | 1,397 |        |           |   | 1,407 |       
|                                                    |                     | Guaranty ($304)           |                                    |                    |       |        |           |   |       |       
|                                                   
|Total
    companies less than 5% owned              |                     | $                         | 762,454                            |                    |       | $      | 692,171   |  
|                                                   
|Total
    private finance (119 portfolio companies) |                     | $                         | 2,173,315                          |                    |       | $      | 2,030,985 |  
|                                                   

|                                                                                                                                                                                                                                                                       |  |  |  |  |  |  |  |  |  | 
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- |  |  |  |  |  |  |  |  |  | 
|(1)Interest
    rates represent the weighted average annual stated interest rate
    on loans and debt securities, which are presented by nature of
    indebtedness for a single issuer. The maturity dates represent
    the earliest and the latest maturity dates.
|(2)Common
    stock, preferred stock, warrants, options, and equity interests
    are generally non-income producing and restricted.                                                                                                                                  
|(3)Public
    company.                                                                                                                                                                                                                                                
|(4)Non-U.S. company
    or principal place of business outside the U.S.                                                                                                                                                                                               
|(5)Non-registered
    investment company.                                                                                                                                                                                                                             



The accompanying notes are an integral part of
these consolidated financial statements.


13



---



##### 



|                                          |                                                                                 |                                                                |  |      |   |                    |   |        |           |  |   |        |         |  |   |        |         | 
|----------------------------------------- | ------------------------------------------------------------------------------- | -------------------------------------------------------------- |  | ---- | - | ------------------ | - | ------ | --------- |  | - | ------ | ------- |  | - | ------ | ------- | 
|                                          |                                                                                 |                                                                |  |      |   |                   
|                                          |                                                                                 |                                                                |  |      |   | September 30, 2004
|                                          |                                                                                 |                                                                |  |      |   |                   
|                                          |                                                                                 |                                                                |  |      |   |                   
|                                          |                                                                                 | Stated                                                         |  |      |   | (unaudited)       
|                                          |                                                                                 | Interest                                                       |  | Face |   | Cost               |   | Value 
|                                          |                                                                                 |                                                                |  |      |   |                    |   |       
|Commercial Real Estate Finance            |                                                                                 |                                                                |  |      |   |                    |   |        |           |  |   |        |         |  |   |       
|(in thousands)                            |                                                                                 |                                                                |  |      |   |                    |   |        |           |  |   |        |         |  |   |       
|Commercial Mortgage-Backed
    Securities |                                                                                 |                                                                |  |      |   |                    |   |        |           |  |   |        |         |  |   |       
|                                          | Mortgage Capital Funding, Series 1998-MC3                                       |                                                                |  | 5.5  | % |                    | $ | 53,100 |           |  | $ | 35,390 |         |  | $ | 28,721 |        
|                                          | Morgan Stanley Capital I, Series 1999-RM1                                       |                                                                |  | 6.4  | % |                    |   | 28,168 |           |  |   | 9,865  |         |  |   | 9,878  |        
|                                          | COMM 1999-1                                                                     |                                                                |  | 5.7  | % |                    |   | 56,477 |           |  |   | 28,009 |         |  |   | 26,588 |        
|                                          | Morgan Stanley Capital I, Series 1999-FNV1                                      |                                                                |  | 6.1  | % |                    |   | 35,737 |           |  |   | 21,217 |         |  |   | 17,463 |        
|                                          | DLJ Commercial Mortgage Trust 1999-CG2                                          |                                                                |  | 6.1  | % |                    |   | 43,131 |           |  |   | 13,966 |         |  |   | 14,141 |        
|                                          | Commercial Mortgage Acceptance Corp.,
    Series 1999-C1                        |                                                                |  | 6.8  | % |                    |   | 18,643 |           |  |   | 4,900  |         |  |   | 7,081  |        
|                                          | LB Commercial Mortgage Trust, Series 1999-C2                                    |                                                                |  | 6.7  | % |                    |   | 11,603 |           |  |   | 1,636  |         |  |   | 1,765  |        
|                                          | Chase Commercial Mortgage Securities Corp.,
    Series 1999-2                   |                                                                |  | 6.5  | % |                    |   | 20,950 |           |  |   | 5,360  |         |  |   | 7,761  |        
|                                          | FUNB CMT, Series 1999-C4                                                        |                                                                |  | 6.5  | % |                    |   | 21,125 |           |  |   | 7,947  |         |  |   | 7,078  |        
|                                          | Heller Financial, HFCMC Series 2000 PH-1                                        |                                                                |  | 6.6  | % |                    |   | 23,665 |           |  |   | 9,192  |         |  |   | 8,652  |        
|                                          | SBMS VII, Inc., Series 2000-NL1                                                 |                                                                |  | 7.2  | % |                    |   | 8,289  |           |  |   | 4,607  |         |  |   | 3,589  |        
|                                          | DLJ Commercial Mortgage Trust,
    Series 2000-CF1                              |                                                                |  | 7.0  | % |                    |   | 26,708 |           |  |   | 11,223 |         |  |   | 10,092 |        
|                                          | Deutsche Bank Alex. Brown, Series Comm
    2000-C1                              |                                                                |  | 6.9  | % |                    |   | 14,987 |           |  |   | 3,949  |         |  |   | 2,837  |        
|                                          | LB-UBS Commercial Mortgage Trust,
    Series 2000-C4                            |                                                                |  | 6.9  | % |                    |   | 16,665 |           |  |   | 3,520  |         |  |   | 3,520  |        
|                                          | Credit Suisse First Boston Mortgage Securities
    Corp., Series 2001-CK1       |                                                                |  | 5.9  | % |                    |   | 23,502 |           |  |   | 9,487  |         |  |   | 10,504 |        
|                                          | JP Morgan-CIBC-Deutsche 2001                                                    |                                                                |  | 5.8  | % |                    |   | 25,398 |           |  |   | 7,252  |         |  |   | 6,320  |        
|                                          | Lehman Brothers-UBS Warburg 2001-C2                                             |                                                                |  | 6.4  | % |                    |   | 23,426 |           |  |   | 6,777  |         |  |   | 9,244  |        
|                                          | SBMS VII, Inc., Series 2001-C1                                                  |                                                                |  | 6.1  | % |                    |   | 19,612 |           |  |   | 3,459  |         |  |   | 1,991  |        
|                                          | GE Capital Commercial Mortgage Securities Corp.,
    Series 2001-2              |                                                                |  | 6.1  | % |                    |   | 21,799 |           |  |   | 7,067  |         |  |   | 7,088  |        
|                                          | Credit Suisse First Boston Mortgage Securities
    Corp.,
    Series 2001-CKN5  |                                                                |  | 5.2  | % |                    |   | 22,292 |           |  |   | 6,898  |         |  |   | 6,970  |        
|                                          | JP Morgan Chase Commercial Mortgage Securities
    Corp.,
    Series 2001-C1    |                                                                |  | 5.6  | % |                    |   | 25,050 |           |  |   | 6,069  |         |  |   | 6,083  |        
|                                          | SBMS VII, Inc., Series 2001-C2                                                  |                                                                |  | 6.2  | % |                    |   | 23,217 |           |  |   | 7,118  |         |  |   | 7,186  |        
|                                          | FUNB CMT, Series 2002-C1                                                        |                                                                |  | 6.0  | % |                    |   | 21,987 |           |  |   | 9,059  |         |  |   | 8,569  |        
|                                          | GE Capital Commercial Mortgage Corp.,
    Series 2002-1                         |                                                                |  | 6.2  | % |                    |   | 40,325 |           |  |   | 17,541 |         |  |   | 20,466 |        
|                                          | GMAC Commercial Mortgage Securities, Inc.,
    Series 2002-C2                   |                                                                |  | 5.8  | % |                    |   | 27,926 |           |  |   | 10,968 |         |  |   | 11,635 |        
|                                          | GE Capital Commercial Mortgage Corp.,
    Series 2002-3                         |                                                                |  | 5.1  | % |                    |   | 38,047 |           |  |   | 13,384 |         |  |   | 14,324 |        
|                                          | Morgan Stanley Dean Witter Capital I Trust
    2002-IQ3                         |                                                                |  | 6.0  | % |                    |   | 15,919 |           |  |   | 3,770  |         |  |   | 4,021  |        
|                                          | LB-UBS Commercial Mortgage Trust 2003-C1                                        |                                                                |  | 4.6  | % |                    |   | 37,896 |           |  |   | 12,406 |         |  |   | 12,869 |        
|                                          | GS Mortgage Securities Corporation II
    Series 2003-C1                        |                                                                |  | 4.7  | % |                    |   | 26,189 |           |  |   | 9,264  |         |  |   | 9,441  |        
|                                          | J.P. Morgan Chase Commercial Mortgage Securities
    Corp.,
    Series 2003-ML1 |                                                                |  | 4.9  | % |                    |   | 2,947  |           |  |   | 2,324  |         |  |   | 2,558  |        
|                                          | Credit Suisse First Boston Mortgage Securities
    Corp., Series 2003-CK2       |                                                                |  | 4.9  | % |                    |   | 56,680 |           |  |   | 28,597 |         |  |   | 30,499 |        
|                                          | COMM 2003-LNB1                                                                  |                                                                |  | 4.4  | % |                    |   | 24,324 |           |  |   | 5,757  |         |  |   | 5,808  |        
|                                          | Wachovia Bank Commercial Mortgage Trust,
    Series 2003-C5                     |                                                                |  | 4.3  | % |                    |   | 48,202 |           |  |   | 17,815 |         |  |   | 18,301 |        
|                                          | GE Commercial Mortgage Corporation,
    Series 2003-C1                          |                                                                |  | 5.1  | % |                    |   | 9,389  |           |  |   | 7,599  |         |  |   | 8,523  |        
|                                          | GMAC Commercial Mortgage Securities, Inc.,
    Series 2003-C2                   |                                                                |  | 5.5  | % |                    |   | 56,441 |           |  |   | 25,413 |         |  |   | 27,793 |        
|                                          | GMAC Commercial Mortgage Securities, Inc.,
    Series 2003-C3                   |                                                                |  | 5.3  | % |                    |   | 6,535  |           |  |   | 5,481  |         |  |   | 6,053  |        
|                                          | LB-UBS Commercial Mortgage Trust 2003-C8                                        |                                                                |  | 5.4  | % |                    |   | 12,999 |           |  |   | 10,460 |         |  |   | 11,471 |        
|                                          | Wachovia Bank Commercial Mortgage Trust, Series
    2003-C9                     |                                                                |  | 5.3  | % |                    |   | 46,793 |           |  |   | 22,736 |         |  |   | 23,863 |        
|                                          | COMM 2004-LNB2                                                                  |                                                                |  | 5.0  | % |                    |   | 4,770  |           |  |   | 3,502  |         |  |   | 3,670  |        
|                                          | GE Commercial Mortgage Corporation, Series 2004-C1                              |                                                                |  | 5.0  | % |                    |   | 48,049 |           |  |   | 21,963 |         |  |   | 22,829 |        
|                                          | LB-UBS Commercial Mortgage Trust 2004-C1                                        |                                                                |  | 4.9  | % |                    |   | 35,400 |           |  |   | 14,886 |         |  |   | 15,466 |        
|                                          | MezzCapp Commercial Mortgage Trust,
    Series 2004-C1                          |                                                                |  | 10.0 | % |                    |   | 1,990  |           |  |   | 819    |         |  |   | 819    |        
|                                          | Wachovia Bank Commercial Mortgage Trust, Series
    2004-C10                    |                                                                |  | 5.0  | % |                    |   | 7,110  |           |  |   | 5,335  |         |  |   | 5,677  |        
|                                          | COMM 2004-LNB3                                                                  |                                                                |  | 5.3  | % |                    |   | 46,785 |           |  |   | 25,347 |         |  |   | 26,398 |        
|                                          | GE Commercial Mortgage Corporation,
    Series 2004-C2                          |                                                                |  | 5.3  | % |                    |   | 14,287 |           |  |   | 12,286 |         |  |   | 12,696 |        
|                                          | GMAC Commercial Mortgage Securities, Inc.
    Series 2004-C1                    |                                                                |  | 5.3  | % |                    |   | 40,671 |           |  |   | 25,533 |         |  |   | 26,005 |        
|                                          | GS Mortgage Securities Corporation II,
    Series 2004-C1                       |                                                                |  | 4.6  | % |                    |   | 39,613 |           |  |   | 24,482 |         |  |   | 24,909 |        
|                                          | J.P. Morgan Chase Commercial Mortgage Securities
    Corp., Series 2004-LN2     |                                                                |  | 5.3  | % |                    |   | 46,630 |           |  |   | 22,039 |         |  |   | 22,163 |        
|                                          | LB-UBS Commercial Mortgage Trust 2004-C6                                        |                                                                |  | 5.2  | % |                    |   | 6,597  |           |  |   | 5,234  |         |  |   | 5,257  |        
|                                          | Wachovia Bank Commercial Mortgage Trust,
    Series 2004-C14                    |                                                                |  | 5.3  | % |                    |   | 38,400 |           |  |   | 17,687 |         |  |   | 17,824 |        
|                                         
|                                          |                                                                                 | Total commercial mortgage-backed securities
    (50 issuances) |  |      |   |                    |   | $      | 1,366,445 |  |   | $      | 596,595 |  |   | $      | 604,459 | 
|                                         



The accompanying notes are an integral part of
these consolidated financial statements.


14



---



##### 



|                                           |                                               |                                                         |   |        |         |  |   |        |         | 
|------------------------------------------ | --------------------------------------------- | ------------------------------------------------------- | - | ------ | ------- |  | - | ------ | ------- | 
|                                           |                                               |                                                        
|                                           |                                               | September 30, 2004                                     
|                                           |                                               |                                                        
|                                           |                                               |                                                        
|                                           |                                               | (unaudited)                                            
|                                           |                                               | Cost                                                    |   | Value 
|                                           |                                               |                                                         |   |       
|Commercial Real Estate Finance             |                                               |                                                         |   |        |         |  |   |       
|(in thousands, except number of
    loans) |                                               |                                                         |   |        |         |  |   |       
|Collateralized Debt Obligations            |                                               |                                                         |   |        |         |  |   |       
|                                           | Crest 2001-1,
    Ltd.(4)                     |                                                         | $ | 22,253 |         |  | $ | 22,253 |        
|                                           | Crest 2002-1,
    Ltd.(4)                     |                                                         |   | 24,410 |         |  |   | 24,410 |        
|                                           | Crest 2002-IG,
    Ltd.(4)                    |                                                         |   | 4,251  |         |  |   | 4,251  |        
|                                           | Crest Clarendon Street
    2002-1, Ltd.(4)    |                                                         |   | 981    |         |  |   | 981    |        
|                                           | Crest 2003-1,
    Ltd.(4)                     |                                                         |   | 93,201 |         |  |   | 93,201 |        
|                                           | Crest 2003-2,
    Ltd.(4)                     |                                                         |   | 26,998 |         |  |   | 26,998 |        
|                                           | TIAA Real Estate CDO
    2003-1, Ltd.(4)      |                                                         |   | 1,883  |         |  |   | 1,959  |        
|                                           | Crest Exeter Street Solar
    2004-1, Ltd.(4) |                                                         |   | 3,789  |         |  |   | 3,792  |        
|                                          
|                                           |                                               | Total
    collateralized debt obligations (8 issuances) |   | $      | 177,766 |  |   | $      | 177,845 | 
|                                          

|                                      |                                      |                  |               |           |   |  |    |    |       |   |           |         |       |   |           |         | 
|------------------------------------- | ------------------------------------ | ---------------- | ------------- | --------- | - |  | -- | -- | ----- | - | --------- | ------- | ----- | - | --------- | ------- | 
|                                      |                                      | Interest         |               | Number of |   |  |    |   
|                                      |                                      | Rate Ranges      |               | Loans     |   |  |    |   
|                                      |                                      |                  |               |           |   |  |    |   
|Commercial Mortgage Loans             |                                      |                  |               |           |   |  |    |    |       |   |           |         |       |   |           |        
|                                      |                                      |                  | Up to 6.99%   |           |   |  | 14 |    |       | $ | 27,512    |         |       | $ | 25,995    |        
|                                      |                                      |                  | 7.00%8.99%   |           |   |  | 37 |    |       |   | 75,595    |         |       |   | 75,495    |        
|                                      |                                      |                  | 9.00%10.99%  |           |   |  | 7  |    |       |   | 26,900    |         |       |   | 26,539    |        
|                                      |                                      |                  | 11.00%12.99% |           |   |  | 5  |    |       |   | 9,745     |         |       |   | 8,799     |        
|                                      |                                      |                  | 13.00%14.99% |           |   |  | 2  |    |       |   | 4,149     |         |       |   | 2,585     |        
|                                      |                                      | 15.00% and above |               |           | 1 |  |    |    | 3,750 |   |           |         | 3,750 |  
|                                     
|                                      | Total commercial mortgage loans      |                  |               |           |   |  |    | 66 |       |   | $         | 147,651 |       |   | $         | 143,163 | 
|                                     
|Real Estate Owned                     |                                      |                  |               |           |   |  |    |    |       |   | 16,075    |         |       |   | 14,637    |        
|                                     
|Equity Interests(Guarantees  $2,731) |                                      |                  |               |           |   |  |    |    |       |   | 9,306     |         |       |   | 8,920     |        
|                                     
|                                      | Total commercial real estate finance |                  |               |           |   |  |    |    |       |   | $         | 947,393 |       |   | $         | 949,024 | 
|                                     
|Total portfolio                       |                                      |                  |               |           |   |  |    |    |       | $ | 3,120,708 |         |       | $ | 2,980,009 |        
|                                     

|                                                                                                                                                                                                                                                                       |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  | 
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  | 
|(1)Interest
    rates represent the weighted average annual stated interest rate
    on loans and debt securities, which are presented by nature of
    indebtedness for a single issuer. The maturity dates represent
    the earliest and the latest maturity dates.
|(2)Common
    stock, preferred stock, warrants, options, and equity interests
    are generally non-income producing and restricted.                                                                                                                                  
|(3)Public
    company.                                                                                                                                                                                                                                                
|(4)Non-U.S. company
    or principal place of business outside the U.S.                                                                                                                                                                                               
|(5)Non-registered
    investment company.                                                                                                                                                                                                                             



The accompanying notes are an integral part of
these consolidated financial statements.


15



---



##### 



ALLIED CAPITAL CORPORATION AND
SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS

(Information at and for the three and
nine


months ended September 30, 2004 and 2003,
is unaudited)


Note 1. Organization

Allied Capital Corporation, a Maryland
corporation, is a closed-end management investment company that
has elected to be regulated as a business development company
(BDC) under the Investment Company Act of 1940
(1940 Act). Allied Capital Corporation
(ACC) has a subsidiary that has also elected to be
regulated as a BDC, Allied Investment Corporation (Allied
Investment), which is licensed under the Small Business
Investment Act of 1958 as a Small Business Investment Company
(SBIC). In addition, ACC has a real estate
investment trust subsidiary, Allied Capital REIT, Inc.
(Allied REIT), and several subsidiaries which are
single member limited liability companies established primarily
to hold real estate properties. ACC also has a subsidiary, A.C.
Corporation (AC Corp), that together with its
subsidiaries provides diligence and structuring services on
private finance and commercial real estate finance transactions,
as well as structuring, transaction, management, and advisory
services to the Company, its portfolio companies and other third
parties.

Allied Capital Corporation and its subsidiaries,
collectively, are referred to as the Company.

In accordance with specific rules prescribed for
investment companies, subsidiaries hold investments on behalf of
the Company or provide substantial services to the Company.
Portfolio investments are held for purposes of deriving
investment income and future capital gains. The Company
consolidates the results of its subsidiaries for financial
reporting purposes. The financial results of the Companys
portfolio investments are not consolidated in the Companys
financial statements.

The investment objective of the Company is to
achieve current income and capital gains. In order to achieve
this objective, the Company generally invests in companies in a
variety of industries, non-investment grade commercial
mortgage-backed securities (CMBS) and collateralized
debt obligation bonds and preferred shares (CDOs).

Note 2. Summary of Significant Accounting
Policies

Basis of
Presentation

The consolidated financial statements include the
accounts of ACC and its subsidiaries. All intercompany accounts
and transactions have been eliminated in consolidation. Certain
reclassifications have been made to the 2003 balances to conform
with the 2004 financial statement presentation.

The accompanying unaudited consolidated financial
statements of the Company have been prepared in accordance with
U.S. generally accepted accounting principles (GAAP)
for interim financial information. Accordingly, they do not
include all of the information and footnotes required by GAAP
for complete consolidated financial statements. In the opinion
of management, the unaudited consolidated financial results of
the Company included herein contain all adjustments (consisting
of only normal recurring accruals) necessary to present fairly
the financial position of the Company as of September 30,
2004, the results of operations for the three and nine months
ended September 30, 2004 and 2003, and changes in net
assets and cash flows for the nine months ended
September 30, 2004 and 2003. The results of operations for
the three and nine months ended September 30, 2004, are not
necessarily indicative of the operating results to be expected
for the full year.

16



---



##### 



ALLIED CAPITAL CORPORATION AND
SUBSIDIARIES


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)



Note 2. Summary of Significant Accounting
Policies, continued


The private finance portfolio and the interest
and related portfolio income and net realized gains (losses) on
the private finance portfolio are presented in three categories:
companies more than 25% owned, which represent portfolio
companies where the Company directly or indirectly owns more
than 25% of the outstanding voting securities of such portfolio
company and, therefore, are deemed controlled by the Company
under the 1940 Act; companies owned 5% to 25%, which represent
portfolio companies where the Company directly or indirectly
owns 5% to 25% of the outstanding voting securities of such
portfolio company or where the Company holds one or more seats
on the portfolio companys board of directors and,
therefore, are deemed to be an affiliated person of the Company
under the 1940 Act; and companies less than 5% owned which
represent portfolio companies where the Company directly or
indirectly owns less than 5% of the outstanding voting
securities of such portfolio company and where the Company has
no other affiliations with such portfolio company. The interest
and related portfolio income and net realized gains (losses)
from the commercial real estate finance portfolio and other
sources are included in the companies less than 5% owned
category on the consolidated statement of operations.



| |                                       
| | --------------------------------------
| | Valuation Of Portfolio
    Investments

The Company, as a BDC, invests in illiquid
securities including debt and equity securities of companies,
non-investment grade CMBS, and the bonds and preferred shares of
CDOs. The Companys investments are generally subject to
restrictions on resale and generally have no established trading
market. The Company values substantially all of its investments
at fair value as determined in good faith by the Board of
Directors in accordance with the Companys valuation
policy. The Company determines fair value to be the amount for
which an investment could be exchanged in an orderly disposition
over a reasonable period of time between willing parties other
than in a forced or liquidation sale. The Companys
valuation policy considers the fact that no ready market exists
for substantially all of the securities in which it invests. The
Companys valuation policy is intended to provide a
consistent basis for determining the fair value of the
portfolio. The Company will record unrealized depreciation on
investments when it believes that an investment has become
impaired, including where collection of a loan or realization of
an equity security is doubtful, or when the enterprise value of
the portfolio company does not currently support the cost of the
Companys debt or equity investments. Enterprise value
means the entire value of the company to a potential buyer,
including the sum of the values of debt and equity securities
used to capitalize the enterprise at a point in time. The
Company will record unrealized appreciation if it believes that
the underlying portfolio company has appreciated in value and,
therefore, the Companys equity security has also
appreciated in value. The value of investments in publicly
traded securities is determined using quoted market prices
discounted for restrictions on resale, if any.



| |                          
| | -------------------------
| | Loans and Debt Securities

For loans and debt securities, fair value
generally approximates cost unless the borrowers
enterprise value, overall financial condition or other factors
lead to a determination of fair value at a different amount.

When the Company receives nominal cost warrants
or free equity securities (nominal cost equity), the
Company allocates its cost basis in its investment between its
debt securities and its nominal cost equity at the time of
origination. At that time, the original issue discount basis of
the

17



---



##### 



ALLIED CAPITAL CORPORATION AND
SUBSIDIARIES


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

Note 2. Summary of Significant Accounting
Policies, continued

nominal cost equity is recorded by increasing the
cost basis in the equity and decreasing the cost basis in the
related debt securities.

Interest income is recorded on an accrual basis
to the extent that such amounts are expected to be collected.
For loans and debt securities with contractual payment-in-kind
interest, which represents contractual interest accrued and
added to the loan balance that generally becomes due at
maturity, the Company will not accrue payment-in-kind interest
if the portfolio company valuation indicates that the
payment-in-kind interest is not collectible. Interest on loans
and debt securities is not accrued if the Company has doubt
about interest collection. Loans in workout status classified as
Grade 4 or 5 assets under the Companys internal
grading system do not accrue interest. In addition, interest may
not accrue on loans or debt securities to portfolio companies
that are more than 50% owned by the Company depending on such
companys capital requirements. Loan origination fees,
original issue discount, and market discount are capitalized and
then amortized into interest income using the effective interest
method. Upon the prepayment of a loan or debt security, any
unamortized loan origination fees are recorded as interest
income and any unamortized original issue discount or market
discount is recorded as a realized gain. Prepayment premiums are
recorded on loans and debt securities when received.

The weighted average yield on loans and debt
securities is computed as the (a) annual stated interest
rate plus the annual amortization of loan origination fees,
original issue discount, and market discount on accruing loans
and debt securities, divided by (b) total loans and debt
securities at value. The weighted average yield is computed as
of the balance sheet date.



| |                  
| | -----------------
| | Equity Securities

The Companys equity interests in portfolio
companies for which there is no liquid public market are valued
at fair value based on the enterprise value of the portfolio
company, which is determined using various factors, including
cash flow from operations of the portfolio company and other
pertinent factors, such as recent offers to purchase a portfolio
company, recent transactions involving the purchase or sale of
the portfolio companys equity securities, or other
liquidation events. The determined equity values are generally
discounted to account for restrictions on resale and minority
ownership positions.

The value of the Companys equity interests
in public companies for which market quotations are readily
available is based on the closing public market price on the
balance sheet date. Securities that carry certain restrictions
on sale are typically valued at a discount from the public
market value of the security.

Dividend income is recorded on preferred equity
securities on an accrual basis to the extent that such amounts
are expected to be collected, and on common equity securities on
the record date for private companies or on the ex-dividend date
for publicly traded companies.



| |                                                                                                   
| | --------------------------------------------------------------------------------------------------
| | Commercial Mortgage-Backed Securities
    (CMBS) and Collateralized Debt Obligations
    (CDO)

CMBS bonds and CDO bonds and preferred shares are
carried at fair value, which is based on a discounted cash flow
model that utilizes prepayment and loss assumptions based on
historical experience and projected performance, economic
factors, the characteristics of the underlying cash flow, and
comparable yields for similar CMBS bonds and CDO bonds and
preferred shares. The

18



---



##### 



ALLIED CAPITAL CORPORATION AND
SUBSIDIARIES


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)



Note 2. Summary of Significant Accounting
Policies, continued


Company recognizes unrealized appreciation or
depreciation on its CMBS bonds and CDO bonds and preferred
shares as comparable yields in the market change and/or based on
changes in estimated cash flows resulting from changes in
prepayment or loss assumptions in the underlying collateral pool.

The Company recognizes income from the
amortization of original issue discount using the effective
interest method, using the anticipated yield over the projected
life of the investment. Yields are revised when there are
changes in actual and estimated prepayment speeds or actual and
estimated credit losses. Changes in estimated yield are
recognized as an adjustment to the estimated yield over the
remaining life of the CMBS bonds and CDO bonds and preferred
shares from the date the estimated yield is changed.



| |                                                                                           
| | ------------------------------------------------------------------------------------------
| | Net Realized Gains or Losses and Net Change
    in Unrealized Appreciation or Depreciation

Realized gains or losses are measured by the
difference between the net proceeds from the repayment or sale
and the cost basis of the investment without regard to
unrealized appreciation or depreciation previously recognized,
and include investments charged off during the year, net of
recoveries. Net change in unrealized appreciation or
depreciation reflects the change in portfolio investment values
during the reporting period, including the reversal of
previously recorded unrealized appreciation or depreciation when
gains or losses are realized.



| |           
| | ----------
| | Fee Income

Fee income includes fees for guarantees and
services rendered by the Company to portfolio companies and
other third parties such as diligence, structuring, transaction
services, management services, and other advisory services.
Guaranty fees are recognized as income over the related period
of the guaranty. Diligence, structuring, and transaction
services fees are generally recognized as income when services
are rendered or when the related transactions are completed.
Management and other advisory services fees are generally
recognized as income as the services are rendered.



| |           
| | ----------
| | Guarantees

The Company accounts for guarantees under FASB
Interpretation No. 45, Guarantors Accounting and
Disclosure Requirements for Guarantees, Including Indirect
Guarantees of Indebtedness of Others (the
Interpretation). In accordance with the
Interpretation, guarantees meeting the characteristics described
in the Interpretation, and issued or modified after
December 31, 2002, are recognized at fair value. However,
certain guarantees are excluded from the initial recognition
provisions of the Interpretation. See Note 5 for
disclosures related to the Companys guarantees.



| |                
| | ---------------
| | Financing Costs

Debt financing costs are based on actual costs
incurred in obtaining debt financing and are deferred and
amortized as part of interest expense over the term of the
related debt instrument. Costs associated with the issuance of
common stock, such as underwriting, accounting and legal fees,
and printing costs are recorded as a reduction to the proceeds
from the sale of common stock.



| |                          
| | -------------------------
| | Cash and Cash Equivalents

Cash and cash equivalents include cash in banks
and all highly liquid investments with original maturities of
three months or less.

19



---



##### 



ALLIED CAPITAL CORPORATION AND
SUBSIDIARIES


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)



Note 2. Summary of Significant Accounting
Policies, continued




| |                          
| | -------------------------
| | Dividends to Shareholders

Dividends to shareholders are recorded on the
record date.



| |                         
| | ------------------------
| | Stock Compensation Plans

The Company has a stock-based employee
compensation plan. The Company accounts for this plan under the
recognition and measurement principles of APB Opinion
No. 25, Accounting for Stock Issued to Employees,
and related interpretations. No stock-based employee
compensation cost is reflected in net increase in net assets
resulting from operations, as all options granted under this
plan had an exercise price equal to the market value of the
underlying common stock on the date of grant. The following
table illustrates the effect on net increase in net assets
resulting from operations and earnings per share if the Company
had applied the fair value recognition provisions of FASB
Statement No. 123, Accounting for Stock-Based
Compensation, to stock-based employee compensation for the
three and nine months ended September 30, 2004 and 2003.

|                                                                                                                                                 |             |               |        |               |  |      |        |      |  |   |         |      |  |   |         |      | 
|------------------------------------------------------------------------------------------------------------------------------------------------ | ----------- | ------------- | ------ | ------------- |  | ---- | ------ | ---- |  | - | ------- | ---- |  | - | ------- | ---- | 
|                                                                                                                                                 |             |               |        |              
|                                                                                                                                                 |             | For the Three |        | For the Nine 
|                                                                                                                                                 |             | Months Ended  |        | Months Ended 
|                                                                                                                                                 |             | September 30, |        | September 30,
|                                                                                                                                                 |             |               |        |              
|                                                                                                                                                 |             | 2004          |        | 2003          |  | 2004 |        | 2003
|(in thousands, except per share amounts)                                                                                                         |             |               |        |               |  |      |        |     
|Net increase in net assets resulting from
    operations as reported                                                                             |             | $             | 85,999 |               |  | $    | 33,744 |      |  | $ | 201,649 |      |  | $ | 113,557 |     
|Less total stock-based employee compensation
    expense determined under fair value based method for all awards,
    net of related tax effects |             |               | (3,226 | )             |  |      | (2,043 | )    |  |   | (13,822 | )    |  |   | (10,121 | )   
|                                                                                                                                                 |             |               |        |               |  |      |        |      |  |   |         |      |  |   |         |     
|Pro forma net increase in net assets resulting
    from operations                                                                               |             |               | 82,773 |               |  |      | 31,701 |      |  |   | 187,827 |      |  |   | 103,436 |     
|Less preferred stock dividends                                                                                                                   |             |               |       |               |  |      | (45    | )    |  |   | (52     | )    |  |   | (155    | )   
|                                                                                                                                                 |             |               |        |               |  |      |        |      |  |   |         |      |  |   |         |     
|Pro forma net income available to common
    shareholders                                                                                        |             | $             | 82,773 |               |  | $    | 31,656 |      |  | $ | 187,775 |      |  | $ | 103,281 |     
|                                                                                                                                                 |             |               |        |               |  |      |        |      |  |   |         |      |  |   |         |     
|Basic earnings per common share:                                                                                                                 |             |               |        |               |  |      |        |      |  |   |         |      |  |   |         |     
|                                                                                                                                                 | As reported |               | $      | 0.67          |  |      | $      | 0.28 |  |   | $       | 1.57 |  |   | $       | 0.99 | 
|                                                                                                                                                 | Pro forma   |               | $      | 0.64          |  |      | $      | 0.27 |  |   | $       | 1.46 |  |   | $       | 0.91 | 
|Diluted earnings per common share:                                                                                                               |             |               |        |               |  |      |        |      |  |   |         |      |  |   |         |     
|                                                                                                                                                 | As reported |               | $      | 0.66          |  |      | $      | 0.28 |  |   | $       | 1.53 |  |   | $       | 0.98 | 
|                                                                                                                                                 | Pro forma   |               | $      | 0.63          |  |      | $      | 0.26 |  |   | $       | 1.43 |  |   | $       | 0.90 | 

Pro forma expenses are based on the underlying
value of the options granted by the Company. The fair value of
each option grant is estimated on the date of grant using the
Black-Scholes option pricing model and expensed over the vesting
period. The following weighted average assumptions

20



---



##### 



ALLIED CAPITAL CORPORATION AND
SUBSIDIARIES


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)



Note 2. Summary of Significant Accounting
Policies, continued


were used to calculate the fair value of options
granted during the three and nine months ended
September 30, 2004 and 2003:

|                                       |  |               |   |               |  |      |      |      |  |   |      |   |  |   |      |  
|-------------------------------------- |  | ------------- | - | ------------- |  | ---- | ---- | ---- |  | - | ---- | - |  | - | ---- | -
|                                       |  |               |   |              
|                                       |  | For the Three |   | For the Nine 
|                                       |  | Months Ended  |   | Months Ended 
|                                       |  | September 30, |   | September 30,
|                                       |  |               |   |              
|                                       |  | 2004(1)       |   | 2003          |  | 2004 |      | 2003
|                                       |  |               |   |               |  |      |      |     
|Risk-free interest rate                |  |               |  |               |  |      | 3.2  | %    |  |   | 2.9  | % |  |   | 2.7  | %
|Expected life                          |  |               |  |               |  |      | 5.0  |      |  |   | 5.0  |   |  |   | 5.0  |  
|Expected volatility                    |  |               |  |               |  |      | 38.1 | %    |  |   | 37.0 | % |  |   | 38.8 | %
|Dividend yield                         |  |               |  |               |  |      | 8.9  | %    |  |   | 8.8  | % |  |   | 8.9  | %
|Weighted average fair value per option |  |               |  |               |  | $    | 3.67 |      |  | $ | 4.19 |   |  | $ | 3.35 |  






|    |                                                                                          
|--- | -----------------------------------------------------------------------------------------
|(1) | There were no stock options granted during the
    three months ended September 30, 2004.



| |                                   
| | ----------------------------------
| | Federal and State Income
    Taxes

The Company intends to comply with the
requirements of the Internal Revenue Code (Code)
that are applicable to regulated investment companies
(RIC) and real estate investment trusts
(REIT). The Company and its subsidiaries that
qualify as a RIC or a REIT intend to annually distribute or
retain through a deemed distribution all of their taxable income
to shareholders; therefore, the Company has made no provision
for income taxes for these entities. AC Corp is a corporation
subject to federal and state income taxes and records a benefit
or expense for income taxes as appropriate.



| |                      
| | ---------------------
| | Per Share Information

Basic earnings per common share is calculated
using the weighted average number of common shares outstanding
for the period presented. Diluted earnings per common share
reflects the potential dilution that could occur if options to
issue common stock were exercised into common stock. Earnings
per share is computed after subtracting dividends on preferred
shares.



| |                                                                
| | ---------------------------------------------------------------
| | Use of Estimates in the Preparation of
    Financial Statements

The preparation of financial statements in
conformity with accounting principles generally accepted in the
United States of America 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 revenue and expenses during the reporting period. Actual
results could differ from these estimates.

The consolidated financial statements include
portfolio investments at value of $3.0 billion and
$2.6 billion at September 30, 2004, and
December 31, 2003, respectively. At September 30,
2004, and December 31, 2003, 87% and 85%, respectively, of
the Companys total assets represented investments whose
fair values have been determined by the Board of Directors in
good faith in the absence of readily available market values.
Because of the inherent uncertainty of valuation, the Board of
Directors determined values may differ significantly from
the values that would have been used had a ready market existed
for the investments, and the differences could be material.

21



---



##### 



ALLIED CAPITAL CORPORATION AND
SUBSIDIARIES


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

Note 3. Portfolio



| |                
| | ---------------
| | Private Finance

At September 30, 2004, and December 31,
2003, the private finance portfolio consisted of the following:

|                          |       |      |           |           |  |          |           |           |  |       |      |          |  |   |           |           |  |   |           |           |  |  |      |   | 
|------------------------- | ----- | ---- | --------- | --------- |  | -------- | --------- | --------- |  | ----- | ---- | -------- |  | - | --------- | --------- |  | - | --------- | --------- |  |  | ---- | - | 
|                          |       |      |           |          
|                          |       | 2004 |           | 2003     
|                          |       |      |           |          
|                          |       | Cost |           | Value     |  | Yield(1) |           | Cost      |  | Value |      | Yield(1)
|($ in thousands)          |       |      |           |           |  |          |           |           |  |       |      |         
|Loans and debt securities |       | $    | 1,533,953 |           |  | $        | 1,401,088 |           |  |       | 15.2 | %        |  | $ | 1,406,052 |           |  | $ | 1,214,886 |           |  |  | 15.0 | %
|Equity interests          |       |      | 639,362   |           |  |          | 629,897   |           |  |       |      |          |  |   | 500,079   |           |  |   | 687,786   |           |  |  |      |  
|                          |       |      |           |           |  |          |           |           |  |       |      |          |  |   |           |           |  |   |           |           |  |  |      |  
|                          | Total |      | $         | 2,173,315 |  |          | $         | 2,030,985 |  |       |      |          |  |   | $         | 1,906,131 |  |   | $         | 1,902,672 |  |  |      |   | 
|                          |       |      |           |           |  |          |           |           |  |       |      |          |  |   |           |           |  |   |           |           |  |  |      |  






|    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  
|--- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(1) | The weighted average yield on loans and debt
    securities is computed as the (a) annual stated interest
    rate plus the annual amortization of loan origination fees,
    original issue discount, and market discount on accruing loans
    and debt securities, divided by (b) total loans and debt
    securities at value. At September 30, 2004, and
    December 31, 2003, the cost and value of loans and debt
    securities include the Class A equity interests in BLX and
    the guaranteed dividend yield on these equity interests is
    included in interest income. The weighted average yield is
    computed as of the balance sheet date.

Private finance investment activity principally
involves providing financing through privately negotiated
long-term debt and equity investments. Private finance
investments are generally issued by private companies and are
generally illiquid and subject to restrictions on resale or
transferability. The annual stated interest rate is only one
factor in pricing the investment relative to the Companys
rights and priority in the portfolio companys capital
structure, and will vary depending on many factors, including if
the Company has received nominal cost equity or other components
of investment return, such as loan origination fees or market
discount. The stated interest rate may include some component of
contractual payment-in-kind interest, which represents
contractual interest accrued and added to the loan balance that
generally becomes due at maturity. At September 30, 2004,
and December 31, 2003, approximately 99% and 97%
respectively, of the Companys loans and debt securities
had fixed interest rates.

Loans and debt securities generally have a
maturity of five to ten years, with interest-only payments in
the early years and payments of both principal and interest in
the later years, although debt maturities and principal
amortization schedules vary.

Equity interests consist primarily of securities
issued by private companies and may be subject to restrictions
on their resale and are generally illiquid. Equity securities
generally do not produce a current return, but are held in
anticipation of investment appreciation and ultimate gain on
sale.

The Companys most significant investments
at September 30, 2004, were in Business Loan Express, LLC
and Advantage Sales & Marketing, Inc. The
Companys most significant investments at December 31,
2003, were in Business Loan Express, LLC and The Hillman
Companies, Inc. The Hillman Companies, Inc. was sold on
March 31, 2004, as discussed below.

At September 30, 2004, and December 31,
2003, the Company had an investment at value totaling
$352.1 million and $342.2 million, respectively, in
Business Loan Express, LLC (BLX), a small business
lender that participates in the U.S. Small Business
Administrations 7(a) Guaranteed Loan Program. At
September 30, 2004, the Company owned 94.9% of the voting
Class C equity interests. BLX has an equity appreciation
rights plan for management which will dilute the value available
to the Class C equity interest holders. BLX is
headquartered in New York, NY.

22



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##### 



ALLIED CAPITAL CORPORATION AND
SUBSIDIARIES


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

Note 3. Portfolio, continued

The Company has provided BLX a $20 million
revolving credit facility for working capital that matures on
June 30, 2005. At June 30, 2004, BLX had outstanding
borrowings of $10 million on the facility. This
$10 million was repaid by BLX during the third quarter, and
there were no amounts outstanding under this facility at
September 30, 2004.

As a limited liability company, BLXs
taxable income flows through directly to its members. BLXs
annual taxable income generally differs from its book income for
the fiscal year due to temporary and permanent differences in
the recognition of income and expenses. The Company holds all of
BLXs Class A and Class B interests, and 94.9% of
the Class C interests. BLXs taxable income is first
allocated to the Class A interests to the extent that
dividends are paid in cash or in kind on such interests, with
the remainder being allocated to the Class B and
Class C interests. BLX declares dividends on its
Class B interests based on an estimate of its annual
taxable income allocable to such interests.

BLX paid dividends to the Company in cash or in
kind on the Class A interests totaling $3.2 million
and $2.9 million for the three months ended
September 30, 2004 and 2003, respectively, and
$9.4 million and $7.4 million for the nine months
ended September 30, 2004 and 2003, respectively. For the
three months ended September 30, 2004 and 2003, total
dividends on the Class A interests included paid in kind
dividends of $1.5 million and $1.4 million,
respectively. For the nine months ended September 30, 2004
and 2003, total dividends on the Class A interests included
paid in kind dividends of $4.5 million and
$3.6 million, respectively. The guaranteed dividend yield
on these equity interests is included in interest income. In
addition, BLX paid dividends to the Company on the Class B
interests totaling $3.5 million and $1.0 million for
the three months ended September 30, 2004 and 2003,
respectively, and $8.3 and $3.0 million for the nine months
ended September 30, 2004 and 2003, respectively. These
dividends were paid to the Company in kind through the issuance
of additional Class B equity interests. The Class B
dividends are included in dividend income. Net change in
unrealized appreciation or depreciation for the nine months
ended September 30, 2004, included a net decrease in
unrealized appreciation of $6.2 million on our investment
in BLX.

At the time of the corporate reorganization of
BLX from a C corporation to a limited liability company in
2003, for tax purposes BLX had a built-in gain
representing the aggregate fair market value of its assets in
excess of the tax basis of its assets. As a regulated investment
company, the Company will be subject to special built-in gain
rules on the assets of BLX. Under these rules, taxes will be
payable by the Company at the time and to the extent that the
built-in gains on BLXs assets at the date of
reorganization are recognized in a taxable disposition of such
assets in the 10-year period following the date of the
reorganization. At such time, the built-in gains realized upon
the disposition of these assets will be included in the
Companys taxable income, net of the corporate level taxes
paid by the Company on the built-in gains. However, if these
assets are disposed of after the 10-year period, there will be
no corporate level taxes on these built-in gains.

While the Company has no obligation to pay the
built-in gains tax until these assets are disposed of in the
future, it may be necessary to record a liability for these
taxes in the future should the Company intend to sell the assets
of BLX within the 10-year period. The Company estimates that its
future tax liability resulting from the built-in gains at the
date of BLXs reorganization may total up to
$40 million. At September 30, 2004, and
December 31, 2003, the Company considered the increase in
fair value of its investment in BLX due to BLXs tax
attributes as an LLC and has also

23



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##### 



ALLIED CAPITAL CORPORATION AND
SUBSIDIARIES


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

Note 3. Portfolio, continued

considered the reduction in fair value of its
investment due to these estimated built-in gain taxes in
determining the fair value of its investment in BLX.

As the controlling equity owner of BLX, the
Company has provided an unconditional guaranty to the BLX credit
facility lenders in an amount up to 50% of the total obligations
(consisting of principal, letters of credit issued under the
facility, accrued interest, and other fees) on BLXs
three-year unsecured $275.0 million revolving credit
facility, which includes a sub-facility for the issuance of
letters of credit for up to a total of $50.0 million. The
facility matures in January 2007. The amount guaranteed by
the Company at September 30, 2004, was $101.6 million.
This guaranty can be called by the lenders only in the event of
a default by BLX. BLX was in compliance with the terms of its
credit facility at September 30, 2004. At
September 30, 2004, the Company had also provided four
standby letters of credit totaling $35.6 million in
connection with four term securitization transactions completed
by BLX. In consideration for providing the guaranty and the
standby letters of credit, BLX paid the Company fees of
$1.6 million and $1.0 million for the three months
ended September 30, 2004 and 2003, and $4.4 million
and $2.9 million for the nine months ended
September 30, 2004 and 2003, respectively.

Total interest and related portfolio income
earned for the Companys investment in BLX for the three
months ended September 30, 2004 and 2003, was
$12.2 million and $10.1 million, respectively, which
includes interest and dividend income of $9.4 million and
$6.5 million, respectively, and fees and other income of
$2.8 million and $3.6 million, respectively. Total
interest and related portfolio income earned for the
Companys investment in BLX for the nine months ended
September 30, 2004 and 2003, was $35.1 million and
$32.8 million, respectively, which includes interest and
dividend income of $25.4 million and $19.5 million,
respectively, loan prepayment premiums of $0 and
$0.1 million, and fees and other income of
$9.7 million and $13.2 million, respectively.

The Company completed the purchase of a majority
ownership position in the business of Advantage Sales &
Marketing, Inc. (Advantage) on June 30, 2004.
At September 30, 2004, the Companys investment
totaled $257.6 million at cost and value. At the closing of
the transaction, the Company invested $90.2 million in
loans and subordinated debt and $73.5 million in common
stock. In addition, prior to completing the purchase, the
Company had invested $93.7 million in subordinated debt in
certain predecessor companies of Advantage, of which $45.5
million was invested during the second quarter of 2004. This
existing debt was exchanged for new subordinated debt in
Advantage as part of the transaction. At closing, the
Companys investment in Advantage totaled $257.2 million at
cost. Advantage is a leading sales and marketing agency
providing outsourced sales, merchandising, and marketing
services to the consumer packaged goods industry. Advantage has
offices across the country and is headquartered in Irvine, CA.

Total interest and related portfolio income
earned for the Companys investment in Advantage for the
three months ended September 30, 2004, was
$7.4 million, which includes interest income of
$5.9 million and fees and other income of
$1.5 million. Total interest and related portfolio income
earned for the Companys investment in Advantage for the
nine months ended September 30, 2004, (since and including
June 30, 2004), was $10.4 million, which includes
interest income of $6.0 million and fees and other income
of $4.4 million.

At December 31, 2003, the Company had an
investment in The Hillman Companies, Inc. (Hillman)
totaling $234.5 million at value. On March 31, 2004,
the Company sold Hillman for a total transaction value of
$510 million, including the repayment of outstanding debt
and adding the value of Hillmans outstanding trust
preferred shares. The Company was repaid its existing

24



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##### 



ALLIED CAPITAL CORPORATION AND
SUBSIDIARIES


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

Note 3. Portfolio, continued

$44.6 million in outstanding mezzanine debt.
Total consideration to the Company from the sale at closing,
including the repayment of debt, was $244.3 million, which
included net cash proceeds of $196.8 million and the
receipt of a new subordinated debt instrument of
$47.5 million. For the nine months ended September 30,
2004, the Company realized a gain of $150.2 million on the
transaction, including a gain of $1.2 million realized
during the second quarter of 2004, resulting from post-closing
adjustments, which provided additional cash consideration to the
Company in the same amount. The sale of Hillman is subject to
certain other post-closing adjustments. During the second
quarter of 2004, the Company sold a $5.0 million
participation in its subordinated debt in Hillman to a third
party, which reduced the Companys investment, and no gain
or loss resulted from the transaction.

Total interest and related portfolio income
earned for the Companys investment in Hillman for the
three months ended September 30, 2003, was
$2.4 million, which included interest income of
$2.0 million and fees and other income of
$0.4 million. Total interest and related portfolio income
earned for the Companys control investment in Hillman for
the nine months ended September 30, 2004 and 2003, was
$2.5 million and $7.2 million, respectively, which
included interest income of $2.1 million and
$5.9 million, respectively, and fees and other income of
$0.4 million and $1.3 million, respectively.

Other activities (at cost) in portfolio companies
more than 25% owned during the nine months ended
September 30, 2004, included:



| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
| | - | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | a $92.9 million debt and equity investment,
    including closing costs, to purchase a majority ownership
    position in Financial Pacific Company;                                                                                                                                                                                                                                                                                                                                                                                                                                   
|
| |  | an $83.9 million debt and equity investment,
    including closing costs, to purchase a majority ownership
    position in Mercury Air Centers, Inc.;                                                                                                                                                                                                                                                                                                                                                                                                                                  
|
| |  | a $6.6 million debt and equity investment,
    including closing costs, to purchase Legacy Partners Group, LLC
    and an additional debt investment of $2.5 million for
    working capital;                                                                                                                                                                                                                                                                                                                                                                                          
|
| |  | an equity investment of $7.5 million and an
    exchange of existing subordinated debt with a cost basis of
    $7.3 million for equity interests in an affiliate of Impact
    Innovations Group, LLC (this investment was repaid during the
    third quarter of 2004);                                                                                                                                                                                                                                                                                                              
|
| |  | GAC Investments, Inc.s (GACI)
    acquisition of certain of the assets of Galaxy American
    Communications, LLC (Galaxy) out of bankruptcy
    during the third quarter of 2004. The Company exchanged its
    investment in Galaxy for debt and equity in GACI to facilitate
    the asset acquisition. The company is doing business as Longview
    Cable & Data. The Companys investment in GACI was
    $54.4 million at cost at September 30, 2004, which
    included additional equity investments of $3.7 million
    during the nine months ended September 30, 2004;
|
| |  | an exchange of existing debt securities, along
    with accrued and unpaid interest thereon, with a total cost
    basis of $49.8 million for $12.5 million of new debt and a
    68.5% common stock interest in Startec Global Communications
    Corporation (Startec) upon its emergence from
    bankruptcy in May 2004. The Company also provided a
    $4.0 million term loan to Startec to make an acquisition
    and for working capital;                                                                                                                                   
|
| |  | a new equity investment of $0.8 million and
    an exchange of existing debt securities, along with accrued and
    unpaid interest thereon, with a total cost basis of
    $13.4 million for new debt of                                                                                                                                                                                                                                                                                                                                                                              

25



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##### 



ALLIED CAPITAL CORPORATION AND
SUBSIDIARIES


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)



| |  |                             
| |  | ----------------------------
| |  | Note 3. Portfolio, continued

$11.3 million with the remaining cost basis
attributed to equity, in Fairchild Industrial Products Company
(Fairchild) upon its emergence from bankruptcy in
July 2004. The Company now owns 100% of the common stock of
Fairchild;



| |   |                                                                                                                                                               
| | - | --------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | the repayment in kind of $10.0 million of
    existing subordinated debt in American Healthcare Services, Inc.
    with debt in MedBridge Healthcare, LLC; and
|
| |  | the sale of The Color Factory, Inc. during the
    third quarter of 2004, resulting in a realized loss of
    $24.5 million.                                  

At September 30, 2004, and December 31,
2003, loans and debt securities at value not accruing interest
were as follows:

|                                                                             |                               |       |   |        |        |  |   |        |         | 
|---------------------------------------------------------------------------- | ----------------------------- | ----- | - | ------ | ------ |  | - | ------ | ------- | 
|                                                                             |                               | 2004  |   | 2003  
|($ in thousands)                                                             |                               |       |   |       
|Loans and debt securities in workout status
    (classified as Grade 4 or 5) |                               |       |   |        |        |  |   |       
|                                                                             | Companies more than 25% owned |       | $ | 25,363 |        |  | $ | 31,873 |        
|                                                                             | Companies 5% to 25% owned     |       |   | 1,698  |        |  |   | 2,777  |        
|                                                                             | Companies less than 5% owned  |       |   | 24,348 |        |  |   | 28,027 |        
|Loans and debt securities not in workout status                              |                               |       |   |        |        |  |   |       
|                                                                             | Companies more than 25% owned |       |   | 22,015 |        |  |   | 31,897 |        
|                                                                             | Companies less than 5% owned  |       |   | 17,468 |        |  |   | 16,532 |        
|                                                                             |                               |       |   |        |        |  |   |       
|                                                                             |                               | Total |   | $      | 90,892 |  |   | $      | 111,106 | 
|                                                                             |                               |       |   |        |        |  |   |       

The industry and geographic compositions of the
private finance portfolio at value at September 30, 2004,
and December 31, 2003, were as follows:

|                       |       |      |    |      |   |  |    |     |  
|---------------------- | ----- | ---- | -- | ---- | - |  | -- | --- | -
|                       |       | 2004 |    | 2003
|                       |       |      |    |     
|Industry               |       |      |    |      |   |  |    |    
|Business services      |       |      | 35 | %    |   |  | 22 | %  
|Financial services     |       |      | 23 |      |   |  | 19 |    
|Consumer products      |       |      | 14 |      |   |  | 30 |    
|Healthcare services    |       |      | 8  |      |   |  | 8  |    
|Industrial products    |       |      | 7  |      |   |  | 6  |    
|Energy services        |       |      | 3  |      |   |  | 4  |    
|Retail                 |       |      | 3  |      |   |  | 4  |    
|Telecommunications     |       |      | 2  |      |   |  | 2  |    
|Broadcasting and cable |       |      | 2  |      |   |  | 2  |    
|Other                  |       |      | 3  |      |   |  | 3  |    
|                       |       |      |    |      |   |  |    |    
|                       | Total |      |    | 100  | % |  |    | 100 | %
|                       |       |      |    |      |   |  |    |    
|Geographic Region      |       |      |    |      |   |  |    |    
|Mid-Atlantic           |       |      | 36 | %    |   |  | 40 | %  
|West                   |       |      | 34 |      |   |  | 16 |    
|Midwest                |       |      | 16 |      |   |  | 26 |    
|Southeast              |       |      | 10 |      |   |  | 13 |    
|Northeast              |       |      | 4  |      |   |  | 4  |    
|International          |       |      |   |      |   |  | 1  |    
|                       |       |      |    |      |   |  |    |    
|                       | Total |      |    | 100  | % |  |    | 100 | %
|                       |       |      |    |      |   |  |    |    

26



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##### 



ALLIED CAPITAL CORPORATION AND
SUBSIDIARIES


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)



Note 3. Portfolio, continued




| |                                   
| | ----------------------------------
| | Commercial Real Estate
    Finance

At September 30, 2004, and December 31,
2003, the commercial real estate finance portfolio consisted of
the following:

|                               |       |      |         |         |  |          |         |         |  |       |      |          |  |   |         |         |  |   |         |         |  |  |      |   | 
|------------------------------ | ----- | ---- | ------- | ------- |  | -------- | ------- | ------- |  | ----- | ---- | -------- |  | - | ------- | ------- |  | - | ------- | ------- |  |  | ---- | - | 
|                               |       |      |         |        
|                               |       | 2004 |         | 2003   
|                               |       |      |         |        
|                               |       | Cost |         | Value   |  | Yield(1) |         | Cost    |  | Value |      | Yield(1)
|($ in thousands)               |       |      |         |         |  |          |         |         |  |       |      |         
|CMBS bonds                     |       | $    | 596,595 |         |  | $        | 604,459 |         |  |       | 12.4 | %        |  | $ | 399,106 |         |  | $ | 393,979 |         |  |  | 14.1 | %
|CDO bonds and preferred shares |       |      | 177,766 |         |  |          | 177,845 |         |  |       | 17.4 | %        |  |   | 186,824 |         |  |   | 186,557 |         |  |  | 16.7 | %
|Loans                          |       |      | 147,651 |         |  |          | 143,163 |         |  |       | 8.1  | %        |  |   | 87,427  |         |  |   | 83,639  |         |  |  | 8.6  | %
|Real estate owned              |       |      | 16,075  |         |  |          | 14,637  |         |  |       |      |          |  |   | 15,931  |         |  |   | 12,856  |         |  |  |      |  
|Equity interests               |       |      | 9,306   |         |  |          | 8,920   |         |  |       |      |          |  |   | 5,641   |         |  |   | 4,896   |         |  |  |      |  
|                               |       |      |         |         |  |          |         |         |  |       |      |          |  |   |         |         |  |   |         |         |  |  |      |  
|                               | Total |      | $       | 947,393 |  |          | $       | 949,024 |  |       |      |          |  |   | $       | 694,929 |  |   | $       | 681,927 |  |  |      |   | 
|                               |       |      |         |         |  |          |         |         |  |       |      |          |  |   |         |         |  |   |         |         |  |  |      |  




|    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              
|--- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(1) | The weighted average yield on the
    interest-bearing investments is computed as the (a) annual
    stated interest rate plus the annual amortization of loan
    origination fees, original issue discount, and market discount
    on accruing interest-bearing investments, divided by
    (b) total interest-bearing investments at value. The
    weighted average yield is computed as of the balance sheet date.
    Interest-bearing investments for the commercial real estate
    finance portfolio include all investments except for real estate
    owned and equity interests.

CMBS Bonds.At September 30, 2004, and December 31, 2003, CMBS bonds
consisted of the following:

|                        |  |      |           |      |  |   |           |  
|----------------------- |  | ---- | --------- | ---- |  | - | --------- | -
|                        |  | 2004 |           | 2003
|($ in thousands)        |  |      |           |     
|Face                    |  | $    | 1,366,445 |      |  | $ | 1,016,533 |  
|Original issue discount |  |      | (769,850  | )    |  |   | (617,427  | )
|                        |  |      |           |      |  |   |           |  
|Cost                    |  | $    | 596,595   |      |  | $ | 399,106   |  
|                        |  |      |           |      |  |   |           |  
|Value                   |  | $    | 604,459   |      |  | $ | 393,979   |  
|                        |  |      |           |      |  |   |           |  

The underlying rating classes of the CMBS bonds
at cost and value at September 30, 2004, and
December 31, 2003, were as follows:

|                 |       |      |         |               |  |             |         |               |  |       |      |             |   |   |         |         |  |   |        |         |  |  |      |       |  
|---------------- | ----- | ---- | ------- | ------------- |  | ----------- | ------- | ------------- |  | ----- | ---- | ----------- | - | - | ------- | ------- |  | - | ------ | ------- |  |  | ---- | ----- | -
|                 |       |      |         |              
|                 |       | 2004 |         | 2003         
|                 |       |      |         |              
|                 |       |      |         | Percentage of |  |             |         | Percentage of
|                 |       | Cost |         | Value         |  | Total Value |         | Cost          |  | Value |      | Total Value
|($ in thousands) |       |      |         |               |  |             |         |               |  |       |      |            
|BBB-             |       | $    | 25,828  |               |  | $           | 26,138  |               |  |       | 4.3  | %           |   | $ |        |         |  | $ |       |         |  |  |     | %    
|BB+              |       |      | 87,558  |               |  |             | 94,836  |               |  |       | 15.7 |             |   |   | 49,477  |         |  |   | 51,157 |         |  |  | 13.0 |      
|BB               |       |      | 58,156  |               |  |             | 62,455  |               |  |       | 10.3 |             |   |   | 22,031  |         |  |   | 23,008 |         |  |  | 5.9  |      
|BB-              |       |      | 38,158  |               |  |             | 41,476  |               |  |       | 6.9  |             |   |   | 13,538  |         |  |   | 14,266 |         |  |  | 3.6  |      
|B+               |       |      | 65,537  |               |  |             | 70,257  |               |  |       | 11.6 |             |   |   | 54,464  |         |  |   | 54,246 |         |  |  | 13.8 |      
|B                |       |      | 59,604  |               |  |             | 60,438  |               |  |       | 10.0 |             |   |   | 38,416  |         |  |   | 38,362 |         |  |  | 9.7  |      
|B-               |       |      | 95,010  |               |  |             | 93,786  |               |  |       | 15.5 |             |   |   | 84,986  |         |  |   | 83,859 |         |  |  | 21.3 |      
|CCC+             |       |      | 24,123  |               |  |             | 20,103  |               |  |       | 3.3  |             |   |   | 15,935  |         |  |   | 15,494 |         |  |  | 3.9  |      
|CCC              |       |      | 22,640  |               |  |             | 17,994  |               |  |       | 3.0  |             |   |   | 13,323  |         |  |   | 11,413 |         |  |  | 2.9  |      
|CCC-             |       |      |        |               |  |             |        |               |  |       |     |             |   |   | 3,133   |         |  |   | 2,410  |         |  |  | 0.6  |      
|CC               |       |      | 1,231   |               |  |             | 791     |               |  |       | 0.2  |             |   |   |        |         |  |   |       |         |  |  |     |      
|Unrated          |       |      | 118,750 |               |  |             | 116,185 |               |  |       | 19.2 |             |   |   | 103,803 |         |  |   | 99,764 |         |  |  | 25.3 |      
|                 |       |      |         |               |  |             |         |               |  |       |      |             |   |   |         |         |  |   |        |         |  |  |      |      
|                 | Total |      | $       | 596,595       |  |             | $       | 604,459       |  |       |      | 100.0       | % |   | $       | 399,106 |  |   | $      | 393,979 |  |  |      | 100.0 | %
|                 |       |      |         |               |  |             |         |               |  |       |      |             |   |   |         |         |  |   |        |         |  |  |      |      

27



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##### 



ALLIED CAPITAL CORPORATION AND
SUBSIDIARIES


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

Note 3. Portfolio, continued

The BBB- rated and non-investment grade and
unrated tranches of the CMBS bonds in which the Company invests
are junior in priority for payment of interest and principal to
the more senior tranches of the related CMBS bond issuance. Cash
flow from the underlying mortgages is generally allocated first
to the senior tranches in order of priority, with the most
senior tranches having a priority right to the cash flow. Then,
any remaining cash flow is allocated, generally, among the other
tranches in order of their relative seniority. To the extent
there are defaults and unrecoverable losses on the underlying
mortgages or the properties securing those mortgages resulting
in reduced cash flows, the most subordinate tranche will bear
this loss first. At September 30, 2004, the face value of
the CMBS bonds held by the Company were subordinate to 79% to
99% of the face value of the bonds issued in these various CMBS
transactions. Given that the non-investment grade CMBS bonds in
which the Company invests are junior in priority for payment of
interest and principal, the Company invests in these CMBS bonds
at a discount from the face amount of the bonds.

At September 30, 2004, and December 31,
2003, the Company held CMBS bonds in 50 and 38 separate CMBS
issuances, respectively. The underlying collateral pool,
consisting of commercial mortgage loans and real estate owned
(REO) properties, for these CMBS issuances consisted
of the following at September 30, 2004, and
December 31, 2003:

|                                                                     |  |      |        |      |  |   |        |    
|-------------------------------------------------------------------- |  | ---- | ------ | ---- |  | - | ------ | ---
|                                                                     |  | 2004 |        | 2003
|($ in millions)                                                      |  |      |        |     
|Approximate number of loans and REO
    properties(1)                |  |      | 6,700  |      |  |   | 5,600  |    
|Total outstanding principal balance                                  |  | $    | 49,559 |      |  | $ | 38,437 |    
|Loans over 30 days delinquent or classified as
    REO properties(2) |  |      | 1.3%   | (3)  |  |   | 1.5%   | (3)






|    |                                                                                                                                                                                                                                                                                                                                                                                                                      
|--- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(1) | Includes approximately 36 and 22 REO
    properties obtained through the foreclosure of commercial
    mortgage loans at September 30, 2004, and December 31,
    2003, respectively.                                                                                                                                                                                                                                
|   
|(2) | As a percentage of total outstanding principal
    balance.                                                                                                                                                                                                                                                                                                                                                          
|   
|(3) | At September 30, 2004, and December 31,
    2003, the Companys investments included bonds in the first
    loss, unrated bond class in 42 and 34 separate CMBS issuances,
    respectively. For these issuances, loans over 30 days delinquent
    or classified as REO properties were 1.6% and 1.7% of the total
    outstanding principal balance at September 30, 2004, and
    December 31, 2003, respectively.

The property types and the geographic composition
of the underlying mortgage loans and REO properties in the
underlying collateral pools for all CMBS issuances calculated
using the outstanding principal balance at September 30,
2004, and December 31, 2003, were as follows:

|              |       |      |    |      |   |  |    |     |  
|------------- | ----- | ---- | -- | ---- | - |  | -- | --- | -
|              |       | 2004 |    | 2003
|              |       |      |    |     
|Property Type |       |      |    |      |   |  |    |    
|Retail        |       |      | 35 | %    |   |  | 35 | %  
|Office        |       |      | 27 |      |   |  | 24 |    
|Housing       |       |      | 23 |      |   |  | 25 |    
|Industrial    |       |      | 5  |      |   |  | 5  |    
|Hospitality   |       |      | 4  |      |   |  | 5  |    
|Other         |       |      | 6  |      |   |  | 6  |    
|              |       |      |    |      |   |  |    |    
|              | Total |      |    | 100  | % |  |    | 100 | %
|              |       |      |    |      |   |  |    |    

28



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##### 



ALLIED CAPITAL CORPORATION AND
SUBSIDIARIES


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)



Note 3. Portfolio, continued


|                  |       |      |    |      |   |  |    |     |  
|----------------- | ----- | ---- | -- | ---- | - |  | -- | --- | -
|                  |       | 2004 |    | 2003
|                  |       |      |    |     
|Geographic Region |       |      |    |      |   |  |    |    
|West              |       |      | 29 | %    |   |  | 31 | %  
|Mid-Atlantic      |       |      | 28 |      |   |  | 27 |    
|Midwest           |       |      | 21 |      |   |  | 21 |    
|Southeast         |       |      | 17 |      |   |  | 17 |    
|Northeast         |       |      | 5  |      |   |  | 4  |    
|                  |       |      |    |      |   |  |    |    
|                  | Total |      |    | 100  | % |  |    | 100 | %
|                  |       |      |    |      |   |  |    |    

The Companys yield on its CMBS bonds is
based upon a number of assumptions that are subject to certain
business and economic uncertainties and contingencies. Examples
include the timing and magnitude of credit losses on the
mortgage loans underlying the CMBS bonds that are a result of
the general condition of the real estate market, including
vacancies, changes in market rental rates and tenant credit
quality. The initial yield on each CMBS bond has generally been
computed assuming an approximate 1% loss rate on its underlying
collateral mortgage pool, with the estimated losses being
assumed to occur in three equal installments in years three,
six, and nine. As each CMBS bond ages, the expected amount of
losses and the expected timing of recognition of such losses
will be updated, and the respective yield will be adjusted as
appropriate. As these uncertainties and contingencies are
difficult to predict and are subject to future events which may
alter these assumptions, no assurance can be given that the
anticipated yields to maturity will be achieved.

At September 30, 2004, and December 31,
2003, the unamortized discount related to the CMBS bond
portfolio was $769.9 million and $617.4 million,
respectively, and the Company had set aside $377.8 million
and $295.8 million, respectively, of this unamortized
discount to absorb potential future losses. The yields on the
CMBS bonds of 12.4% and 14.1%, respectively, assume that this
amount that has been set aside will not be amortized.

At September 30, 2004, and December 31,
2003, the Company had cumulatively reduced the face amount and
the original issue discount on the CMBS bonds for specifically
identified losses of $57.6 million and $52.6 million,
respectively, which had the effect of also reducing the amount
of unamortized discount set aside to absorb potential future
losses since those losses have now been recognized. The
reduction of the face amount and the original issue discount on
the CMBS bonds to reflect specifically identified losses did not
result in a change in the cost basis of the CMBS bonds at the
time that the face amount and original issue discount were
reduced.

At September 30, 2004, and December 31,
2003, CMBS bonds with a value of $85 thousand and
$0.2 million, respectively, were not accruing interest.

Collateralized Debt Obligation Bonds and
Preferred Shares
(CDOs).At
September 30, 2004, the Company owned BB rated bonds
in two CDOs totaling $2.9 million at value and preferred
shares in eight CDOs totaling $174.9 million at value. At
December 31, 2003, the Company owned BBB rated bonds in one
CDO totaling $16.0 million at value, BB rated bonds in one
CDO totaling $0.9 million at value and preferred shares in
seven CDOs totaling $169.7 million at value.

The bonds and the preferred shares of the CDOs in
which the Company has invested are junior in priority for
payment of interest and principal to the more senior tranches of
debt issued by the CDOs. Cash flow from the underlying
collateral generally is allocated first to the senior bond
tranches in order of priority, with the most senior tranches
having a priority right to the cash flow. Then, any

29



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##### 



ALLIED CAPITAL CORPORATION AND
SUBSIDIARIES


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)



Note 3. Portfolio, continued


remaining cash flow is generally distributed to
the preferred shareholders. To the extent there are defaults and
unrecoverable losses on the underlying collateral that result in
reduced cash flows, the preferred shares will bear this loss
first and then the bonds would bear any loss after the preferred
shares. At September 30, 2004, the Companys bonds and
preferred shares in the CDOs were subordinate to 70% to 98% of
the more senior tranches of debt issued in the various CDO
transactions. In addition, included in the CMBS collateral for
the CDOs at September 30, 2004, and December 31, 2003,
were certain CMBS bonds that are senior in priority of repayment
to certain lower rated CMBS bonds held directly by the Company.

At September 30, 2004, and December 31,
2003, the underlying collateral for the Companys
investments in the outstanding CDO issuances had balances as
follows:

|                                   |                  |      |         |         |  |   |         |         | 
|---------------------------------- | ---------------- | ---- | ------- | ------- |  | - | ------- | ------- | 
|                                   |                  | 2004 |         | 2003   
|($ in millions)                    |                  |      |         |        
|Investment grade REIT debt(1)      |                  | $    | 1,392.3 |         |  | $ | 1,338.0 |        
|Investment grade CMBS bonds(2)     |                  |      | 807.4   |         |  |   | 662.3   |        
|Non-investment grade CMBS bonds(3) |                  |      | 1,183.3 |         |  |   | 1,133.7 |        
|Other collateral                   |                  |      | 118.7   |         |  |   | 32.4    |        
|                                   |                  |      |         |         |  |   |         |        
|                                   | Total collateral |      | $       | 3,501.7 |  |   | $       | 3,166.4 | 
|                                   |                  |      |         |         |  |   |         |        



---



|    |                                                                            
|--- | ---------------------------------------------------------------------------
|(1) | Issued by 42 and 44 REITs, respectively, for the
    periods presented.    
|   
|(2) | Issued in 97 and 78 issuances, respectively, for
    the periods presented.
|   
|(3) | Issued in 76 and 68 issuances, respectively, for
    the periods presented.

The initial yields on the CDO bonds and preferred
shares are based on the estimated future cash flows from the
assets in the underlying collateral pool to be paid to these CDO
classes. As each CDO bond and preferred share ages, the
estimated future cash flows will be updated based on the
estimated performance of the collateral, and the respective
yield will be adjusted as necessary. As future cash flows are
subject to uncertainties and contingencies that are difficult to
predict and are subject to future events which may alter current
assumptions, no assurance can be given that the anticipated
yields to maturity will be achieved.

As of September 30, 2004 and 2003, the
Company acted as the disposition consultant with respect to five
and four, respectively, of the CDOs, which allows the Company to
approve disposition plans for individual collateral securities.
For these services, the Company collects annual fees based on
the outstanding collateral pool balance, and for the nine months
ended September 30, 2004 and 2003, these fees totaled
$1.3 million and $0.9 million, respectively.

Loans and Equity Interests.The commercial mortgage loan
portfolio contains loans that were originated by the Company or
were purchased from third-party sellers. At September 30,
2004, approximately 96% and 4% of the Companys commercial
mortgage loan portfolio was composed of fixed and adjustable
interest rate loans, respectively. At December 31, 2003,
approximately 92% and 8% of the Companys commercial
mortgage loan portfolio was composed of fixed and adjustable
interest rate loans, respectively. As of September 30,
2004, and December 31, 2003, loans with a value of
$18.6 million and $6.8 million, respectively, were not
accruing interest. Loans greater than 120 days delinquent
generally do not accrue interest.

Equity interests consist primarily of equity
securities issued by privately owned companies that invest in
single real estate properties. These equity interests may be
subject to restrictions on their

30



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##### 



ALLIED CAPITAL CORPORATION AND
SUBSIDIARIES


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)



Note 3. Portfolio, continued


resale and are generally illiquid. Equity
interests generally do not produce a current return, but are
generally held in anticipation of investment appreciation and
ultimate realized gain on sale.

The property types and the geographic composition
securing the commercial mortgage loans and equity interests at
value at September 30, 2004, and December 31, 2003,
were as follows:

|                  |       |      |    |      |   |  |    |     |  
|----------------- | ----- | ---- | -- | ---- | - |  | -- | --- | -
|                  |       | 2004 |    | 2003
|                  |       |      |    |     
|Property Type     |       |      |    |      |   |  |    |    
|Retail            |       |      | 48 | %    |   |  | 21 | %  
|Hospitality       |       |      | 34 |      |   |  | 41 |    
|Office            |       |      | 13 |      |   |  | 22 |    
|Housing           |       |      | 2  |      |   |  | 4  |    
|Healthcare        |       |      |   |      |   |  | 7  |    
|Other             |       |      | 3  |      |   |  | 5  |    
|                  |       |      |    |      |   |  |    |    
|                  | Total |      |    | 100  | % |  |    | 100 | %
|                  |       |      |    |      |   |  |    |    
|Geographic Region |       |      |    |      |   |  |    |    
|Southeast         |       |      | 39 | %    |   |  | 34 | %  
|Midwest           |       |      | 30 |      |   |  | 30 |    
|Mid-Atlantic      |       |      | 15 |      |   |  | 9  |    
|West              |       |      | 12 |      |   |  | 20 |    
|Northeast         |       |      | 4  |      |   |  | 7  |    
|                  |       |      |    |      |   |  |    |    
|                  | Total |      |    | 100  | % |  |    | 100 | %
|                  |       |      |    |      |   |  |    |    

Note 4. Debt

At September 30, 2004, and December 31,
2003, the Company had the following debt:

|                              |                         |                                    |         |           |         |          |         |           |         |        |     |          |      |   |         |           |         |  |   |         |         |  |   |     |      |  
|----------------------------- | ----------------------- | ---------------------------------- | ------- | --------- | ------- | -------- | ------- | --------- | ------- | ------ | --- | -------- | ---- | - | ------- | --------- | ------- |  | - | ------- | ------- |  | - | --- | ---- | -
|                              |                         |                                    |         |          
|                              |                         | 2004                               |         | 2003     
|                              |                         |                                    |         |          
|                              |                         |                                    |         | Annual    |         |          |         | Annual   
|                              |                         | Facility                           |         | Amount    |         | Interest |         | Facility  |         | Amount |     | Interest
|                              |                         | Amount                             |         | Drawn     |         | Cost(1)  |         | Amount    |         | Drawn  |     | Cost(1) 
|($ in thousands)              |                         |                                    |         |           |         |          |         |           |         |        |     |         
|Notes payable and debentures: |                         |                                    |         |           |         |          |         |           |         |        |     |          |      |   |         |           |         |  |   |         |         |  |   |    
|                              | Unsecured notes payable |                                    | $       | 757,278   |         |          | $       | 757,278   |         |        |     | 7.1      | %    |   | $       | 854,000   |         |  | $ | 854,000 |         |  |   | 7.2 | %   
|                              | SBA debentures          |                                    |         | 84,800    |         |          |         | 77,500    |         |        |     | 8.2      | %    |   |         | 101,800   |         |  |   | 94,500  |         |  |   | 8.1 | %   
|                              | OPIC loan               |                                    |         | 5,700     |         |          |         | 5,700     |         |        |     | 6.6      | %    |   |         | 5,700     |         |  |   | 5,700   |         |  |   | 6.6 | %   
|                              |                         |                                    |         |           |         |          |         |           |         |        |     |          |      |   |         |           |         |  |   |         |         |  |   |    
|                              |                         | Total notes payable and debentures |         |           | 847,778 |          |         |           | 840,478 |        |     |          | 7.2  | % |         |           | 961,500 |  |   |         | 954,200 |  |   |     | 7.3  | %
|Revolving line of credit      |                         |                                    | 552,500 |           |         |          | 327,250 |           |         |        | 3.9 | %(2)     |      |   | 532,500 |           |         |  |  |         |         |  |  | (2)
|                              |                         |                                    |         |           |         |          |         |           |         |        |     |          |      |   |         |           |         |  |   |         |         |  |   |    
|                              | Total debt              |                                    | $       | 1,400,278 |         |          | $       | 1,167,728 |         |        |     | 6.3      | %(2) |   | $       | 1,494,000 |         |  | $ | 954,200 |         |  |   | 7.5 | %(2)
|                              |                         |                                    |         |           |         |          |         |           |         |        |     |          |      |   |         |           |         |  |   |         |         |  |   |    



---



|    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             
|--- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(1) | The weighted average annual interest cost is
    computed as the (a) annual stated interest rate on the debt
    plus the annual amortization of commitment fees and other
    facility fees that are recognized into interest expense over the
    contractual life of the respective borrowings, divided by
    (b) debt outstanding on the balance sheet date.                                                                                                                                                                                                                                                           
|   
|(2) | The current interest rate payable on the
    revolving line of credit was 3.2% at September 30, 2004,
    which excluded the annual cost of commitment fees and other
    facility fees of $2.2 million. The annual interest cost for
    total debt includes the annual cost of commitment fees and other
    facility fees on the revolving line of credit regardless of the
    amount drawn on the facility as of the balance sheet date. There
    were no amounts drawn on the revolving line of credit at
    December 31, 2003, and the annual cost of commitment fees
    and other facility fees was $2.7 million.

31



---



##### 



ALLIED CAPITAL CORPORATION AND
SUBSIDIARIES


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)



Note 4. Debt, continued


Notes Payable and
Debentures

Unsecured Notes
Payable.The Company has issued
unsecured long-term notes to private institutional investors.
The notes require semi-annual interest payments until maturity
and have original terms of five or seven years. At
September 30, 2004, the notes had remaining maturities of
one month to six years. During the second quarter of
2004, the Company repaid $112.0 million of these notes that
matured on May 1, 2004. The notes may be prepaid in whole
or in part, together with an interest premium, as stipulated in
the note agreement.

On March 25, 2004, the Company issued
five-year unsecured long-term notes denominated in Euros and
Sterling for a total U.S. dollar equivalent of
$15.2 million. The notes have fixed interest rates and have
substantially the same terms as the Companys existing
unsecured notes. The Euro notes require annual interest payments
and the Sterling notes require semi-annual interest payments
until maturity. Simultaneous with issuing the notes, the Company
entered into a cross-currency swap with a financial institution
which fixed the Companys interest and principal payments
in U.S. dollars for the life of the debt.

SBA
Debentures.At September 30,
2004, and December 31, 2003, the Company had debentures
payable to the SBA with original terms of ten years and at fixed
interest rates ranging from 5.9% to 7.6%. During the first and
third quarters of 2004, the Company repaid $7.0 million and
$10.0 million of the SBA debentures, respectively. At
September 30, 2004, the debentures had remaining maturities
of one to eight years. The debentures require semi-annual
interest-only payments with all principal due upon maturity. The
SBA debentures are subject to prepayment penalties if paid prior
to the fifth anniversary date of the notes. At
September 30, 2004, the Company had a commitment from the
SBA to borrow up to an additional $7.3 million above the
current amount outstanding. The commitment expires on
September 30, 2005.

Scheduled
Maturities.Scheduled future
maturities of notes payable and debentures at September 30,
2004, were as follows:

|           |       |                  |         |         | 
|---------- | ----- | ---------------- | ------- | ------- | 
|Year       |       | Amount Maturing 
|           |       |                 
|           |       | ($ in thousands)
|2004       |       | $                | 102,000 |        
|2005       |       |                  | 169,000 |        
|2006       |       |                  | 180,700 |        
|2007       |       |                  |        |        
|2008       |       |                  | 153,000 |        
|Thereafter |       |                  | 235,778 |        
|           |       |                  |         |        
|          
|           | Total |                  | $       | 840,478 | 
|           |       |                  |         |        



| |                         
| | ------------------------
| | Revolving Line of Credit

The committed amount under the unsecured
revolving credit facility was expanded during the second quarter
of 2004 to $552.5 million and may be further expanded
through new or additional commitments up to $600.0 million
at the Companys option. The renewed line of credit expires
in April 2005 and may be extended under substantially similar
terms for one additional year at the Companys option. The
facility generally bears interest at a rate, at the
Companys option, equal to

32



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##### 



ALLIED CAPITAL CORPORATION AND
SUBSIDIARIES


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)



Note 4. Debt, continued


(i) the one-month LIBOR plus 1.50%,
(ii) the Bank of America, N.A. cost of funds plus 1.50% or
(iii) the higher of the Bank of America, N.A. prime rate or
the Federal Funds rate plus 0.50%. The interest rate adjusts at
the beginning of each new interest period, usually every
30 days. The facility requires an annual commitment fee
equal to 0.25% of the committed amount. The annual cost of
commitment fees and other facility fees was $2.2 million
and $2.7 million at September 30, 2004, and
December 31, 2003, respectively. The line of credit
generally requires monthly payments of interest, and all
principal is due upon maturity.

The average debt outstanding on the revolving
line of credit was $77.9 million and $55.4 million for
the nine months ended September 30, 2004 and 2003,
respectively, and $41.5 million for the year ended
December 31, 2003. The maximum amount borrowed under this
facility and the weighted average stated interest rate for the
nine months ended September 30, 2004 and 2003, and the year
ended December 31, 2003, were $353.0 million and 2.2%,
$208.8 million and 2.6%, and $208.8 million and 2.0%,
respectively. As of September 30, 2004, the amount
available under the revolving line of credit was
$180.0 million, net of amounts committed for standby
letters of credit of $45.3 million issued under the credit
facility.



| |                    
| | -------------------
| | Covenant Compliance

The Company has various financial and operating
covenants required by the notes payable and debentures and the
revolving line of credit. These covenants require the Company to
maintain certain financial ratios, including debt to equity and
interest coverage, and a minimum net worth. The Companys
credit facilities limit its ability to declare dividends if the
Company defaults under certain provisions. As of
September 30, 2004, the Company was in compliance with
these covenants.

Note 5. Guarantees and Other
Commitments

In the ordinary course of business, the Company
has issued guarantees and has extended standby letters of credit
through financial intermediaries on behalf of certain portfolio
companies. All standby letters of credit have been issued
through Bank of America, N.A. As of September 30, 2004, and
December 31, 2003, the Company had issued guarantees of
debt, rental obligations, lease obligations and severance
obligations aggregating $107.4 million and
$83.4 million, respectively, and had extended standby
letters of credit aggregating $45.3 million and
$45.5 million, respectively. Under these arrangements, the
Company would be required to make payments to third-party
beneficiaries if the portfolio companies were to default on
their related payment obligations. The maximum amount of future
payments was $152.7 million and $128.9 million at
September 30, 2004, and December 31, 2003,
respectively. At September 30, 2004, $0.3 million had
been recorded as a liability for the Companys guarantees
and no amounts had been recorded as a liability for the
Companys standby letters of credit. At December 31,
2003, no amounts had been recorded as a liability for the
Companys guarantees or standby letters of credit.

33



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##### 



ALLIED CAPITAL CORPORATION AND
SUBSIDIARIES


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

Note 5. Guarantees and Other
Commitments, continued

As of September 30, 2004, the guarantees and
standby letters of credit expire as follows:

|                             |       |       |       |       |  |      |     |      |  |      |     |      |  |       |      |      |  |   |       |       |  |   |   |   |  |   |     |     | 
|---------------------------- | ----- | ----- | ----- | ----- |  | ---- | --- | ---- |  | ---- | --- | ---- |  | ----- | ---- | ---- |  | - | ----- | ----- |  | - | - | - |  | - | --- | --- | 
|                             |       |       |       |       |  |      |     |      |  |      |     |      |  | After
|                             |       | Total |       | 2004  |  | 2005 |     | 2006 |  | 2007 |     | 2008 |  | 2008 
|(in millions)                |       |       |       |       |  |      |     |      |  |      |     |      |  |      
|Guarantees                   |       | $     | 107.4 |       |  | $    | 0.3 |      |  | $    | 0.6 |      |  | $     | 1.1  |      |  | $ | 101.8 |       |  | $ |  |   |  | $ | 3.6 |    
|Standby letters of credit(1) |       |       | 45.3  |       |  |      |    |      |  |      | 1.2 |      |  |       | 44.1 |      |  |   |      |       |  |   |  |   |  |   |    |    
|                             |       |       |       |       |  |      |     |      |  |      |     |      |  |       |      |      |  |   |       |       |  |   |   |   |  |   |     |    
|                             | Total |       | $     | 152.7 |  |      | $   | 0.3  |  |      | $   | 1.8  |  |       | $    | 45.2 |  |   | $     | 101.8 |  |   | $ |  |  |   | $   | 3.6 | 
|                             |       |       |       |       |  |      |     |      |  |      |     |      |  |       |      |      |  |   |       |       |  |   |   |   |  |   |     |    



---

|    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
|--- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(1) | Standby letters of credit are issued under the
    Companys revolving line of credit that expires in April
    2005 and may be extended under substantially similar terms for
    one additional year at the Companys option, for an assumed
    maturity of April 2006. Therefore, unless a standby letter of
    credit is set to expire at an earlier date, it is assumed that
    the standby letters of credit will expire contemporaneously with
    the expiration of the Companys line of credit in April
    2006.

In the ordinary course of business, the Company
enters into agreements with service providers and other parties
that may contain provisions for the Company to indemnify such
parties under certain circumstances.

At September 30, 2004, the Company had
outstanding commitments to fund investments totaling
$399.4 million.

Note 6. Preferred Stock

At December 31, 2003, Allied Investment had
outstanding a total of 60,000 shares of $100 par value, 3%
cumulative preferred stock and 10,000 shares of $100 par value,
4% redeemable cumulative preferred stock issued to the SBA
pursuant to Section 303(c) of the Small Business Investment Act
of 1958, as amended. In April 2004, Allied Investment
redeemed the preferred stock by paying the SBA the par value of
such securities plus any dividends accumulated and unpaid to the
date of redemption.

Note 7. Shareholders
Equity

Sales of common stock for the nine months ended
September 30, 2004 and 2003, were as follows:

|                                        |              |                     |   |      |  |   |         |         | 
|--------------------------------------- | ------------ | ------------------- | - | ---- |  | - | ------- | ------- | 
|                                        |              |                    
|                                        |              | For the Nine Months
|                                        |              | Ended September 30,
|                                        |              |                    
|                                        |              | 2004                |   | 2003
|                                        |              |                    
|(in thousands)                          |              |                    
|Number of common shares                 |              |                     |  |      |  |   | 13,670  |        
|Gross proceeds                          |              | $                   |  |      |  | $ | 312,845 |        
|Less costs, including underwriting fees |              |                     |  |      |  |   | (14,596 | )      
|                                        |              |                     |   |      |  |   |         |        
|                                        | Net proceeds |                     | $ |     |  |   | $       | 298,249 | 
|                                        |              |                     |   |      |  |   |         |        

In addition, the Company issued 123,814 shares of
common stock with a value of $3.2 million to acquire one
portfolio investment during the nine months ended
September 30, 2004.

34



---



##### 



ALLIED CAPITAL CORPORATION AND
SUBSIDIARIES


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)



Note 7. Shareholders Equity,
continued


The Company has a dividend reinvestment plan,
whereby the Company may buy shares of its common stock in the
open market or issue new shares in order to satisfy dividend
reinvestment requests. If the Company issues new shares, the
issue price is equal to the average of the closing sale prices
reported for the Companys common stock for the five
consecutive trading days immediately prior to the dividend
payment date. For the nine months ended September 30, 2004
and 2003, the Company issued new shares in order to satisfy
dividend reinvestment requests.

Dividend reinvestment plan activity for the nine
months ended September 30, 2004 and 2003, was as follows:

|                                         |  |                     |       |      |  |   |       | 
|---------------------------------------- |  | ------------------- | ----- | ---- |  | - | ----- | 
|                                         |  |                    
|                                         |  | For the Nine Months
|                                         |  | Ended September 30,
|                                         |  |                    
|                                         |  | 2004                |       | 2003
|(in thousands, except per share amounts) |  |                     |       |     
|Shares issued                            |  |                     | 167   |      |  |   | 219   | 
|Average price per share                  |  | $                   | 26.34 |      |  | $ | 22.62 | 

Note 8. Earnings Per Common
Share

Earnings per common share for the three and nine
months ended September 30, 2004 and 2003, were as follows:

|                                                         |  |                      |         |                     |  |      |         |      |  |   |         |   |  |   |         |  
|-------------------------------------------------------- |  | -------------------- | ------- | ------------------- |  | ---- | ------- | ---- |  | - | ------- | - |  | - | ------- | -
|                                                         |  |                      |         |                    
|                                                         |  | For the Three Months |         | For the Nine Months
|                                                         |  | Ended September 30,  |         | Ended September 30,
|                                                         |  |                      |         |                    
|                                                         |  | 2004                 |         | 2003                |  | 2004 |         | 2003
|(in thousands, except per share amounts)                 |  |                      |         |                     |  |      |         |     
|Net increase in net assets resulting from
    operations |  | $                    | 85,999  |                     |  | $    | 33,744  |      |  | $ | 201,649 |   |  | $ | 113,557 |  
|Less preferred stock dividends                           |  |                      |        |                     |  |      | (45     | )    |  |   | (52     | ) |  |   | (155    | )
|                                                         |  |                      |         |                     |  |      |         |      |  |   |         |   |  |   |         |  
|Income available to common shareholders                  |  | $                    | 85,999  |                     |  | $    | 33,699  |      |  | $ | 201,597 |   |  | $ | 113,402 |  
|                                                         |  |                      |         |                     |  |      |         |      |  |   |         |   |  |   |         |  
|Weighted average common shares
    outstanding  basic   |  |                      | 129,304 |                     |  |      | 118,855 |      |  |   | 128,812 |   |  |   | 113,985 |  
|Dilutive options outstanding to officers                 |  |                      | 1,888   |                     |  |      | 2,051   |      |  |   | 2,675   |   |  |   | 1,243   |  
|                                                         |  |                      |         |                     |  |      |         |      |  |   |         |   |  |   |         |  
|Weighted average common shares
    outstanding  diluted |  |                      | 131,192 |                     |  |      | 120,906 |      |  |   | 131,487 |   |  |   | 115,228 |  
|                                                         |  |                      |         |                     |  |      |         |      |  |   |         |   |  |   |         |  
|Basic earnings per common share                          |  | $                    | 0.67    |                     |  | $    | 0.28    |      |  | $ | 1.57    |   |  | $ | 0.99    |  
|                                                         |  |                      |         |                     |  |      |         |      |  |   |         |   |  |   |         |  
|Diluted earnings per common share                        |  | $                    | 0.66    |                     |  | $    | 0.28    |      |  | $ | 1.53    |   |  | $ | 0.98    |  
|                                                         |  |                      |         |                     |  |      |         |      |  |   |         |   |  |   |         |  

Note 9. Individual Performance
Award

In the first quarter of 2004, the Company
established the Individual Performance Award (IPA)
as a long-term incentive compensation program for its senior
officers. In conjunction with the program, the Company has
approved a non-qualified deferred compensation plan
(DCP II), which is administered through a
trust. The administrator of the DCP II is the Compensation

35



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##### 



ALLIED CAPITAL CORPORATION AND
SUBSIDIARIES


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)



Note 9. Individual Performance Award,
continued


Committee of the Companys Board of
Directors (DCP II Administrator) and the
DCP II trust is administered by a Company-appointed trustee.

The IPA, which will generally be determined
annually at the beginning of each year, will be deposited in the
trust in four equal installments, generally on a quarterly
basis, in the form of cash. The Compensation Committee has
designed the DCP II to then require the trustee to use the
cash exclusively to purchase shares of the Companys common
stock in the open market.

All amounts deposited and then credited to a
participants account in the trust, based on the amount of
the IPA received by such participant, are credited solely for
purposes of accounting and computation and remain assets of the
Company and subject to the claims of the Companys general
creditors. Amounts credited to participants under the
DCP II are immediately vested and non-forfeitable once
deposited by the Company into the trust. A participants
account shall generally become distributable only after his or
her termination of employment, or in the event of a change of
control of the Company. Upon the participants termination
of employment, one-third of the participants account will
be immediately distributed, one-half of the then current
remaining balance will be distributed on the first anniversary
of his or her employment termination date and the remainder of
the account balance will be distributed on the second
anniversary of the employment termination date. Distributions
are subject to the participants adherence to certain
non-solicitation requirements. All DCP II accounts will be
distributed in a single lump sum in the event of a change of
control of the Company. To the extent that a participant has an
employment agreement, such participants DCP II
account will be fully distributed in the event that such
participants employment is terminated for good reason as
defined under that participants employment agreement. The
DCP II Administrator may also determine other distributable
events and the timing of such distributions. Sixty days
following a distributable event, the Company and each
participant may, at the discretion of the Company, and subject
to the Companys trading window during that time, redirect
the participants account to other investment options.

During any period of time in which a participant
has an account in the DCP II, any dividends declared and
paid on shares of the Companys common stock allocated to
the participants account shall be reinvested by the
trustee as soon as practicable in shares of the Companys
common stock purchased in the open market.

For the three and nine months ended
September 30, 2004, the Company recorded $3.2 million
and $10.2 million, respectively in IPA expense. These
amounts were contributed into the DCP II trust and have or
will be invested in the Companys common stock. The
accounts of the DCP II are consolidated with the
Companys accounts. The common stock is classified as
common stock held in deferred compensation trust in the
accompanying financial statements and the deferred compensation
obligation, which represents the amount owed to the employees,
is included in other liabilities. Changes in the value of the
Companys common stock are not recognized in the common
stock held in deferred compensation trust. However, the
obligation is adjusted with a corresponding charge or credit to
compensation expense. The effect of this adjustment for the
three and nine months ended September 30, 2004, was to
reduce the individual performance award expense by
$0.1 million and $0.7 million, respectively. This
resulted in a total IPA expense of $3.1 million and
$9.5 million for the three and nine months ended
September 30, 2004, respectively.

36



---



##### 



ALLIED CAPITAL CORPORATION AND
SUBSIDIARIES


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

Note 10. Stock Option Plan

The purpose of the stock option plan
(Option Plan) is to provide officers and non-officer
directors of the Company with additional incentives. Options are
exercisable at a price equal to the fair market value of the
shares on the day the option is granted. Each option states the
period or periods of time within which the option may be
exercised by the optionee, which may not exceed ten years from
the date the option is granted. The options granted vest ratably
over a three- or five-year period.

All rights to exercise options terminate
60 days after an optionee ceases to be (i) a
non-officer director, (ii) both an officer and a director,
if such optionee serves in both capacities, or (iii) an
officer (if such officer is not also a director) of the Company
for any cause other than death or total and permanent
disability. In the event of a change of control of the Company,
all outstanding options will become fully vested and exercisable
as of the change of control.

On May 12, 2004, the Companys
shareholders amended the Option Plan to increase the authorized
number of shares under the plan to 32.2 million. At
December 31, 2003, there were 26.0 million shares
authorized under the Option Plan. At September 30, 2004,
and December 31, 2003, the number of shares available to be
granted under the Option Plan was 8.1 million and
8.8 million, respectively. For the nine months ended
September 30, 2004, 7.9 million shares were granted to
employees under the Option Plan at an average exercise price of
$28.47 per share.

Options were outstanding for 20.4 million
and 14.9 million shares with a weighted average exercise
price of $23.53 and $20.68 per share at September 30,
2004, and December 31, 2003, respectively.

Note 11. Dividends and
Distributions

The Companys Board of Directors declared
and the Company paid a dividend of $0.57 per common share
for the first, second and third quarters of 2004 and 2003. These
dividends totaled $220.8 million and $196.2 million
for the nine months ended September 30, 2004 and 2003,
respectively. The Company declared an extra cash dividend of
$0.03 per share during 2002 and this was paid to shareholders on
January 9, 2003.

The Companys Board of Directors also
declared a dividend of $0.57 per common share for the
fourth quarter of 2004.

Note 12. Supplemental Disclosure of Cash
Flow Information

For the nine months ended September 30, 2004
and 2003, the Company paid interest of $46.8 million and
$42.3 million, respectively. For the nine months ended
September 30, 2004, the Companys non-cash financing
activities totaled $4.4 million related to the issuance of
common stock in lieu of cash distributions, and
$3.2 million related to the issuance of common stock as
consideration to acquire Legacy Partners Group, LLC. For the
nine months ended September 30, 2003, the Companys
non-cash financing activities totaled $5.0 million related
to the issuance of common stock in lieu of cash distributions.

Non-cash operating activities for the nine months
ended September 30, 2004, include notes or other securities
received as consideration from the sale of investments of
$53.9 million. The notes received for the nine months ended
September 30, 2004, include a note received for
$47.5 million in conjunction with the sale of the
Companys investment in Hillman. During the second quarter
of 2004, the Company sold a $5.0 million participation in
its subordinated debt in Hillman to a third party, which reduced
its investment, and no gain or loss resulted from the
transaction. Non-cash

37



---



##### 



ALLIED CAPITAL CORPORATION AND
SUBSIDIARIES


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)



Note 12. Supplemental Disclosure of Cash
Flow Information, continued


operating activities for the nine months ended
September 30, 2004, also included an exchange of
$48.3 million of subordinated debt in certain predecessor
companies of Advantage Sales & Marketing, Inc. for new
subordinated debt in Advantage; an exchange of existing debt
securities with a cost basis of $46.4 million for new debt and
common stock in Startec Global Communications Corporation; an
exchange of existing debt securities with a cost basis of
$13.1 million for new debt of $11.3 million with the
remaining cost basis attributed to equity in Fairchild
Industrial Products Company; the repayment in kind of
$10.0 million of existing subordinated debt in American
Healthcare Services, Inc. with debt in MedBridge Healthcare,
LLC; and an exchange of existing subordinated debt with a cost
basis of $7.3 million for equity interests in an affiliate of
Impact Innovations Group, LLC. In addition, GACI acquired
certain assets of Galaxy out of bankruptcy during the third
quarter of 2004. The Company exchanged its $50.7 million
debt investment in Galaxy for debt and equity in GACI to
facilitate the asset acquisition. See Note 3 for related
disclosures.

Non-cash operating activities for the nine months
ended September 30, 2003, included transfers of commercial
mortgage loans and real estate owned in the repayment of the
Companys residual interest related to the Companys
1998 asset securitization totaling $69.3 million, real
estate owned received in connection with foreclosure on
commercial mortgage loans of $9.1 million, receipt of
commercial mortgage loans in satisfaction of private finance
loans and debt securities of $9.1 million and receipt of a
note as consideration from the sale of real estate owned of $2.1
million.

Note 13. Hedging Activities

The Company invests in CMBS and CDO bonds, which
are purchased at prices that are based in part on comparable
Treasury rates. The Company has entered into transactions with
one or more financial institutions to hedge against movement in
Treasury rates on certain of the higher rated CMBS bonds and CDO
bonds. These transactions, referred to as short sales, involve
the Company receiving the proceeds from the short sales of
borrowed Treasury securities, with the obligation to replenish
the borrowed Treasury securities at a later date based on the
then current market price. Borrowed Treasury securities and the
related obligations to replenish the borrowed Treasury securities

38



---



##### 



ALLIED CAPITAL CORPORATION AND
SUBSIDIARIES


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)



Note 13. Hedging Activities,
continued


at value, including accrued interest payable on
the obligations, as of September 30, 2004, and
December 31, 2003, consisted of the following:

|                                               |       |      |        |         |  |   |        |        | 
|---------------------------------------------- | ----- | ---- | ------ | ------- |  | - | ------ | ------ | 
|($ in thousands)                               |       |      |        |        
|Description of Issue                           |       | 2004 |        | 2003   
|                                               |       |      |        |        
|5-year Treasury securities, due November 2007  |       | $    | 7,211  |         |  | $ | 7,185  |       
|5-year Treasury securities, due February 2008  |       |      |       |         |  |   | 5,977  |       
|5-year Treasury securities, due March 2009     |       |      | 11,018 |         |  |   |       |       
|5-year Treasury securities, due April 2009     |       |      | 2,219  |         |  |   |       |       
|5-year Treasury securities, due May 2009       |       |      | 5,674  |         |  |   |       |       
|5-year Treasury securities, due June 2009      |       |      | 6,845  |         |  |   |       |       
|5-year Treasury securities, due September 2009 |       |      | 18,205 |         |  |   |       |       
|10-year Treasury securities, due November 2012 |       |      | 9,627  |         |  |   | 9,357  |       
|10-year Treasury securities, due February 2013 |       |      | 22,605 |         |  |   | 32,226 |       
|10-year Treasury securities, due May 2013      |       |      | 5,425  |         |  |   | 5,281  |       
|10-year Treasury securities, due August 2013   |       |      | 21,449 |         |  |   | 23,666 |       
|10-year Treasury securities, due November 2013 |       |      | 35,230 |         |  |   | 14,833 |       
|10-year Treasury securities, due February 2014 |       |      | 38,735 |         |  |   |       |       
|10-year Treasury securities, due May 2014      |       |      | 40,174 |         |  |   |       |       
|10-year Treasury securities, due August 2014   |       |      | 46,245 |         |  |   |       |       
|                                               |       |      |        |         |  |   |        |       
|                                               | Total |      | $      | 270,662 |  |   | $      | 98,525 | 
|                                               |       |      |        |         |  |   |        |       

As of September 30, 2004, the total
obligations to replenish borrowed Treasury securities had
increased since the related original sale dates due to changes
in the yield on the borrowed Treasury securities, resulting in
unrealized depreciation on the obligations of $2.3 million.
As of December 31, 2003, the total obligations to replenish
borrowed Treasury securities had decreased since the related
original sale dates due to changes in the yield on the borrowed
Treasury securities, resulting in unrealized appreciation on the
obligations of $0.6 million.

The net proceeds related to the sales of the
borrowed Treasury securities were $267.5 million and
$98.5 million at September 30, 2004, and
December 31, 2003, respectively. Under the terms of the
transactions, the Company had provided additional cash
collateral of $3.2 million and $18 thousand at
September 30, 2004, and December 31, 2003, respectively,
for the difference between the net proceeds related to the sales
of the borrowed Treasury securities and the obligations to
replenish the securities.

The Company has deposited the proceeds related to
the sales of the borrowed Treasury securities and the additional
cash collateral with Wachovia Capital Markets, LLC under
repurchase agreements. The repurchase agreements are
collateralized by U.S. Treasury securities and are settled
weekly. As of September 30, 2004, the repurchase agreements
were due on October 6, 2004, and had a weighted average
interest rate of 1.2%. The weighted average interest rate on the
repurchase agreements as of December 31, 2003, was 0.3%.

39



---



##### 



ALLIED CAPITAL CORPORATION AND
SUBSIDIARIES


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

Note 14. Financial Highlights

|                                                                                          |                                                               |                   |           |                |   |      |           |       |   |   |           |       |  
|----------------------------------------------------------------------------------------- | ------------------------------------------------------------- | ----------------- | --------- | -------------- | - | ---- | --------- | ----- | - | - | --------- | ----- | -
|                                                                                          |                                                               |                   |           |               
|                                                                                          |                                                               | At and for the    |           |               
|                                                                                          |                                                               | Nine Months Ended |           | At and for the
|                                                                                          |                                                               | September 30,     |           | Year Ended    
|                                                                                          |                                                               |                   |           | December 31,  
|                                                                                          |                                                               | 2004(1)           |           | 2003           |   | 2003
|                                                                                          |                                                               |                   |           |                |   |     
|Per Common Share
    Data(2)                                                              |                                                               |                   |           |                |   |      |           |       |   |   |           |      
|Net asset value, beginning of period                                                      |                                                               | $                 | 14.94     |                |   | $    | 14.22     |       |   | $ | 14.22     |      
|                                                                                          |                                                               |                   |           |                |   |      |           |       |   |   |           |      
|                                                                                          | Net investment income                                         |                   |           | 1.11           |   |      |           | 1.22  |   |   |           | 1.65  |  
|                                                                                          | Net realized gains(3)                                         |                   |           | 1.34           |   |      |           | 0.44  |   |   |           | 0.63  |  
|                                                                                          | Net change in unrealized appreciation or
    depreciation (3) |                   |           | (0.92          | ) |      |           | (0.68 | ) |   |           | (0.66 | )
|                                                                                          |                                                               |                   |           |                |   |      |           |       |   |   |           |      
|Net increase in net assets resulting from
    operations                                  |                                                               |                   | 1.53      |                |   |      | 0.98      |       |   |   | 1.62      |      
|                                                                                          |                                                               |                   |           |                |   |      |           |       |   |   |           |      
|Net decrease in net assets from shareholder
    distributions                             |                                                               |                   | (1.71     | )              |   |      | (1.71     | )     |   |   | (2.28     | )    
|Net increase in net assets from capital share
    transactions                            |                                                               |                   | 0.14      |                |   |      | 0.97      |       |   |   | 1.38      |      
|                                                                                          |                                                               |                   |           |                |   |      |           |       |   |   |           |      
|Net asset value, end of period                                                            |                                                               | $                 | 14.90     |                |   | $    | 14.46     |       |   | $ | 14.94     |      
|                                                                                          |                                                               |                   |           |                |   |      |           |       |   |   |           |      
|Market value, end of period                                                               |                                                               | $                 | 24.39     |                |   | $    | 24.59     |       |   | $ | 27.88     |      
|Total return(4)                                                                           |                                                               |                   | (7        | )%             |   |      | 21        | %     |   |   | 41        | %    
|Ratios and Supplemental Data($ and shares in thousands,
    except per
    share amounts) |                                                               |                   |           |                |   |      |           |       |   |   |           |      
|Ending net assets                                                                         |                                                               | $                 | 1,935,740 |                |   | $    | 1,775,587 |       |   | $ | 1,914,577 |      
|Common shares outstanding at end of period                                                |                                                               |                   | 129,898   |                |   |      | 122,766   |       |   |   | 128,118   |      
|Diluted weighted average common shares outstanding                                        |                                                               |                   | 131,487   |                |   |      | 115,228   |       |   |   | 118,351   |      
|Employee and administrative expenses/average net
    assets (5)                           |                                                               |                   | 3.31      | %              |   |      | 2.58      | %     |   |   | 3.50      | %    
|Total expenses/average net assets                                                         |                                                               |                   | 6.32      | %              |   |      | 6.09      | %     |   |   | 8.06      | %    
|Net investment income/average net assets                                                  |                                                               |                   | 7.66      | %              |   |      | 8.59      | %     |   |   | 11.51     | %    
|Net increase in net assets resulting from
    operations/ average net assets              |                                                               |                   | 10.56     | %              |   |      | 6.92      | %     |   |   | 11.33     | %    
|Portfolio turnover rate                                                                   |                                                               |                   | 20.19     | %              |   |      | 20.04     | %     |   |   | 31.12     | %    
|Average debt outstanding                                                                  |                                                               | $                 | 973,528   |                |   | $    | 939,903   |       |   | $ | 943,507   |      
|Average debt per share(2)                                                                 |                                                               | $                 | 7.40      |                |   | $    | 8.16      |       |   | $ | 7.97      |      



---

|    |                                                                                                                                                                                                         
|--- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(1) | The results for the nine months ended
    September 30, 2004, are not necessarily indicative of the
    operating results to be expected for the full year.                                             
|   
|(2) | Based on diluted weighted average number of
    common shares outstanding for the period.                                                                                                               
|   
|(3) | Net realized gains and net change in unrealized
    appreciation or depreciation can fluctuate significantly from
    period to period. As a result, year-to-date comparisons may not
    be meaningful.
|   
|(4) | Total return assumes the reinvestment of all
    dividends paid for the periods presented.                                                                                                              
|   
|(5) | Employee expenses for the nine months ended
    September 30, 2004, include the expense related to the
    individual performance award totaling $9.5 million.                                          

40



---



##### 



ALLIED CAPITAL CORPORATION AND
SUBSIDIARIES


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

Note 15. Litigation

The Company is party to certain lawsuits in the
normal course of business. While the outcome of these legal
proceedings cannot at this time be predicted with certainty, the
Company does not expect that these proceedings will have a
material effect upon the Companys financial condition or
results of operations.

41



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##### 



Report of Independent Registered Public
Accounting Firm

The Board of Directors and Shareholders

Allied Capital Corporation:


We have reviewed the accompanying consolidated
balance sheet of Allied Capital Corporation and subsidiaries,
including the consolidated statement of investments, as of
September 30, 2004, and the related consolidated statements
of operations for the three- and nine-month periods ended
September 30, 2004 and 2003, the consolidated statements of
changes in net assets and cash flows and the financial
highlights (included in Note 14) for the nine-month periods
ended September 30, 2004 and 2003. These consolidated
financial statements and financial highlights are the
responsibility of the Companys management.

We conducted our reviews in accordance with
standards of the Public Company Accounting Oversight Board
(United States). A review of interim financial information
consists principally of applying analytical procedures and
making inquiries of persons responsible for financial and
accounting matters. It is substantially less in scope than an
audit conducted in accordance with the standards of the Public
Company Accounting Oversight Board (United States), the
objective of which is the expression of an opinion regarding the
financial statements taken as a whole. Accordingly, we do not
express such an opinion.

Based on our reviews, we are not aware of any
material modifications that should be made to the consolidated
financial statements and financial highlights referred to above
for them to be in conformity with U.S. generally accepted
accounting principles.

We have previously audited, in accordance with
standards of the Public Company Accounting Oversight Board
(United States), the consolidated balance sheet of Allied
Capital Corporation and subsidiaries as of December 31,
2003, and the related consolidated statements of operations,
changes in net assets and cash flows (not presented herein), and
the financial highlights (included in Note 14), for the
year then ended; and in our report dated February 17, 2004,
we expressed an unqualified opinion on those consolidated
financial statements. In our opinion, the information set forth
in the accompanying condensed consolidated balance sheet as of
December 31, 2003, is fairly stated, in all material
respects, in relation to the consolidated balance sheet from
which it has been derived.

/s/ KPMG LLP

Washington, D.C.

October 26, 2004


42



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##### 





|         |                                                                                          
|-------- | -----------------------------------------------------------------------------------------
|Item  2. | Managements Discussion and Analysis
    of Financial Condition and Results of Operations

The following analysis of the financial
condition and results of operations of the Company should be
read in conjunction with the Companys Consolidated
Financial Statements and the Notes thereto included herein and
in the Companys annual report on Form 10-K for the
year ended December 31, 2003. This quarterly report on Form
10-Q contains certain forward-looking statements. These
statements include the plans and objectives of management for
future operations and financial objectives and can be identified
by the use of forward-looking terminology such as
may, will, expect,
intend, anticipate,
estimate, or continue or the negative
thereof or other variations thereon or comparable terminology.
These forward-looking statements are subject to the inherent
uncertainties in predicting future results and conditions.
Certain factors that could cause actual results and conditions
to differ materially from those projected in these
forward-looking statements are set forth below in the Risk
Factors section. Other factors that could cause actual results
to differ materially include:



| |   |                                                                                                                        
| | - | -----------------------------------------------------------------------------------------------------------------------
| |  | changes in the economy;                                                                                                
|
| |  | risks associated with possible disruption in
    our operations due to terrorism;                                      
|
| |  | future changes in laws or regulations and
    conditions in our operating areas; and                                   
|
| |  | other risks and uncertainties as may be
    detailed from time to time in our public announcements and SEC
    filings.

Financial or other information presented for
private finance portfolio companies has been obtained from the
portfolio companies, and the financial information presented may
represent unaudited, projected or pro forma financial
information, and therefore may not be indicative of actual
results. In addition, the private equity industry uses financial
measures such as EBITDA or EBITDAM (Earnings Before Interest,
Taxes, Depreciation, Amortization and, in some instances,
Management fees) in order to assess a portfolio companys
financial performance and to value a portfolio company. EBITDA
and EBITDAM are not intended to represent cash flow from
operations as defined by U.S. generally accepted accounting
principles and such information should not be considered as an
alternative to net income, cash flow from operations or any
other measure of performance prescribed by U.S. generally
accepted accounting principles.

OVERVIEW

We are a business development company that
provides long-term debt and equity investment capital to
companies in a variety of industries. Our lending and investment
activity is generally focused on private finance and commercial
real estate finance, primarily the investment in non-investment
grade commercial mortgage-backed securities, which we refer to
as CMBS, and collateralized debt obligation bonds and preferred
shares, which we refer to as CDOs. Our private finance activity
principally involves providing financing through privately
negotiated long-term debt and equity investment capital. Our
private financing is generally used to fund growth,
acquisitions, buyouts, recapitalizations, note purchases, bridge
financings and other types of financings. We generally invest in
private companies though, from time to time, we may invest in
companies that are public but lack access to additional public
capital or whose securities may not be marginable.

43



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##### 



Our portfolio composition at September 30,
2004, and December 31, 2003, was as follows:

|                               |  |      |    |      |  |  |    |  
|------------------------------ |  | ---- | -- | ---- |  |  | -- | -
|                               |  | 2004 |    | 2003
|                               |  |      |    |     
|Private finance                |  |      | 68 | %    |  |  | 74 | %
|Commercial real estate finance |  |      | 32 | %    |  |  | 26 | %

Our earnings depend primarily on the level of
interest and dividend income, fee and other income, and net
gains or losses earned on our investment portfolio after
deducting interest expense on borrowed capital and operating
expenses. Interest income results from the stated interest rate
earned on a loan and the amortization of loan origination points
and discounts. The level of interest income is directly related
to the balance of the interest-bearing investment portfolio
outstanding during the period multiplied by the weighted average
yield. Our ability to generate interest income is dependent on
economic, regulatory, and competitive factors that influence new
investment activity, the amount of loans and debt securities for
which interest is not accruing and our ability to secure debt
and equity capital for our investment activities.

Because we are a regulated investment company for
tax purposes, we distribute substantially all of our taxable
income as dividends to our shareholders.

PORTFOLIO AND INVESTMENT ACTIVITY

The total portfolio at value, investment
activity, and the yield on interest-bearing investments at and
for the three and nine months ended September 30, 2004 and
2003, and at and for the year ended December 31, 2003, were
as follows:

|                                                                    |  |                    |         |                   |  |                |         |      |  |      |         |   |  |   |         |   |  |   |         |  
|------------------------------------------------------------------- |  | ------------------ | ------- | ----------------- |  | -------------- | ------- | ---- |  | ---- | ------- | - |  | - | ------- | - |  | - | ------- | -
|                                                                    |  |                    |         |                   |  |               
|                                                                    |  | At and for the     |         | At and for the    |  |               
|                                                                    |  | Three Months Ended |         | Nine Months Ended |  | At and for the
|                                                                    |  | September 30,      |         | September 30,     |  | Year Ended    
|                                                                    |  |                    |         |                   |  | December 31,  
|                                                                    |  | 2004               |         | 2003              |  | 2004           |         | 2003 |  | 2003
|($ in millions)                                                     |  |                    |         |                   |  |                |         |      |  |     
|                                                                    |  |                    |         |                   |  |               
|                                                                    |  | (unaudited)        |         | (unaudited)       |  |               
|Portfolio at value                                                  |  | $                  | 2,980.0 |                   |  | $              | 2,601.1 |      |  | $    | 2,980.0 |   |  | $ | 2,601.1 |   |  | $ | 2,584.6 |  
|Investments funded                                                  |  | $                  | 311.9   |                   |  | $              | 138.4   |      |  | $    | 1,106.9 |   |  | $ | 664.8   |   |  | $ | 931.5   |  
|Change in accrued or reinvested interest and
    dividends          |  | $                  | 5.5     |                   |  | $              | 19.6    |      |  | $    | 31.7    |   |  | $ | 40.0    |   |  | $ | 45.0    |  
|Principal collections related to investment
    repayments or sales |  | $                  | 111.7   |                   |  | $              | 74.5    |      |  | $    | 542.5   |   |  | $ | 501.5   |   |  | $ | 784.0   |  
|Yield(1)                                                            |  |                    | 14.2    | %                 |  |                | 14.5    | %    |  |      | 14.2    | % |  |   | 14.5    | % |  |   | 14.7    | %




|    |                                                                                                                                                                                                                                                                                                                                                                                                                     
|--- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(1) | The weighted average yield on interest-bearing
    investments is computed as the (a) annual stated interest
    rate plus the annual amortization of loan origination fees,
    original issue discount, and market discount on accruing
    interest-bearing investments, divided by (b) total
    interest-bearing investments at value. The weighted average
    yield is computed as of the balance sheet date.

44



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##### 



Private Finance

The private finance portfolio at value,
investment activity, and the yield on loans and debt securities
at and for the three and nine months ended September 30,
2004 and 2003, and at and for the year ended December 31,
2003, were as follows:

|                                                                    |                           |                    |         |                   |  |                |         |         |  |      |         |         |  |   |         |         |  |   |         |         | 
|------------------------------------------------------------------- | ------------------------- | ------------------ | ------- | ----------------- |  | -------------- | ------- | ------- |  | ---- | ------- | ------- |  | - | ------- | ------- |  | - | ------- | ------- | 
|                                                                    |                           |                    |         |                   |  |               
|                                                                    |                           | At and for the     |         | At and for the    |  |               
|                                                                    |                           | Three Months Ended |         | Nine Months Ended |  | At and for the
|                                                                    |                           | September 30,      |         | September 30,     |  | Year Ended    
|                                                                    |                           |                    |         |                   |  | December 31,  
|                                                                    |                           | 2004               |         | 2003              |  | 2004           |         | 2003    |  | 2003
|($ in millions)                                                     |                           |                    |         |                   |  |                |         |         |  |     
|                                                                    |                           |                    |         |                   |  |               
|                                                                    |                           | (unaudited)        |         | (unaudited)       |  |               
|Portfolio at value:                                                 |                           |                    |         |                   |  |                |         |         |  |      |         |         |  |   |         |         |  |   |         |        
|                                                                    | Loans and debt securities |                    | $       | 1,401.1           |  |                | $       | 1,158.7 |  |      | $       | 1,401.1 |  |   | $       | 1,158.7 |  |   | $       | 1,214.9 | 
|                                                                    | Equity interests          |                    |         | 629.9             |  |                |         | 650.0   |  |      |         | 629.9   |  |   |         | 650.0   |  |   |         | 687.8   | 
|                                                                    |                           |                    |         |                   |  |                |         |         |  |      |         |         |  |   |         |         |  |   |         |        
|Total portfolio                                                     |                           | $                  | 2,031.0 |                   |  | $              | 1,808.7 |         |  | $    | 2,031.0 |         |  | $ | 1,808.7 |         |  | $ | 1,902.7 |        
|                                                                    |                           |                    |         |                   |  |                |         |         |  |      |         |         |  |   |         |         |  |   |         |        
|Investments funded(1)                                               |                           | $                  | 244.0   |                   |  | $              | 31.7    |         |  | $    | 806.4   |         |  | $ | 305.7   |         |  | $ | 498.0   |        
|Change in accrued or reinvested interest and
    dividends          |                           | $                  | 3.9     |                   |  | $              | 18.4    |         |  | $    | 25.4    |         |  | $ | 37.8    |         |  | $ | 41.8    |        
|Principal collections related to investment
    repayments or sales |                           | $                  | 98.8    |                   |  | $              | 53.7    |         |  | $    | 493.2   |         |  | $ | 199.7   |         |  | $ | 314.3   |        
|Yield(2)                                                            |                           |                    | 15.2    | %                 |  |                | 15.3    | %       |  |      | 15.2    | %       |  |   | 15.3    | %       |  |   | 15.0    | %      






|    |                                                                                                                                                                                                                                                                                                                                                                                                            
|--- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(1) | Investments funded for the nine months ended
    September 30, 2004, include a $47.5 million
    subordinated debt investment in The Hillman Companies, Inc.
    received in conjunction with the sale of Hillman as discussed
    below.                                                                                                                                                                  
|   
|(2) | The weighted average yield on loans and debt
    securities is computed as the (a) annual stated interest
    rate plus the annual amortization of loan origination fees,
    original issue discount, and market discount on accruing loans
    and debt securities, divided by (b) total loans and debt
    securities at value. The weighted average yield is computed as
    of the balance sheet date.

Investments funded for the nine months ended
September 30, 2004 and 2003, and for the year ended
December 31, 2003, consisted of the following:

|                                                 |                               |            |   |           |       |       |   |       |       |  |   |       |       | 
|------------------------------------------------ | ----------------------------- | ---------- | - | --------- | ----- | ----- | - | ----- | ----- |  | - | ----- | ----- | 
|                                                 |                               | Loans and  |   |           |       |      
|                                                 |                               | Debt       |   | Equity    |       |      
|                                                 |                               | Securities |   | Interests |       | Total
|($ in millions)                                  |                               |            |   |           |       |      
|For the Nine Months Ended
    September 30, 2004 |                               |            |   |           |       |       |   |       |       |  |   |      
|                                                 | Companies more than 25% owned |            | $ | 267.1     |       |       | $ | 135.4 |       |  | $ | 402.5 |      
|                                                 | Companies 5% to 25% owned     |            |   | 89.4      |       |       |   | 24.4  |       |  |   | 113.8 |      
|                                                 | Companies less than 5% owned  |            |   | 276.5     |       |       |   | 13.6  |       |  |   | 290.1 |      
|                                                 |                               |            |   |           |       |       |   |       |       |  |   |      
|                                                 |                               | Total      |   | $         | 633.0 |       |   | $     | 173.4 |  |   | $     | 806.4 | 
|                                                 |                               |            |   |           |       |       |   |       |       |  |   |      
|For the Nine Months Ended
    September 30, 2003 |                               |            |   |           |       |       |   |       |       |  |   |      
|                                                 | Companies more than 25% owned |            | $ | 48.0      |       |       | $ | 28.2  |       |  | $ | 76.2  |      
|                                                 | Companies 5% to 25% owned     |            |   | 18.2      |       |       |   | 1.8   |       |  |   | 20.0  |      
|                                                 | Companies less than 5% owned  |            |   | 203.8     |       |       |   | 5.7   |       |  |   | 209.5 |      
|                                                 |                               |            |   |           |       |       |   |       |       |  |   |      
|                                                 |                               | Total      |   | $         | 270.0 |       |   | $     | 35.7  |  |   | $     | 305.7 | 
|                                                 |                               |            |   |           |       |       |   |       |       |  |   |      
|For the Year Ended December 31,
    2003         |                               |            |   |           |       |       |   |       |       |  |   |      
|                                                 | Companies more than 25% owned |            | $ | 53.0      |       |       | $ | 34.0  |       |  | $ | 87.0  |      
|                                                 | Companies 5% to 25% owned     |            |   | 23.8      |       |       |   | 1.9   |       |  |   | 25.7  |      
|                                                 | Companies less than 5% owned  |            |   | 377.4     |       |       |   | 7.9   |       |  |   | 385.3 |      
|                                                 |                               |            |   |           |       |       |   |       |       |  |   |      
|                                                 |                               | Total      |   | $         | 454.2 |       |   | $     | 43.8  |  |   | $     | 498.0 | 
|                                                 |                               |            |   |           |       |       |   |       |       |  |   |      

45



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##### 



The level of investment activity for investments
funded and principal repayments for private finance investments
can vary substantially from period to period depending on many
factors, including the amount of debt and equity capital
available to middle market companies, the level of merger and
acquisition activity for such companies, the general economic
environment, and the competitive environment for the types of
investments we make. Merger and acquisition activity in the
middle market has been strong in the first three quarters of
2004, which has resulted in an increase in private finance
investments funded, as well as increased repayments. The yield
on the private finance loans and debt securities was 15.2% at
September 30, 2004, as compared to 15.0% at
December 31, 2003. The yield on the portfolio has remained
relatively stable, however, we expect that if the market
continues to be as competitive for investment opportunities as
it currently is, we may experience some yield compression going
forward.

On June 30, 2004, we completed the purchase
of a majority ownership position in the business of Advantage
Sales & Marketing, Inc. (Advantage), a leading sales and
marketing agency providing outsourced sales, merchandising, and
marketing services to the consumer packaged goods industry. At
September 30, 2004, our investment in Advantage totaled
$257.6 million at cost and value in debt and equity securities,
including closing costs. At the closing of the transaction, we
invested $90.2 million in loans and subordinated debt and
$73.5 million in common stock. In addition, prior to
completing the purchase, we had invested $93.7 million in
subordinated debt in certain predecessor companies of Advantage,
of which $45.5 million was invested during the second
quarter of 2004. This existing debt was exchanged for new
subordinated debt in Advantage as part of the transaction.

Also during the second quarter, we completed the
purchase of a majority ownership position in Mercury Air
Centers, Inc. (Mercury), an operator of fixed base operations,
from Mercury Air Group, Inc. At September 30, 2004, our
investment in Mercury totaled $83.9 million at cost and
value, including closing costs, which consisted of
$53.5 million in debt and $30.4 million in common
stock. We have an additional $8.5 million commitment to
fund senior subordinated debt for future working capital and
construction commitments. In connection with the transaction,
Mercury Air Group, Inc. repaid its $24 million subordinated
debt obligation to Allied Capital.

During the third quarter of 2004, we completed
the purchase of a majority ownership position in Financial
Pacific Company (Financial Pacific), a specialized commercial
finance company focused on providing leases for
business-essential equipment to small businesses nationwide. At
September 30, 2004, our investment in Financial Pacific
totaled $92.9 million at cost and value, including closing
costs, which consisted of $68.1 million in debt and
$24.8 million in preferred and common stock.

On March 31, 2004, we sold The Hillman Companies,
Inc. (Hillman) for a total transaction value of
$510 million, including the repayment of outstanding debt
and adding the value of Hillmans outstanding trust
preferred shares. We were repaid our existing $44.6 million
in outstanding mezzanine debt. Total consideration to us from
this sale at closing, including the repayment of debt, was
$244.3 million, which included net cash proceeds of
$196.8 million and the receipt of a new subordinated debt
instrument of $47.5 million. During the second quarter of
2004, we sold a $5.0 million participation in our
subordinated debt in Hillman to a third party, which reduced our
investment, and no gain or loss resulted from the transaction.
For the nine months ended September 30, 2004, we realized a
gain of $150.2 million on the transaction, including a gain
of $1.2 million realized during the second quarter of 2004,
resulting from post-closing adjustments, which provided
additional cash consideration to us in the same amount. The sale
of Hillman is subject to certain other post-closing adjustments.

In addition, investments funded to portfolio
companies more than 25% owned during the nine months ended
September 30, 2004, included a $6.6 million debt and equity
investment, including

46



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##### 



closing costs, to purchase Legacy Partners Group,
LLC and an additional debt investment of $2.5 million for
working capital.


We generally fund new investments using cash. In
addition, we may acquire securities in exchange for our common
equity. Also, we may acquire new securities through the
reinvestment of previously accrued interest and dividends in
debt or equity securities, or the current reinvestment of
interest and dividend income through the receipt of a debt or
equity security (payment-in-kind income). From time to time we
may opt to reinvest accrued interest receivable in a new debt or
equity security in lieu of receiving such interest in cash and
then using that cash to make a subsequent investment.

At September 30, 2004, we had outstanding
investment commitments to private finance portfolio companies
totaling $395.1 million. In addition, we had commitments to
private finance portfolio companies in the form of guarantees
and standby letters of credit totaling $150.0 million.

Significant outstanding investment commitments at
September 30, 2004, included the following:



| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
| | - | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | $97.7 million of financing and purchase
    commitments to Callidus Capital Corporation (Callidus), an asset
    management company that structures and manages collateralized
    debt obligations (CDOs), senior loan collateralized loan
    obligations (CLOs), and other related investments. Our
    commitment consists of $50 million of subordinated debt to
    support Callidus warehouse facilities and warehousing
    activities, $47.0 million to purchase below investment
    grade bonds and preferred equity securities in Callidus
    future CDO or CLO transactions, and $0.7 million for
    working capital needs. In addition, we have an outstanding
    commitment of $150.0 million in the form of a revolving
    line of credit facility to support Callidus middle-market
    underwriting and syndication activities. There were no amounts
    outstanding under this facility at September 30, 2004. At
    September 30, 2004, we had an investment in Callidus
    totaling $7.1 million at value, which included equity
    ownership for 80% of the management company. We made our initial
    investment in Callidus in the fourth quarter of 2003.
|
| |   | Callidus has a secured warehouse credit facility
    for up to $350 million to finance the acquisition of senior
    corporate loans pending securitization through a CDO or CLO. In
    conjunction with this warehouse credit facility, we have agreed
    to designate $32.3 million of our $50 million subordinated
    debt commitment for Callidus to draw upon to provide first loss
    capital as needed to support the warehouse facility.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
|
| |  | $55.1 million in the form of subordinated
    debt to CBA Mezzanine Capital Finance, LLC to support its loan
    origination activity. This commitment expires in April 2005 and
    there are currently no amounts outstanding under this facility.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
|
| |  | $20.0 million in the form of a revolving
    credit facility to Business Loan Express, LLC (BLX) to provide
    working capital to the company. At September 30, 2004, BLX
    had no outstanding borrowings on the facility.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
|
| |  | $24.0 million in the form of equity to eight
    private venture capital funds.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
|
| |  | $9.7 million in the form of equity to
    Pennsylvania Avenue Investors, L.P., a limited partnership that
    invests in private buyout equity funds.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         

In addition to the commitments listed above, we
may have commitments to fund additional amounts under earn-out
arrangements in the future if certain performance targets are
met.

Our most significant investments at
September 30, 2004, were in Business Loan Express,
LLC (BLX), which was acquired in 2000, and Advantage
Sales & Marketing, Inc. (Advantage), which was acquired
on June 30, 2004.

47



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##### 



Business Loan Express,
LLC.At
September 30, 2004, our investment in BLX totaled
$271.2 million at cost and $352.1 million at value, or
10.2% of our total assets, which includes unrealized
appreciation of $80.9 million.

BLX is a national, non-bank lender utilizing the
SBAs 7(a) Guaranteed Loan Program and is licensed by
the SBA as a Small Business Lending Company (SBLC). BLX is a
nationwide preferred lender, as designated by the SBA, and
originates, sells, and services small business loans. In
addition to the SBA 7(a) Guaranteed Loan Program, BLX
originates conventional small business loans, originates loans
under the USDA Business and Industry Guaranteed Loan Program
(B&I) and during the quarter ended March 31, 2004, BLX
began originating small investment real estate loans. BLX has
offices across the United States and is headquartered in New
York, New York. Changes in the laws or regulations that govern
SBLCs or the SBA 7(a) Guaranteed Loan Program or changes in
government funding for this program could have a material
adverse impact on BLX and, as a result, could negatively affect
our financial results.

Certain legislation regarding the SBA 7(a) loan
program expired on September 30, 2004. In addition, the SBA is
operating under a continuing resolution which allows funding for
the agency until Congress approves its appropriations for fiscal
year 2005. As a result, certain changes were implemented in the
SBA 7(a) loan program effective October 1, 2004. The
maximum loan guarantee was reduced from $1.5 million to
$1 million and piggyback lending (when the SBA 7(a) loan is
in a junior lien position) was prohibited. At this time, based
upon our analysis of BLXs position in the market, the
strength of its non-SBA conventional loan program, we do not
believe there will be any long-term adverse effect on BLX.

48



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##### 



Summary financial data for BLX at and for its
fiscal years ended September 30, 2004 and 2003, is
presented below. Summary financial data has been provided by BLX
and is unaudited.

|                                    |                                                                    |                    |                         |         |       |       |   |         |       |       |  
|----------------------------------- | ------------------------------------------------------------------ | ------------------ | ----------------------- | ------- | ----- | ----- | - | ------- | ----- | ----- | -
|                                    |                                                                    |                   
|                                    |                                                                    | At and for the    
|                                    |                                                                    | Fiscal Years Ended
|                                    |                                                                    | September 30,     
|                                    |                                                                    |                   
|                                    |                                                                    | 2004(1)            |                         | 2003   
|($ in millions)                     |                                                                    |                    |                         |        
|Operating Data                      |                                                                    |                    |                         |         |       |       |   |        
|                                    | Total revenue                                                      |                    | $                       | 118.3   |       |       | $ | 108.3   |      
|                                    | Net income(2)                                                      |                    | $                       | 13.2    |       |       | $ | 4.7     |      
|                                    | Earnings before interest, taxes and management
    fees (EBITM)(2) |                    | $                       | 44.7    |       |       | $ | 37.5    |      
|Balance Sheet Data                  |                                                                    |                    |                         |         |       |       |   |        
|                                    | Total assets                                                       |                    | $                       | 443.7   |       |       | $ | 353.0   |      
|                                    | Total debt                                                         |                    | $                       | 229.2   |       |       | $ | 178.5   |      
|                                    | Total owners equity                                               |                    | $                       | 152.0   |       |       | $ | 136.1   |      
|Other Data                          |                                                                    |                    |                         |         |       |       |   |        
|                                    | Loan originations                                                  |                    |                         |         |       |       |   |         |      
|                                    |                                                                    | SBA 7(a)           |                         | $       | 358.6 |       |   | $       | 502.4 |      
|                                    |                                                                    | Conventional       |                         |         | 287.0 |       |   |         | 151.6 |      
|                                    |                                                                    | B&I                |                         |         | 11.4  |       |   |         | 31.8  |      
|                                    |                                                                    |                    |                         |         |       |       |   |        
|                                    |                                                                    |                    | Total loan originations |         | $     | 657.0 |   |         | $     | 685.8 |  
|                                    |                                                                    |                    |                         |         |       |       |   |        
|                                   
|                                    | Serviced loan portfolio                                            |                    | $                       | 2,572.9 |       |       | $ | 2,227.4 |      
|                                    | Number of loans                                                    |                    |                         | 3,573   |       |       |   | 3,136   |      
|                                    | Loan delinquencies(3)                                              |                    |                         | 8.9     | %     |       |   | 8.3     | %    
|Serviced Loan Portfolio by Industry |                                                                    |                    |                         |         |       |       |   |        
|                                    | Hotels                                                             |                    |                         | 24      | %     |       |   | 24      | %    
|                                    | Gas stations/convenience stores                                    |                    |                         | 20      |       |       |   | 19      |      
|                                    | Professional and retail services                                   |                    |                         | 12      |       |       |   | 12      |      
|                                    | Restaurants                                                        |                    |                         | 8       |       |       |   | 9       |      
|                                    | Manufacturing and industrial                                       |                    |                         | 8       |       |       |   | 9       |      
|                                    | Car wash/auto repair services                                      |                    |                         | 7       |       |       |   | 7       |      
|                                    | Child care and health care services                                |                    |                         | 6       |       |       |   | 6       |      
|                                    | Recreation                                                         |                    |                         | 5       |       |       |   | 5       |      
|                                    | Shrimp/fishing vessels                                             |                    |                         | 4       |       |       |   | 5       |      
|                                    | Other                                                              |                    |                         | 6       |       |       |   | 4       |      
|                                    |                                                                    |                    |                         |         |       |       |   |        
|                                    |                                                                    |                    | Total                   |         |       | 100   | % |         |       | 100   | %
|                                    |                                                                    |                    |                         |         |       |       |   |        



---



|    |                                                                                                                     | 
|--- | ------------------------------------------------------------------------------------------------------------------- | 
|(1) | Summary financial data at and for BLXs
    fiscal year ended September 30, 2004, is preliminary and
    unaudited. | 



|    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             
|--- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(2) | For the fiscal year ended September 30,
    2003, EBITM and net income were reduced by $2.3 million due
    to costs associated with its acquisition of Amresco Independence
    Funding, Inc. and its reorganization from a corporation to a
    limited liability company (LLC) and $2.3 million due to the
    increased value of issued and outstanding equity appreciation
    rights. In addition, net income for the fiscal year ended
    September 30, 2003, was increased by $3.4 million due
    to the reversal of certain net deferred tax liabilities upon the
    conversion of BLX from a corporation to a limited liability
    company. As an LLC, BLX is generally not subject to federal
    income tax; however, BLX is subject to certain state income and
    franchise taxes, and income taxes associated with a taxable
    subsidiary corporation.



|    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          | 
|--- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- | 
|(3) | Represents the percentage of loans in the total
    serviced loan portfolio that are greater than 30 days
    delinquent, which includes loans in workout status. Loans
    greater than 30 days delinquent for the SBA 7(a) loan
    portfolio only, which are included in the total serviced loan
    portfolio, were 9.5% at September 30, 2004. SBA 7(a)
    loans greater than one year old at September 30, 2004, had
    a delinquency rate of 11.6%. BLX will from time to time grant a
    90-day deferment to borrowers experiencing short-term cash flow
    shortfalls. Loans that have been granted a deferment that
    perform as required are not considered delinquent consistent
    with SBA practice. The ability of small businesses to repay
    their loans may be adversely affected by numerous factors,
    including a downturn in their industry or negative economic
    conditions. Small businesses are also more vulnerable to
    customer preferences, competition, rising fuel prices and market
    conditions and, as a result, delinquencies in BLXs
    portfolio may increase. For instance, the shrimp and fishing
    industry has been affected by rising fuel costs and competition
    from imported shrimp, which has resulted in an increase in loan
    delinquencies. For these reasons, BLX focuses on collateral
    protection for each loan in addition to the cash flow of the
    small business and generally receives personal guarantees from
    the principal owners of the small business. | 

49



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##### 



BLXs revenues consist of cash premiums from
guaranteed loan sales, gain on sale income arising from loans
sold at par or securitized where BLX will receive future cash
flows representing the spread between loan interest and the
interest paid on bonds issued including service fee income,
interest income on loans remaining in BLXs portfolio, and
other income. Gain on sale income is a non-cash source of income
when recognized, and as future cash flows are received, the
resulting cash reduces the receivable or residual interest that
is recognized when the loan is sold. The total of cash loan sale
premiums, cash interest income and cash received from residual
interests and other cash income is equal to approximately 83% of
BLXs revenue of $118.3 million for the fiscal year
ended September 30, 2004, and approximately 83% of
BLXs revenue of $108.3 million for the fiscal year
ended September 30, 2003.

BLXs business is to originate small
business loans and then sell substantially all of the loans
originated for cash proceeds. Loans originated during the fiscal
year ended September 30, 2004, totaled $657.0 million.
Proceeds from loan sales during the fiscal year ended
September 30, 2004, totaled approximately
$618.8 million. Loans originated during the fiscal year
ended September 30, 2003, totaled $685.8 million.
Proceeds from loan sales during the fiscal year ended
September 30, 2003, totaled approximately
$664.2 million. From time to time, BLX funds the
construction of commercial real estate projects and as a result
is unable to sell a construction loan until the loan is fully
funded and the construction is complete. In addition, BLX
typically does not immediately receive the proceeds from the
sale of its SBA 7(a) guaranteed and unguaranteed loan
strips sold, but receives the cash upon settlement. Therefore,
until BLX sells construction loans or fully funded loans held
for sale, it will finance the origination of the loans through
funding on its revolving line of credit, or through financing
provided by us.

BLX sells the guaranteed piece of SBA 7(a)
guaranteed loans for cash premiums of up to 10% of the
guaranteed loan amount plus a retained annual servicing fee
generally between 1.0% and 2.4% of the guaranteed loan amount.
Cash premiums received from guaranteed loan sales during the
fiscal years ended September 30, 2004 and 2003, were
approximately $27.1 million and $31.3 million in
total, respectively. Alternatively, BLX may sell the guaranteed
pieces of SBA 7(a) guaranteed loans at par and receive cash
only for the face amount of the loan sold, and instead of
receiving a cash premium, BLX will receive an annual servicing
spread on the loans sold of between 4.0% and 5.0%.

In addition, BLX sells the unguaranteed pieces of
the SBA 7(a) loans and conventional loans it originates
into a conduit facility. The conduit loans are securitized and
BLX retains an interest of up to 5.0% of the loan pool. BLX then
receives the excess of loan interest payments on the loans sold
over the interest cost on the securities issued in the
securitization over the life of the loan pool, which is
generally between 4.3% and 5.0% annually on the loans sold into
the securitization pools.

When BLX sells a guaranteed piece of an
SBA 7(a) loan at par, or when BLX securitizes a loan, it
will record a residual interest and servicing asset, together
referred to as the Residual Interest, in order to account for
the retained interest in the loans sold and the net present
value of the future cash flows it expects to receive from the
loans sold or securitized. In computing the Residual Interest,
BLX discounts estimated future cash flows after making
assumptions as to future loan losses and loan prepayments, which
may reduce future cash flows. For the fiscal years ended
September 30, 2004 and 2003, BLX received cash payments
from the Residual Interest of approximately $59.7 million
and $49.3 million, respectively.

At September 30, 2004, BLXs Residual
Interest totaled $215.5 million, representing BLXs
estimate of the net present value of future cash flows of
scheduled loan payments, after estimated future loan losses and
loan prepayments. If scheduled loan payments were to be received
as stated in the loan agreements with no future losses or
prepayments, BLX would receive future cash flows of
$924.3 million over time, with approximately
$73.1 million, $65.2 million, $63.7 million, and

50



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##### 



$62.0 million (or $264.0 million in the
aggregate) scheduled to be received in the next four years
ending on September 30, 2005, 2006, 2007, and 2008,
respectively.


As a limited liability company, BLXs
taxable income flows through directly to its members. BLXs
annual taxable income generally differs from its book income for
the fiscal year due to temporary and permanent differences in
the recognition of income and expenses. We hold all of
BLXs Class A and Class B interests, and 94.9% of
the Class C interests. BLXs taxable income is first
allocated to the Class A interests to the extent that
dividends are paid in cash or in kind on such interests, with
the remainder being allocated to the Class B and
Class C interests. BLX declares dividends on its
Class B interests based on an estimate of its annual
taxable income allocable to such interests.

For the nine months ended September 30, 2004
and 2003, BLX paid dividends to us in cash or in kind on the
Class A interests totaling $9.4 million and
$7.4 million, respectively. The guaranteed dividend yield
on these equity interests is included in interest income. In
addition, for the nine months ended September 30, 2004 and
2003, BLX paid dividends to us on the Class B interests
totaling $8.3 million and $3.0 million, respectively,
and these dividends were paid to us in kind through the issuance
of additional Class B equity interests.

At September 30, 2004, BLX had a three-year
$275.0 million revolving credit facility that matures in
January 2007. The facility provides for a sub-facility for the
issuance of letters of credit for up to a total of $50.0
million. As the controlling equity owner in BLX, we have
provided an unconditional guaranty to the revolving credit
facility lenders in an amount of up to 50% of the total
obligations (consisting of principal, letters of credit issued
under the facility, accrued interest, and other fees) of BLX
under the revolving credit facility. At September 30, 2004,
the principal amount outstanding on the revolving credit
facility was $185.8 million and letters of credit issued
under the facility were $17.0 million. The total
obligations guaranteed by us at September 30, 2004, was
$101.6 million. This guaranty can be called by the lenders
only in the event of a default by BLX. BLX was in compliance
with the terms of the revolving credit facility at
September 30, 2004. At September 30, 2004, we had also
provided four standby letters of credit totaling
$35.6 million in connection with four term securitization
transactions completed by BLX.

We have a commitment to BLX of $20.0 million
in the form of a revolving credit facility to provide working
capital to the company. This facility matures on June 30,
2005. At September 30, 2004, BLX had no outstanding
borrowings under this facility.

Advantage Sales & Marketing,
Inc.At
September 30, 2004, our investment in Advantage
Sales & Marketing, Inc. totaled $257.6 million at
cost and value, or 7.5% of our total assets. As discussed above,
we completed the purchase of a majority ownership position in
Advantage on June 30, 2004. Advantage is a leading sales
and marketing agency providing outsourced sales, merchandising,
and marketing services to the consumer packaged goods industry.
Advantage has offices across the country and is headquartered in
Irvine, CA.

51



---



##### 



Commercial Real Estate Finance

The commercial real estate finance portfolio at
value, investment activity, and the yield on interest-bearing
investments at and for the three and nine months ended
September 30, 2004 and 2003, and at and for the year ended
December 31, 2003, were as follows:

|                                                                    |                                |                    |       |                   |  |                |  |          |  |              |       |          |  |       |  |          |  |       |       |          |  |  |  |       |  |   |       |       |  |  |  |       |  |   |       |       |  |  |  |       | 
|------------------------------------------------------------------- | ------------------------------ | ------------------ | ----- | ----------------- |  | -------------- |  | -------- |  | ------------ | ----- | -------- |  | ----- |  | -------- |  | ----- | ----- | -------- |  |  |  | ----- |  | - | ----- | ----- |  |  |  | ----- |  | - | ----- | ----- |  |  |  | ----- | 
|                                                                    |                                |                    |       |                   |  |                |  |         
|                                                                    |                                | At and for the     |       | At and for the    |  |                |  |         
|                                                                    |                                | Three Months Ended |       | Nine Months Ended |  |               
|                                                                    |                                | September 30,      |       | September 30,     |  | At and for    
|                                                                    |                                |                    |       |                   |  | the Year Ended
|                                                                    |                                |                    |       |                   |  |                |  |          |  | December 31,
|                                                                    |                                | 2004               |       | 2003              |  | 2004           |  | 2003     |  | 2003        
|                                                                    |                                |                    |       |                   |  |                |  |          |  |             
|                                                                    |                                |                    |       |                   |  |               
|                                                                    |                                | (unaudited)        |       | (unaudited)       |  |               
|                                                                    |                                | Value              |       | Yield(1)          |  | Value          |  | Yield(1) |  | Value        |       | Yield(1) |  | Value |  | Yield(1) |  | Value |       | Yield(1)
|($ in millions)                                                     |                                |                    |       |                   |  |                |  |          |  |              |       |          |  |       |  |          |  |       |       |         
|Portfolio at value:                                                 |                                |                    |       |                   |  |                |  |          |  |              |       |          |  |       |  |          |  |       |       |          |  |  |  |       |  |   |       |       |  |  |  |       |  |   |       |       |  |  |  |      
|                                                                    | CMBS bonds                     |                    | $     | 604.5             |  |                |  | 12.4%    |  |              | $     | 523.6    |  |       |  | 12.9%    |  |       | $     | 604.5    |  |  |  | 12.4% |  |   | $     | 523.6 |  |  |  | 12.9% |  |   | $     | 394.0 |  |  |  | 14.1% | 
|                                                                    | CDO bonds and preferred shares |                    |       | 177.8             |  |                |  | 17.4%    |  |              |       | 164.8    |  |       |  | 16.9%    |  |       |       | 177.8    |  |  |  | 17.4% |  |   |       | 164.8 |  |  |  | 16.9% |  |   |       | 186.6 |  |  |  | 16.7% | 
|                                                                    | Commercial mortgage loans      |                    |       | 143.2             |  |                |  | 8.1%     |  |              |       | 85.5     |  |       |  | 8.7%     |  |       |       | 143.2    |  |  |  | 8.1%  |  |   |       | 85.5  |  |  |  | 8.7%  |  |   |       | 83.6  |  |  |  | 8.6%  | 
|                                                                    | Real estate owned              |                    |       | 14.6              |  |                |  |          |  |              |       | 13.5     |  |       |  |          |  |       |       | 14.6     |  |  |  |       |  |   |       | 13.5  |  |  |  |       |  |   |       | 12.8  |  |  |  |       | 
|                                                                    | Equity interests               |                    |       | 8.9               |  |                |  |          |  |              |       | 5.0      |  |       |  |          |  |       |       | 8.9      |  |  |  |       |  |   |       | 5.0   |  |  |  |       |  |   |       | 4.9   |  |  |  |       | 
|                                                                    |                                |                    |       |                   |  |                |  |          |  |              |       |          |  |       |  |          |  |       |       |          |  |  |  |       |  |   |       |       |  |  |  |       |  |   |       |       |  |  |  |      
|Total portfolio                                                     |                                | $                  | 949.0 |                   |  |                |  |          |  | $            | 792.4 |          |  |       |  |          |  | $     | 949.0 |          |  |  |  |       |  | $ | 792.4 |       |  |  |  |       |  | $ | 681.9 |       |  |  |  |      
|                                                                    |                                |                    |       |                   |  |                |  |          |  |              |       |          |  |       |  |          |  |       |       |          |  |  |  |       |  |   |       |       |  |  |  |       |  |   |       |       |  |  |  |      
|Investments funded                                                  |                                | $                  | 67.9  |                   |  |                |  |          |  | $            | 106.7 |          |  |       |  |          |  | $     | 300.5 |          |  |  |  |       |  | $ | 359.1 |       |  |  |  |       |  | $ | 433.5 |       |  |  |  |      
|Change in accrued or reinvested interest                            |                                | $                  | 1.6   |                   |  |                |  |          |  | $            | 1.2   |          |  |       |  |          |  | $     | 6.3   |          |  |  |  |       |  | $ | 2.2   |       |  |  |  |       |  | $ | 3.2   |       |  |  |  |      
|Principal collections related to investment
    repayments or sales |                                | $                  | 12.9  |                   |  |                |  |          |  | $            | 20.8  |          |  |       |  |          |  | $     | 49.3  |          |  |  |  |       |  | $ | 301.8 |       |  |  |  |       |  | $ | 469.7 |       |  |  |  |      




|    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              
|--- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(1) | The weighted average yield on the
    interest-bearing investments is computed as the (a) annual
    stated interest rate plus the annual amortization of loan
    origination fees, original issue discount, and market discount
    on accruing interest-bearing investments, divided by
    (b) total interest-bearing investments at value. The
    weighted average yield is computed as of the balance sheet date.
    Interest-bearing investments for the commercial real estate
    finance portfolio include all investments except for real estate
    owned and equity interests.

Our commercial real estate investment activity
for the nine months ended September 30, 2004 and 2003, and
for the year ended December 31, 2003, was as follows:

|                                                 |       |        |       |          |  |        |        |        |   |   |       |       | 
|------------------------------------------------ | ----- | ------ | ----- | -------- |  | ------ | ------ | ------ | - | - | ----- | ----- | 
|                                                 |       | Face   |       |          |  | Amount
|                                                 |       | Amount |       | Discount |  | Funded
|($ in millions)                                  |       |        |       |          |  |       
|For the Nine Months Ended
    September 30, 2004 |       |        |       |          |  |        |        |        |   |   |       |      
|CMBS bonds (14 issuances)                        |       | $      | 363.9 |          |  | $      | (158.6 | )      |   | $ | 205.3 |      
|CDO bonds and preferred shares (1 issuance)      |       |        | 4.0   |          |  |        | (0.3   | )      |   |   | 3.7   |      
|Commercial mortgage loans                        |       |        | 99.7  |          |  |        | (8.3   | )      |   |   | 91.4  |      
|Equity interests                                 |       |        | 0.1   |          |  |        |       |        |   |   | 0.1   |      
|                                                 |       |        |       |          |  |        |        |        |   |   |       |      
|                                                 | Total |        | $     | 467.7    |  |        | $      | (167.2 | ) |   | $     | 300.5 | 
|                                                 |       |        |       |          |  |        |        |        |   |   |       |      
|For the Nine Months Ended
    September 30, 2003 |       |        |       |          |  |        |        |        |   |   |       |      
|CMBS bonds (14 issuances)                        |       | $      | 432.1 |          |  | $      | (195.1 | )      |   | $ | 237.0 |      
|CDO bonds and preferred shares (1 issuance)      |       |        | 118.4 |          |  |        | (0.3   | )      |   |   | 118.1 |      
|Commercial mortgage loans                        |       |        | 1.8   |          |  |        |       |        |   |   | 1.8   |      
|Equity interests                                 |       |        | 2.2   |          |  |        |       |        |   |   | 2.2   |      
|                                                 |       |        |       |          |  |        |        |        |   |   |       |      
|                                                 | Total |        | $     | 554.5    |  |        | $      | (195.4 | ) |   | $     | 359.1 | 
|                                                 |       |        |       |          |  |        |        |        |   |   |       |      
|For the Year Ended December 31,
    2003         |       |        |       |          |  |        |        |        |   |   |       |      
|CMBS bonds (18 issuances)                        |       | $      | 508.5 |          |  | $      | (225.9 | )      |   | $ | 282.6 |      
|CDO bonds and preferred shares (3 issuances)     |       |        | 145.8 |          |  |        | (0.4   | )      |   |   | 145.4 |      
|Commercial mortgage loans                        |       |        | 3.0   |          |  |        |       |        |   |   | 3.0   |      
|Real estate owned                                |       |        | 2.5   |          |  |        |       |        |   |   | 2.5   |      
|                                                 |       |        |       |          |  |        |        |        |   |   |       |      
|                                                 | Total |        | $     | 659.8    |  |        | $      | (226.3 | ) |   | $     | 433.5 | 
|                                                 |       |        |       |          |  |        |        |        |   |   |       |      

52



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##### 



At September 30, 2004, we had outstanding
funding commitments related to commercial mortgage loans and
equity interests of $4.2 million and commitments in the
form of standby letters of credit and guarantees related to
equity interests of $2.7 million.

CMBS Bonds.The underlying pools of mortgage
loans that are collateral for our investments in new CMBS bond
issuances for the nine months ended September 30, 2004 and
2003, and for the year ended December 31, 2003, had
respective original underwritten loan to value and underwritten
debt service coverage ratios as follows:

|                               |  |                           |          |            |  |                    |     |            |  |        |          |            |  |  |     |   |  |   |          |   |  |  |     |  
|------------------------------ |  | ------------------------- | -------- | ---------- |  | ------------------ | --- | ---------- |  | ------ | -------- | ---------- |  |  | --- | - |  | - | -------- | - |  |  | --- | -
|                               |  |                           |          |            |  |                   
|                               |  | For the Nine Months Ended |          |            |  |                   
|                               |  | September 30,             |          |            |  |                   
|                               |  |                           |          |           
|                               |  |                           |          |            |  | For the Year Ended
|                               |  | 2004                      |          | 2003       |  | December 31, 2003 
|                               |  |                           |          |            |  |                   
|Loan to Value Ranges           |  | Amount                    |          | Percentage |  | Amount             |     | Percentage |  | Amount |          | Percentage
|($ in millions)                |  |                           |          |            |  |                    |     |            |  |        |          |           
|Less than 60%                  |  | $                         | 3,164.5  |            |  |                    | 24  | %          |  | $      | 3,265.2  |            |  |  | 23  | % |  | $ | 4,114.3  |   |  |  | 22  | %
|60-65%                         |  |                           | 1,245.8  |            |  |                    | 10  |            |  |        | 1,091.1  |            |  |  | 8   |   |  |   | 1,582.8  |   |  |  | 9   |  
|65-70%                         |  |                           | 1,088.1  |            |  |                    | 8   |            |  |        | 1,484.1  |            |  |  | 10  |   |  |   | 1,768.0  |   |  |  | 10  |  
|70-75%                         |  |                           | 2,555.1  |            |  |                    | 20  |            |  |        | 3,065.8  |            |  |  | 21  |   |  |   | 4,024.3  |   |  |  | 22  |  
|75-80%                         |  |                           | 4,500.1  |            |  |                    | 35  |            |  |        | 5,324.2  |            |  |  | 37  |   |  |   | 6,560.5  |   |  |  | 36  |  
|Greater than 80%               |  |                           | 430.3    |            |  |                    | 3   |            |  |        | 75.5     |            |  |  | 1   |   |  |   | 138.6    |   |  |  | 1   |  
|                               |  |                           |          |            |  |                    |     |            |  |        |          |            |  |  |     |   |  |   |          |   |  |  |     |  
|Total                          |  | $                         | 12,983.9 |            |  |                    | 100 | %          |  | $      | 14,305.9 |            |  |  | 100 | % |  | $ | 18,188.5 |   |  |  | 100 | %
|                               |  |                           |          |            |  |                    |     |            |  |        |          |            |  |  |     |   |  |   |          |   |  |  |     |  
|Weighted average loan to value |  |                           | 68.0     | %          |  |                    |     |            |  |        | 68.5     | %          |  |  |     |   |  |   | 68.5     | % |  |  |     |  

|                                             |  |                           |          |            |  |                    |     |            |  |        |          |            |  |  |     |   |  |   |          |  |  |  |     |  
|-------------------------------------------- |  | ------------------------- | -------- | ---------- |  | ------------------ | --- | ---------- |  | ------ | -------- | ---------- |  |  | --- | - |  | - | -------- |  |  |  | --- | -
|                                             |  |                           |          |            |  |                   
|                                             |  | For the Nine Months Ended |          |            |  |                   
|                                             |  | September 30,             |          |            |  |                   
|                                             |  |                           |          |           
|                                             |  |                           |          |            |  | For the Year Ended
|                                             |  | 2004                      |          | 2003       |  | December 31, 2003 
|Debt Service Coverage                        |  |                           |          |            |  |                   
|Ratio Ranges                                 |  | Amount                    |          | Percentage |  | Amount             |     | Percentage |  | Amount |          | Percentage
|($ in millions)                              |  |                           |          |            |  |                    |     |            |  |        |          |           
|Greater than 2.00                            |  | $                         | 2,015.3  |            |  |                    | 16  | %          |  | $      | 3,563.6  |            |  |  | 25  | % |  | $ | 4,208.7  |  |  |  | 23  | %
|1.76-2.00                                    |  |                           | 1,356.8  |            |  |                    | 10  |            |  |        | 1,439.9  |            |  |  | 10  |   |  |   | 2,094.6  |  |  |  | 12  |  
|1.51-1.75                                    |  |                           | 1,703.8  |            |  |                    | 13  |            |  |        | 2,589.5  |            |  |  | 18  |   |  |   | 3,132.8  |  |  |  | 17  |  
|1.26-1.50                                    |  |                           | 5,836.7  |            |  |                    | 45  |            |  |        | 5,654.4  |            |  |  | 40  |   |  |   | 7,362.9  |  |  |  | 40  |  
|Less than 1.25                               |  |                           | 2,071.3  |            |  |                    | 16  |            |  |        | 1,058.5  |            |  |  | 7   |   |  |   | 1,389.5  |  |  |  | 8   |  
|                                             |  |                           |          |            |  |                    |     |            |  |        |          |            |  |  |     |   |  |   |          |  |  |  |     |  
|Total                                        |  | $                         | 12,983.9 |            |  |                    | 100 | %          |  | $      | 14,305.9 |            |  |  | 100 | % |  | $ | 18,188.5 |  |  |  | 100 | %
|                                             |  |                           |          |            |  |                    |     |            |  |        |          |            |  |  |     |   |  |   |          |  |  |  |     |  
|Weighted average debt service coverage ratio |  |                           | 1.62     |            |  |                    |     |            |  |        | 1.75     |            |  |  |     |   |  |   | 1.73     |  |  |  |     |  

53



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##### 



From time to time, we may sell lower yielding
CMBS bonds rated BB+ through BB-, and to a lesser extent
CMBS bonds rated B+ and B, in order to maximize the return
on our CMBS bond portfolio. The cost basis of and the gross
sales proceeds from CMBS bonds sold, the related net realized
gains from these sales, and the weighted average yield on the
CMBS bonds sold for the nine months ended September 30,
2004 and 2003, and for the year ended December 31, 2003,
were as follows:

|                                                              |  |               |     |              |  |      |       |   |  |   |       |  
|------------------------------------------------------------- |  | ------------- | --- | ------------ |  | ---- | ----- | - |  | - | ----- | -
|                                                              |  |               |     |             
|                                                              |  | For the Nine  |     |             
|                                                              |  | Months Ended  |     | For the Year
|                                                              |  | September 30, |     | Ended       
|                                                              |  |               |     | December 31,
|                                                              |  | 2004          |     | 2003         |  | 2003
|($ in millions)                                               |  |               |     |              |  |     
|Cost basis                                                    |  | $             | 6.3 |              |  | $    | 253.5 |   |  | $ | 412.3 |  
|Gross sales proceeds(1)                                       |  | $             | 6.4 |              |  | $    | 284.8 |   |  | $ | 446.8 |  
|Net realized gains (net of related hedge gains or
    losses) |  | $             | 0.1 |              |  | $    | 24.6  |   |  | $ | 31.6  |  
|Weighted average yield                                        |  |               | 7.7 | %            |  |      | 11.8  | % |  |   | 10.1  | %






|    |                                                                                                                                                                                                      
|--- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(1) | Gross sales proceeds represent the total cash
    consideration received, including the repayment of the cost
    basis of the bonds and proceeds related to the net realized
    gains on the bonds.

The BBB- rated and non-investment grade and
unrated tranches of the CMBS bonds in which we invest are junior
in priority for payment of interest and principal to the more
senior tranches of the related CMBS bond issuance. Cash flow
from the underlying mortgages is generally allocated first to
the senior tranches in order of priority, with the most senior
tranches having a priority right to the cash flow. Then, any
remaining cash flow is allocated, generally, among the other
tranches in order of their relative seniority. To the extent
there are defaults and unrecoverable losses on the underlying
mortgages or the properties securing those mortgages resulting
in reduced cash flows, our most subordinate tranche will bear
this loss first. At September 30, 2004, the face value of
the CMBS bonds we held were subordinate to 79% to 99% of the
face value of the bonds issued in these various CMBS
transactions. Given that the non-investment grade CMBS bonds in
which we invest are junior in priority for payment of interest
and principal, we invest in these CMBS bonds at a discount from
the face amount of the bonds. The discount increases with the
decrease in the seniority of the CMBS bonds. For the nine months
ended September 30, 2004 and 2003, and for the year ended
December 31, 2003, the average discount for the CMBS bonds
in which we invested was 44%, 45% and 44%, respectively.

At September 30, 2004, the unamortized
discount related to the CMBS bond portfolio was
$769.9 million, of which $377.8 million has been set
aside to absorb potential future losses. The yield on the CMBS
bonds of 12.4% assumes that this amount that has been set aside
will not be amortized. As the amount of future losses and the
expected timing of recognition of such losses is difficult to
predict and are subject to future events which may alter these
assumptions, no assurance can be given that the anticipated
yield will be achieved. At September 30, 2004, the CMBS
bond portfolio had a fair value of $604.5 million, which
included net unrealized appreciation on the CMBS bonds of
$7.9 million.

54



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##### 



The yield on the CMBS bond portfolio at any point
in time will vary depending on the concentration of lower
yielding BB- and above rated CMBS bonds held in the portfolio.
Our CMBS bond portfolio and the related yields at
September 30, 2004, and December 31, 2003, were as follows:

|                               |       |               |       |              |  |       |      |       |   |   |       |       |  |  |      |      |  
|------------------------------ | ----- | ------------- | ----- | ------------ |  | ----- | ---- | ----- | - | - | ----- | ----- |  |  | ---- | ---- | -
|                               |       |               |       |             
|                               |       | September 30, |       | December 31,
|                               |       | 2004          |       | 2003        
|                               |       |               |       |             
|                               |       | Value         |       | Yield        |  | Value |      | Yield
|($ in millions)                |       |               |       |              |  |       |      |      
|CMBS bonds rated BB- and above |       | $             | 224.9 |              |  |       | 7.4  | %     |   | $ | 88.4  |       |  |  | 8.2  | %   
|CMBS bonds rated below BB-     |       |               | 379.6 |              |  |       | 15.4 | %     |   |   | 305.6 |       |  |  | 15.8 | %   
|                               |       |               |       |              |  |       |      |       |   |   |       |       |  |  |      |     
|                               | Total |               | $     | 604.5        |  |       |      | 12.4  | % |   | $     | 394.0 |  |  |      | 14.1 | %
|                               |       |               |       |              |  |       |      |       |   |   |       |       |  |  |      |     

We sold substantially all of our B+ and above
rated CMBS bonds in October 2004. As a result of this bond sale,
the yield on the remaining CMBS portfolio will increase.

At September 30, 2004, and December 31,
2003, the age of our bonds rated below BB- was as follows:

|                         |       |       |       |            |  |       |      |            |   |   |       |       |  |  |      |       |  
|------------------------ | ----- | ----- | ----- | ---------- |  | ----- | ---- | ---------- | - | - | ----- | ----- |  |  | ---- | ----- | -
|                         |       |       |       |           
|                         |       | 2004  |       | 2003      
|                         |       |       |       |           
|                         |       | Value |       | Percentage |  | Value |      | Percentage
|($ in millions)          |       |       |       |            |  |       |      |           
|Less than one year old   |       | $     | 99.3  |            |  |       | 26.2 | %          |   | $ | 83.9  |       |  |  | 27.5 | %    
|One to two years old     |       |       | 81.6  |            |  |       | 21.5 |            |   |   | 41.0  |       |  |  | 13.4 |      
|Two to three years old   |       |       | 45.6  |            |  |       | 12.0 |            |   |   | 43.8  |       |  |  | 14.3 |      
|Three years old or older |       |       | 153.1 |            |  |       | 40.3 |            |   |   | 136.9 |       |  |  | 44.8 |      
|                         |       |       |       |            |  |       |      |            |   |   |       |       |  |  |      |      
|                         | Total |       | $     | 379.6      |  |       |      | 100.0      | % |   | $     | 305.6 |  |  |      | 100.0 | %
|                         |       |       |       |            |  |       |      |            |   |   |       |       |  |  |      |      

At September 30, 2004, and December 31,
2003, we held CMBS bonds in 50 and 38 separate CMBS issuances,
respectively. The underlying collateral pool, consisting of
commercial mortgage loans and real estate owned (REO)
properties, for these CMBS bonds consisted of the following at
September 30, 2004, and December 31, 2003:

|                                                                     |  |      |        |      |  |   |        |    
|-------------------------------------------------------------------- |  | ---- | ------ | ---- |  | - | ------ | ---
|                                                                     |  | 2004 |        | 2003
|($ in million)                                                       |  |      |        |     
|Approximate number of loans and
    REO properties(1)                |  |      | 6,700  |      |  |   | 5,600  |    
|Total outstanding principal balance                                  |  | $    | 49,559 |      |  | $ | 38,437 |    
|Loans over 30 days delinquent or classified
    as REO properties(2) |  |      | 1.3%   | (3)  |  |   | 1.5%   | (3)



---



|    |                                                                                                                                                                                                                                                                                                                                                                                                            
|--- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(1) | Includes approximately 36 and 22 REO
    properties obtained through the foreclosure of commercial
    mortgage loans at September 30, 2004, and December 31,
    2003, respectively.                                                                                                                                                                                                                      
|   
|(2) | As a percentage of total outstanding principal
    balance.                                                                                                                                                                                                                                                                                                                                                
|   
|(3) | At September 30, 2004, and December 31,
    2003, our investments included bonds in the first loss, unrated
    bond class in 42 and 34 separate CMBS issuances,
    respectively. For these issuances, loans over 30 days
    delinquent or classified as REO properties were 1.6% and 1.7% of
    the total outstanding principal balance at September 30,
    2004, and December 31, 2003, respectively.

Collateralized Debt Obligation Bonds and
Preferred Shares.During the nine
months ended September 30, 2004, we sold CDO bonds with a
cost basis of $16.3 million for a net realized gain of
$0.1 million, net of the related hedge gain. During the
nine months ended September 30, 2003, and the year ended
December 31, 2003, we sold CDO bonds and preferred shares
with a cost basis of $8.6 million and $13.9 million,
respectively, for net realized losses of $0.1 million for
both periods, net of the related hedge gains or losses. The
yield on the CDO bonds and preferred shares sold was 7.6%, 8.2%,
and 8.0% for the nine months ended September 30, 2004 and
2003, and for the year ended December 31, 2003,
respectively.

The BB rated bonds and the preferred shares of
the CDOs in which we have invested are junior in priority for
payment of interest and principal to the more senior tranches of
debt issued by the

55



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##### 



CDOs. To the extent there are defaults and
unrecoverable losses on the underlying collateral that result in
reduced cash flows, the preferred shares will bear this loss
first and then the bonds would bear any loss after the preferred
shares. At September 30, 2004, our bonds and preferred
shares in the CDOs were subordinate to 70% to 98% of the more
senior tranches of debt issued in the various CDO transactions.
In addition, included in the CMBS collateral for the CDOs at
September 30, 2004, are certain CMBS bonds that are senior
in priority of repayment to certain lower rated CMBS bonds held
directly by us.


The yield on our CDO bonds and preferred
shares at September 30, 2004 and 2003, and
December 31, 2003, was 17.4%, 16.9% and 16.7%,
respectively. The yield on the CDO portfolio at any point
in time will generally vary depending on the amount of lower
yielding CDO bonds held in the portfolio.

At September 30, 2004, and December 31,
2003, the underlying collateral for our investments in the
outstanding CDO issuances had balances as follows:

|                                   |                  |      |         |         |  |   |         |         | 
|---------------------------------- | ---------------- | ---- | ------- | ------- |  | - | ------- | ------- | 
|                                   |                  | 2004 |         | 2003   
|($ in millions)                    |                  |      |         |        
|Investment grade REIT debt(1)      |                  | $    | 1,392.3 |         |  | $ | 1,338.0 |        
|Investment grade CMBS bonds(2)     |                  |      | 807.4   |         |  |   | 662.3   |        
|Non-investment grade CMBS bonds(3) |                  |      | 1,183.3 |         |  |   | 1,133.7 |        
|Other collateral                   |                  |      | 118.7   |         |  |   | 32.4    |        
|                                   |                  |      |         |         |  |   |         |        
|                                   | Total collateral |      | $       | 3,501.7 |  |   | $       | 3,166.4 | 
|                                   |                  |      |         |         |  |   |         |        



---



|    |                                                                            
|--- | ---------------------------------------------------------------------------
|(1) | Issued by 42 and 44 REITs, respectively, for the
    periods presented.    
|   
|(2) | Issued in 97 and 78 issuances, respectively, for
    the periods presented.
|   
|(3) | Issued in 76 and 68 issuances, respectively, for
    the periods presented.

Portfolio Asset Quality

Portfolio by Grade.We employ a standard grading
system for our entire portfolio. Grade 1 is used for those
investments from which a capital gain is expected. Grade 2
is used for investments performing in accordance with plan.
Grade 3 is used for investments that require closer
monitoring; however, no loss of investment return or principal
is expected. Grade 4 is used for investments that are in
workout and for which some loss of current investment return is
expected, but no loss of principal is expected. Grade 5 is
used for investments that are in workout and for which some loss
of principal is expected.

At September 30, 2004, and December 31,
2003, our portfolio was graded as follows:

|                |  |                       |         |                      |  |           |       |                 |  |   |         |  |  |  |       |  
|--------------- |  | --------------------- | ------- | -------------------- |  | --------- | ----- | --------------- |  | - | ------- |  |  |  | ----- | -
|                |  |                       |         |                     
|                |  | At September 30, 2004 |         | At December 31, 2003
|                |  |                       |         |                     
|                |  | Portfolio             |         | Percentage of        |  | Portfolio |       | Percentage of  
|Grade           |  | at Value              |         | Total Portfolio      |  | at Value  |       | Total Portfolio
|                |  |                       |         |                      |  |           |       |                
|($ in millions) |  |                       |         |                      |  |           |       |                
|1               |  | $                     | 646.0   |                      |  |           | 21.7  | %               |  | $ | 985.1   |  |  |  | 38.1  | %
|2               |  |                       | 2,109.0 |                      |  |           | 70.7  |                 |  |   | 1,271.4 |  |  |  | 49.2  |  
|3               |  |                       | 118.3   |                      |  |           | 4.0   |                 |  |   | 212.4   |  |  |  | 8.2   |  
|4               |  |                       | 11.4    |                      |  |           | 0.4   |                 |  |   | 34.7    |  |  |  | 1.4   |  
|5               |  |                       | 95.3    |                      |  |           | 3.2   |                 |  |   | 81.0    |  |  |  | 3.1   |  
|                |  |                       |         |                      |  |           |       |                 |  |   |         |  |  |  |       |  
|                |  | $                     | 2,980.0 |                      |  |           | 100.0 | %               |  | $ | 2,584.6 |  |  |  | 100.0 | %
|                |  |                       |         |                      |  |           |       |                 |  |   |         |  |  |  |       |  

The decrease in Grade 1 assets at
September 30, 2004, as compared to December 31, 2003,
is primarily due to the sale of Hillman on March 31, 2004.
The value of Hillman at December 31, 2003, was
$234.5 million, and this value was included in Grade 1
assets. We received $47.5 million of

56



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##### 



new subordinated debt in Hillman in conjunction
with the sale. During the second quarter of 2004, we sold a
participation in this debt of $5.0 million to a third
party, which reduced our investment. The remaining balance of
this new debt was included in Grade 2 assets at
September 30, 2004. Grade 2 investments at
September 30, 2004, increased over Grade 2 investments
at December 31, 2004, primarily due to new investments made
during 2004. Investments in new portfolio companies generally
enter the portfolio as Grade 2 investments. We continue to
include our CMBS portfolio in Grade 2 assets, as we are
uncertain as to whether the unrealized appreciation or
depreciation on our CMBS portfolio at September 30, 2004,
will necessarily result in a realized gain or loss.


Total Grade 3, 4 and 5 portfolio assets were
$225.0 million, or 7.5% of the portfolio, at
September 30, 2004, as compared to $328.1 million, or
12.7% of the portfolio, at December 31, 2003. Included in
Grade 3, 4 and 5 assets at September 30, 2004, and
December 31, 2003, were assets totaling $51.5 million
and $31.1 million, respectively, that are secured by or invested
in commercial real estate.

Grade 4 and 5 assets include loans, debt
securities, and equity securities. We expect that a number of
portfolio companies will be in the Grade 4 or 5 categories
from time to time. Part of the business of private finance is
working with troubled portfolio companies to improve their
businesses and protect our investment. The number of portfolio
companies and related investment amount included in Grade 4
and 5 may fluctuate from period to period. We continue to follow
our historical practice of working with such companies in order
to recover the maximum amount of our investment.

Loans and Debt Securities on Non-Accrual
Status.At September 30,
2004, and December 31, 2003, loans and debt securities at
value not accruing interest for the total investment portfolio
were as follows:

|                                                                                |                                |                               |  |      |        |  |  |     |       | 
|------------------------------------------------------------------------------- | ------------------------------ | ----------------------------- |  | ---- | ------ |  |  | --- | ----- | 
|                                                                                |                                | 2004                          |  | 2003
|($ in millions)                                                                 |                                |                               |  |     
|Loans and debt securities in workout status
    (classified as Grade 4 or 5)(1) |                                |                               |  |      |        |  |  |    
|                                                                                | Private finance                |                               |  |      |        |  |  |     |      
|                                                                                |                                | Companies more than 25% owned |  | $    | 25.4   |  |  | $   | 31.9  | 
|                                                                                |                                | Companies 5% to 25% owned     |  |      | 1.7    |  |  |     | 2.7   | 
|                                                                                |                                | Companies less than 5% owned  |  |      | 24.3   |  |  |     | 28.0  | 
|                                                                                | Commercial real estate finance |                               |  | 8.3  |        |  |  | 6.8 |      
|Loans and debt securities not in workout status                                 |                                |                               |  |      |        |  |  |    
|                                                                                | Private finance                |                               |  |      |        |  |  |     |      
|                                                                                |                                | Companies more than 25% owned |  |      | 22.0   |  |  |     | 31.9  | 
|                                                                                |                                | Companies less than 5% owned  |  |      | 17.5   |  |  |     | 16.5  | 
|                                                                                | Commercial real estate finance |                               |  | 10.3 |        |  |  | 0.2 |      
|                                                                                |                                |                               |  |      |        |  |  |    
|                                                                                |                                | Total                         |  | $    | $109.5 |  |  | $   | 118.0 | 
|                                                                                |                                |                               |  |      |        |  |  |    
|                                                                                |                                | Percentage of total portfolio |  |      | 3.7%   |  |  |     | 4.6%  | 



---



|    |                                                                                                                               
|--- | ------------------------------------------------------------------------------------------------------------------------------
|(1) | Workout loans and debt securities exclude equity
    securities that are included in the total Grade 4 and 5
    assets above.

Loans and Debt Securities Over 90 Days
Delinquent.Loans and debt
securities greater than 90 days delinquent at value at
September 30, 2004, and December 31, 2003, were as
follows:

|                               |                           |                               |      |      |       |   |      |      |       | 
|------------------------------ | ------------------------- | ----------------------------- | ---- | ---- | ----- | - | ---- | ---- | ----- | 
|                               |                           | 2004                          |      | 2003
|($ in millions)                |                           |                               |      |     
|Private finance                |                           | $                             | 71.6 |      |       | $ | 85.6 |     
|Commercial real estate finance |                           |                               |      |      |       |   |      |     
|                               | CMBS bonds                |                               |      | 48.7 |       |   |      | 40.3 |      
|                               | Commercial mortgage loans |                               |      | 8.1  |       |   |      | 3.7  |      
|                               |                           |                               |      |      |       |   |      |     
|                               |                           | Total                         |      | $    | 128.4 |   |      | $    | 129.6 | 
|                               |                           |                               |      |      |       |   |      |     
|                               |                           | Percentage of total portfolio |      |      | 4.3%  |   |      |      | 5.0%  | 

Loans and debt securities on non-accrual status
and over 90 days delinquent should not be added together as
they are two separate measures of portfolio asset quality. Loans
and debt securities that are in both categories (i.e., on
non-accrual status and over 90 days delinquent)
totaled $40.5 million

57



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##### 



and $46.1 million at September 30,
2004, and December 31, 2003, respectively, which included
loans and debt securities that are secured by commercial real
estate of $8.2 million and $3.9 million, respectively.


As a provider of long-term privately negotiated
investment capital, we may defer payment of principal or
interest from time to time. The nature of our private finance
portfolio company relationships frequently provide an
opportunity for portfolio companies to amend the terms of
payment to us or to restructure their debt and equity capital.
During such restructuring, we may not receive or accrue interest
or dividend payments. As a result, the amount of the private
finance portfolio that is greater than 90 days delinquent
or on non-accrual status may vary from period to period. The
investment portfolio is priced to provide current returns for
shareholders assuming that a portion of the portfolio at any
time may not be accruing interest currently. We also price our
private finance investments for a total return including
interest or dividends plus capital gains from the sale of equity
securities.

For CMBS bonds, interest payments are made to
bondholders from the cash flow on the underlying collateral. To
the extent there are defaults and unrecoverable losses on the
underlying collateral resulting in reduced cash flows, the lower
rated tranches of the CMBS bonds in which we invest may not
receive current interest payments and, therefore, may become
delinquent. However, if the reduced cash flows resulting from
defaults or losses in the underlying collateral pool have been
factored into our yield on the bonds, we may continue to accrue
interest on the bonds to the extent that we expect to collect
such interest over time.

Given these factors, the amount of loans, debt
securities, or CMBS bonds on non-accrual status or greater than
90 days delinquent is not necessarily an indication of
future principal loss or loss of anticipated investment return.
Our portfolio grading system is used as a means to assess loss
of investment return or investment principal.

Hedging Activities

We have invested in CMBS bonds, which are
purchased at prices that are based in part on comparable
Treasury rates. We have entered into transactions with financial
institutions to hedge against movement in Treasury rates on
certain of the higher rated CMBS bonds and CDO bonds. These
transactions, referred to as short sales, involve receiving the
proceeds from the short sales of borrowed Treasury securities,
with the obligation to replenish the borrowed Treasury
securities at a later date based on the then current market
price, whatever that price may be. Risks in these contracts
arise from movements in the value of the borrowed Treasury
securities due to changes in interest rates and from the
possible inability of counterparties to meet the terms of their
contracts. If the value of the borrowed Treasury securities
increases, we will incur losses on these transactions. These
losses are limited to the increase in value of the borrowed
Treasury securities; conversely, the value of the hedged CMBS
and CDO bonds would likely increase. If the value of the
borrowed Treasury securities decreases, we will incur gains on
these transactions which are limited to the decline in value of
the borrowed Treasury securities; conversely, the value of the
hedged CMBS and CDO bonds would likely decrease. We do not
anticipate nonperformance by any counterparty in connection with
these transactions.

The total obligations to replenish borrowed
Treasury securities, including accrued interest payable on the
obligations, were $270.7 million and $98.5 million at
September 30, 2004, and December 31, 2003,
respectively. The net proceeds related to the sales of the
borrowed Treasury securities plus the additional cash collateral
provided under the terms of the transactions were
$270.7 million and $98.5 million at September 30,
2004, and December 31, 2003, respectively. The amount of
the hedge will vary from period to period depending upon the
amount of higher rated CMBS bonds and CDO bonds that we own
and have hedged as of the balance sheet date.

58



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##### 



RESULTS OF OPERATIONS

Comparison of Three Months Ended
September 30, 2004 and 2003

The following table summarizes the Companys
operating results for the three months ended September 30,
2004 and 2003.

|                                                         |                                                           |                                             |         |        |        |            |         |         |         |   |        |        |        |  |     |     |    |  
|-------------------------------------------------------- | --------------------------------------------------------- | ------------------------------------------- | ------- | ------ | ------ | ---------- | ------- | ------- | ------- | - | ------ | ------ | ------ |  | --- | --- | -- | -
|                                                         |                                                           |                                             |         |        |        |           
|                                                         |                                                           | For the Three                               |         |        |        |           
|                                                         |                                                           | Months Ended                                |         |        |        |           
|                                                         |                                                           | September 30,                               |         |        |        |           
|                                                         |                                                           |                                             |         |        |        | Percentage
|                                                         |                                                           | 2004                                        |         | 2003   |        | Change     |         | Change 
|($ in thousands, except per share amounts)               |                                                           |                                             |         |        |        |            |         |        
|                                                         |                                                           |                                             |         |        |        |           
|                                                         |                                                           | (unaudited)                                 |         |        |        |           
|Interest and Related Portfolio Income                    |                                                           |                                             |         |        |        |            |         |         |         |   |        |        |        |  |     |    
|                                                         | Interest and dividends                                    |                                             | $       | 85,828 |        |            | $       | 78,895  |         |   | $      | 6,933  |        |  |     | 9   | % 
|                                                         | Loan prepayment premiums                                  |                                             |         | 193    |        |            |         | 2,523   |         |   |        | (2,330 | )      |  |     | (92 | )%
|                                                         | Fees and other income                                     |                                             |         | 10,842 |        |            |         | 7,452   |         |   |        | 3,390  |        |  |     | 45  | % 
|                                                         |                                                           |                                             |         |        |        |            |         |         |         |   |        |        |        |  |     |    
|                                                         |                                                           | Total interest and related portfolio income |         |        | 96,863 |            |         |         | 88,870  |   |        |        | 7,993  |  |     |     | 9  | %
|                                                         |                                                           |                                             |         |        |        |            |         |         |         |   |        |        |        |  |     |    
|Expenses                                                 |                                                           |                                             |         |        |        |            |         |         |         |   |        |        |        |  |     |    
|                                                         | Interest                                                  |                                             |         | 20,253 |        |            |         | 20,334  |         |   |        | (81    | )      |  |     |    | % 
|                                                         | Employee                                                  |                                             |         | 10,817 |        |            |         | 9,480   |         |   |        | 1,337  |        |  |     | 14  | % 
|                                                         | Individual performance award                              |                                             |         | 3,079  |        |            |         |        |         |   |        | 3,079  |        |  |     | **  |   
|                                                         | Administrative                                            |                                             |         | 10,169 |        |            |         | 5,897   |         |   |        | 4,272  |        |  |     | 72  | % 
|                                                         |                                                           |                                             |         |        |        |            |         |         |         |   |        |        |        |  |     |    
|                                                         |                                                           | Total operating expenses                    |         |        | 44,318 |            |         |         | 35,711  |   |        |        | 8,607  |  |     |     | 24 | %
|                                                         |                                                           |                                             |         |        |        |            |         |         |         |   |        |        |        |  |     |    
|Net investment income before income taxes                |                                                           |                                             | 52,545  |        |        |            | 53,159  |         |         |   | (614   | )      |        |  | (1  | )% 
|Income tax benefit                                       |                                                           |                                             | (200    | )      |        |            | (449    | )       |         |   | 249    |        |        |  | **  |    
|                                                         |                                                           |                                             |         |        |        |            |         |         |         |   |        |        |        |  |     |    
|Net investment income                                    |                                                           |                                             | 52,745  |        |        |            | 53,608  |         |         |   | (863   | )      |        |  | (2  | )% 
|                                                         |                                                           |                                             |         |        |        |            |         |         |         |   |        |        |        |  |     |    
|Net Realized and Unrealized Gains (Losses)               |                                                           |                                             |         |        |        |            |         |         |         |   |        |        |        |  |     |    
|                                                         | Net realized gains (losses)                               |                                             |         | 1,300  |        |            |         | (6,438  | )       |   |        | 7,738  |        |  |     | *   |   
|                                                         | Net change in unrealized appreciation or
    depreciation |                                             |         | 31,954 |        |            |         | (13,426 | )       |   |        | 45,380 |        |  |     | *   |   
|                                                         |                                                           |                                             |         |        |        |            |         |         |         |   |        |        |        |  |     |    
|                                                         |                                                           | Total net gains (losses)                    |         |        | 33,254 |            |         |         | (19,864 | ) |        |        | 53,118 |  |     |     | *  |  
|                                                         |                                                           |                                             |         |        |        |            |         |         |         |   |        |        |        |  |     |    
|Net income                                               |                                                           | $                                           | 85,999  |        |        | $          | 33,744  |         |         | $ | 52,255 |        |        |  | 155 | %  
|                                                         |                                                           |                                             |         |        |        |            |         |         |         |   |        |        |        |  |     |    
|Diluted earnings per common share                        |                                                           | $                                           | 0.66    |        |        | $          | 0.28    |         |         | $ | 0.38   |        |        |  | 136 | %  
|                                                         |                                                           |                                             |         |        |        |            |         |         |         |   |        |        |        |  |     |    
|Weighted average common shares
    outstanding  diluted |                                                           |                                             | 131,192 |        |        |            | 120,906 |         |         |   | 10,286 |        |        |  | 9   | %  



---



|   |                                                                                                                                                                                                                                         
|-- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|*  | Net realized gains and losses and net change in
    unrealized appreciation or depreciation can fluctuate
    significantly from period to period. As a result, quarterly
    comparisons of net gains and losses may not be meaningful.
|  
|** | Percentage change is not meaningful.                                                                                                                                                                                                    

Interest and Related Portfolio
Income.Total interest and related
portfolio income includes interest and dividend income, loan
prepayment premiums, and fees and other income.

Interest and dividend income for the three months
ended September 30, 2004 and 2003, was composed of the
following:

|                |                              |      |      |      |  |   |      |      | 
|--------------- | ---------------------------- | ---- | ---- | ---- |  | - | ---- | ---- | 
|                |                              | 2004 |      | 2003
|($ in millions) |                              |      |      |     
|Interest        |                              | $    | 81.4 |      |  | $ | 75.6 |     
|Dividends       |                              |      | 4.4  |      |  |   | 3.3  |     
|                |                              |      |      |      |  |   |      |     
|                | Total interest and dividends |      | $    | 85.8 |  |   | $    | 78.9 | 
|                |                              |      |      |      |  |   |      |     

The level of interest income, which includes
interest paid in cash and in kind, is directly related to the
balance of the interest-bearing investment portfolio outstanding
during the period multiplied by the weighted average yield. The
weighted average yield varies from period to period based on the

59



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current stated interest rate earned on
interest-bearing investments and the amount of loans and debt
securities for which interest is not accruing. The
interest-bearing investments in the portfolio at value and the
weighted average yield on the interest-bearing investments in
the portfolio at September 30, 2004 and 2003, were as
follows:


|                           |  |      |         |      |  |   |         |  
|-------------------------- |  | ---- | ------- | ---- |  | - | ------- | -
|                           |  | 2004 |         | 2003
|($ in millions)            |  |      |         |     
|Interest-bearing portfolio |  | $    | 2,341.2 |      |  | $ | 1,946.1 |  
|Portfolio yield            |  |      | 14.2    | %    |  |   | 14.5    | %

Dividend income results from the dividend yield
on preferred equity interests, if any, or the declaration of
dividends by a portfolio company on preferred or common equity
interests. Dividend income will vary from period to period
depending upon the level of yield on our preferred equity
interests and the timing and amount of dividends that are
declared by a portfolio company on preferred or common equity
interests. Dividend income for the three months ended
September 30, 2004 and 2003, includes $3.5 million and
$1.0 million, respectively, of dividends from BLX on the
Class B equity interests held by us. These dividends were paid
in kind through the issuance of additional Class B equity
interests.

Loan prepayment premiums were $0.2 million
and $2.5 million for the three months ended
September 30, 2004 and 2003, respectively. While the
scheduled maturities of private finance and commercial real
estate loans range from five to ten years, it is not unusual for
our borrowers to refinance or pay off their debts to us ahead of
schedule. Therefore, we generally structure our loans to require
a prepayment premium for the first three to five years of the
loan. Accordingly, the amount of prepayment premiums will vary
depending on the level of repayments and the age of the loans at
the time of repayment.

Fees and other income primarily include fees
related to financial structuring, diligence, transaction
services, management services to portfolio companies,
guarantees, and other advisory services. As a business
development company, we are required to make significant
managerial assistance available to the companies in our
investment portfolio. Managerial assistance includes management
and consulting services including, but not limited to, corporate
finance, information technology, marketing, human resources,
personnel and board member recruiting, corporate governance, and
risk management.

Fees and other income for the three months ended
September 30, 2004 and 2003, included fees relating to the
following:

|                                                                                                   |                             |      |     |      |  |   |     |     | 
|-------------------------------------------------------------------------------------------------- | --------------------------- | ---- | --- | ---- |  | - | --- | --- | 
|                                                                                                   |                             | 2004 |     | 2003
|($ in millions)                                                                                    |                             |      |     |     
|Structuring and diligence                                                                          |                             | $    | 4.3 |      |  | $ | 0.7 |    
|Transaction and other services provided to
    portfolio companies                                 |                             |      | 0.8 |      |  |   | 2.2 |    
|Management services provided to portfolio
    companies, other advisory services and guaranty fees |                             |      | 5.1 |      |  |   | 4.3 |    
|Other income                                                                                       |                             |      | 0.6 |      |  |   | 0.3 |    
|                                                                                                   |                             |      |     |      |  |   |     |    
|                                                                                                   | Total fees and other income |      | $   | 10.8 |  |   | $   | 7.5 | 
|                                                                                                   |                             |      |     |      |  |   |     |    

Fees and other income are generally related to
specific transactions or services and therefore may vary
substantially from period to period depending on the level and
types of services provided. Loan origination fees that represent
yield enhancement on a loan are capitalized and amortized into
interest income over the life of the loan. Fees and other income
for the three months ended September 30, 2004, include
structuring fees from Financial Pacific totaling
$2.2 million.

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BLX and Advantage were our most significant
investments at September 30, 2004, and together represented
17.7% of our total assets. Total interest and related portfolio
income earned from BLX and Advantage for the three months ended
September 30, 2004, was $12.2 million and
$7.4 million, respectively.

BLX and Hillman were our most significant
investments at September 30, 2003, and together represented
17.7% of our total assets. Total interest and related portfolio
income earned from BLX and Hillman for the three months ended
September 30, 2003, was $10.1 million and
$2.4 million, respectively. As discussed above, we sold
Hillman on March 31, 2004.

Operating
Expenses.Operating expenses
include interest, employee, and administrative expenses. Our
single largest expense is interest on our indebtedness. The
fluctuations in interest expense during the three months ended
September 30, 2004 and 2003, were primarily attributable to
changes in the level of our borrowings under various notes
payable and debentures and our revolving line of credit. Our
borrowing activity and weighted average cost of debt, including
fees and closing costs, at and for the three months ended
September 30, 2004 and 2003, were as follows:

|                         |  |                |         |      |  |   |       | 
|------------------------ |  | -------------- | ------- | ---- |  | - | ----- | 
|                         |  |               
|                         |  | At and for the
|                         |  | Three Months  
|                         |  | Ended         
|                         |  | September 30, 
|                         |  |               
|                         |  | 2004           |         | 2003
|($ in millions)          |  |                |         |     
|Total Outstanding Debt   |  | $              | 1,167.7 |      |  | $ | 954.2 | 
|Average Outstanding Debt |  | $              | 1,075.3 |      |  | $ | 965.3 | 
|Weighted Average Cost(1) |  |                | 6.3%    |      |  |   | 7.5%  | 



---



|    |                                                                                                                                                                                                                                                                                                                                                                  
|--- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(1) | The weighted average annual interest cost is
    computed as the (a) annual stated interest rate on the debt
    plus the annual amortization of commitment fees and other
    facility fees that are recognized into interest expense over the
    contractual life of the respective borrowings, divided by
    (b) debt outstanding on the balance sheet date.

In addition to interest on indebtedness, interest
expense includes interest on our obligations to replenish
borrowed Treasury securities related to our hedging activities
of $1.9 million and $1.8 million for the three months
ended September 30, 2004 and 2003, respectively.

Employee expenses include salaries and employee
benefits. The change in employee expenses reflects the effect of
wage increases, increased staffing, and the change in mix of
employees given their area of responsibility and relevant
experience level. Total employees were 159 and 117 at
September 30, 2004 and 2003, respectively. During 2003,
employee expenses included a retention award program whereby
senior officers received cash awards as part of their
compensation. The retention award component for the three months
ended September 30, 2003, was $2.1 million. Beginning
January 1, 2004, we no longer provided retention awards.

In the first quarter of 2004, we established the
Individual Performance Award (IPA) as a long-term incentive
compensation program for our senior officers. In conjunction
with the program, the Board has approved a non-qualified
deferred compensation plan (DCP II), which is administered
through a trust.

The IPA, which will generally be determined
annually at the beginning of each year, is deposited in the
trust in four equal installments, generally on a quarterly
basis, in the form of cash. The Compensation Committee of the
Board of Directors has designed the DCP II to then require
the trustee to use the cash exclusively to purchase shares of
our common stock in the open market.

Amounts credited to participants under the
DCP II are immediately vested once deposited by us into the
trust. A participants account shall generally become
distributable only after his or her termination of employment,
or in the event of a change of control of the Company. The

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Compensation Committee of the Board of Directors
may also determine other distributable events and the timing of
such distributions.


For the three months ended September 30,
2004, we accrued $3.2 million in IPA expense, or
$0.02 per share. We contributed these amounts into the
DCP II trust during the quarter. Because the IPA is
deferred compensation, the cost of this award is not a current
expense for purposes of computing our taxable income. The
expense is deferred for tax purposes until distributions are
made from the trust. The accounts of the DCP II are consolidated
with our accounts. Further, we are required to mark to market
the liability to pay the employees in our stock and this
adjustment is recorded to the IPA compensation expense. The
effect of this adjustment for the three months ended
September 30, 2004, was to reduce the individual
performance award expense by $0.1 million.

Administrative expenses include legal and
accounting fees, valuation assistance fees, insurance premiums,
the cost of leases for our headquarters in Washington, DC,
and our regional offices, stock record expenses, directors
fees, and various other expenses. Administrative expenses were
$10.2 million for the three months ended September 30,
2004, a $4.3 million increase over administrative expenses
of $5.9 million for the three months ended
September 30, 2003.

A large component of the increase in expenses
results from the costs of operating as a public company. Legal,
accounting, valuation assistance, insurance, and directors
fees were $2.1 million higher for the three months ended
September 30, 2004, than for the same period in the prior
year.

During the second quarter of 2004, we opened an
office in Los Angeles, CA, and expanded our office space in New
York, NY. Accordingly, occupancy costs and the costs associated
with staffing these offices were $0.5 million higher for
the three months ended September 30, 2004, than for the
same period in the prior year.

We have also incurred increased deal costs
related to evaluating potential new investments. Costs related
to mezzanine lending are generally paid by the borrower,
however, costs related to buyout investments are generally
funded by us. Accordingly, if a prospective deal does not close,
we incur expenses that are not recoverable. As a result, these
related costs were $0.1 million higher for the three months
ended September 30, 2004, than for the same period in the
prior year. We have increased our focus on managing
buyout-related costs, however we expect that there will be some
increased costs from this activity going forward.

In addition, administrative expenses related to
portfolio development and workout activities were
$1.1 million higher for the three months ended
September 30, 2004, versus the prior year period. We expect
the costs related to workouts to decline given the declining
level of workout assets in the portfolio.

Realized Gains and Losses.Net realized gains result from the
sale of equity securities associated with certain private
finance investments, the sale of CMBS bonds, and the realization
of unamortized discount resulting from the sale and early
repayment of private finance loans and commercial mortgage
loans, offset by losses on investments. Net realized gains for
the three months ended September 30, 2004 and 2003, were as
follows:

|                   |  |               |       |      |  |   |      |  
|------------------ |  | ------------- | ----- | ---- |  | - | ---- | -
|                   |  |              
|                   |  | For the      
|                   |  | Three Months 
|                   |  | Ended        
|                   |  | September 30,
|                   |  |              
|                   |  | 2004          |       | 2003
|($ in millions)    |  |               |       |     
|Realized gains     |  | $             | 37.6  |      |  | $ | 3.5  |  
|Realized losses    |  |               | (36.3 | )    |  |   | (9.9 | )
|                   |  |               |       |      |  |   |      |  
|Net realized gains |  | $             | 1.3   |      |  | $ | (6.4 | )
|                   |  |               |       |      |  |   |      |  

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Realized gains and losses for the three months
ended September 30, 2004 and 2003, resulted from various
private finance and commercial real estate finance transactions.

Realized gains for the three months ended
September 30, 2004, primarily resulted from transactions
involving five private finance portfolio companies 
Professional Paint, Inc. ($13.7 million), Impact
Innovations Group, LLC ($9.4 million), United Pet Group,
Inc. ($3.7 million), Housecall Medical Resources, Inc.
($2.6 million) and Matrics, Inc. ($2.1 million) and
one transaction involving a commercial mortgage loan
($1.8 million).

Realized gains for the three months ended
September 30, 2003, primarily resulted from transactions
involving five private finance portfolio companies, including
Autania AG ($0.9 million), Blue Rhino Corporation
($0.9 million), Kyrus Corporation ($0.6 million),
Oriental Trading Company, Inc. ($0.3 million), and Icon
International, Inc. ($0.2 million), and one transaction
involving a commercial mortgage loan totaling $0.4 million.

For the three months ended September 30,
2004 and 2003, we reversed previously recorded unrealized
appreciation totaling $20.6 million and $2.0 million,
respectively, when gains were realized. When we exit an
investment and realize a gain, we make an accounting entry to
reverse any unrealized appreciation we had previously recorded
to reflect the appreciated value of the investment.

Realized losses for the three months ended
September 30, 2004, primarily resulted from transactions
involving two private finance portfolio companies 
The Color Factory, Inc. ($24.5 million) and Prosperco
Finanz Holding AG ($7.5 million), and one transaction
involving a commercial mortgage loan ($1.0 million).

Realized losses for the three months ended
September 30, 2003, primarily resulted from a private
finance transaction involving Allied Office Products, Inc.
totaling $7.7 million and one transaction involving a
commercial mortgage loan totaling $1.5 million.

For the three months ended September 30,
2004 and 2003, we reversed previously recorded unrealized
depreciation totaling $37.6 million and $9.4 million,
respectively, when losses were realized. When we exit an
investment and realize a loss, we make an accounting entry to
reverse any unrealized depreciation we had previously recorded
to reflect the depreciated value of the investment.

Change in Unrealized Appreciation or
Depreciation.We determine the
value of each investment in our portfolio on a quarterly basis,
and changes in value result in unrealized appreciation or
depreciation being recognized in our statement of operations.
Value, as defined in Section 2(a)(41) of the Investment
Company Act of 1940, is (i) the market price for those
securities for which a market quotation is readily available and
(ii) for all other securities and assets, fair value is as
determined in good faith by the Board of Directors. Since there
is typically no readily available market value for the
investments in our portfolio, we value substantially all of our
portfolio investments at fair value as determined in good faith
by the Board of Directors pursuant to a valuation policy and a
consistently applied valuation process. At September 30,
2004, portfolio investments recorded at fair value were
approximately 87% of our total assets. Because of the inherent
uncertainty of determining the fair value of investments that do
not have a readily available market value, the fair value of our
investments determined in good faith by the Board of Directors
may differ significantly from the values that would have been
used had a ready market existed for the investments, and the
differences could be material.

There is no single standard for determining fair
value in good faith. As a result, determining fair value
requires that judgment be applied to the specific facts and
circumstances of each portfolio investment while employing a
consistently applied valuation process for the types of
investments we make. Unlike banks, we are not permitted to
provide a general reserve for anticipated loan losses. Instead,
we are required to specifically value each individual investment
on a quarterly basis. We will record unrealized depreciation on
investments when we believe that an investment has become

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##### 



impaired, including where collection of a loan or
realization of an equity security is doubtful, or when the
enterprise value of the portfolio company does not currently
support the cost of our debt or equity investment. Enterprise
value means the entire value of the company to a potential
buyer, including the sum of the values of debt and equity
securities used to capitalize the enterprise at a point in time.
We will record unrealized appreciation if we believe that the
underlying portfolio company has appreciated in value and,
therefore, our equity security has also appreciated in value.
Changes in fair value are recorded in the statement of
operations as net change in unrealized appreciation or
depreciation.


As a business development company, we invest in
illiquid securities including debt and equity securities of
companies, non-investment grade CMBS bonds, and CDO bonds and
preferred shares. The structure of each private finance debt and
equity security is specifically negotiated to enable us to
protect our investment and maximize our returns. We include many
terms governing interest rate, repayment terms, prepayment
penalties, financial covenants, operating covenants, ownership
parameters, dilution parameters, liquidation preferences, voting
rights, and put or call rights. Our investments are generally
subject to restrictions on resale and generally have no
established trading market. Because of the type of investments
that we make and the nature of our business, our valuation
process requires an analysis of various factors. Our fair value
methodology includes the examination of, among other things, the
underlying investment performance, financial condition, and
market changing events that impact valuation.

Valuation Methodology  Private
Finance.Our process for determining
the fair value of a private finance investment begins with
determining the enterprise value of the portfolio company. The
fair value of our investment is based on the enterprise value at
which the portfolio company could be sold in an orderly
disposition over a reasonable period of time between willing
parties other than in a forced or liquidation sale. The
liquidity event whereby we exit a private finance investment is
generally the sale, the recapitalization or, in some cases, the
initial public offering of the portfolio company.

There is no one methodology to determine
enterprise value and, in fact, for any one portfolio company,
enterprise value is best expressed as a range of fair values,
from which we derive a single estimate of enterprise value. To
determine the enterprise value of a portfolio company, we
analyze its historical and projected financial results. We
generally require portfolio companies to provide annual audited
and quarterly unaudited financial statements, as well as annual
projections for the upcoming fiscal year. Typically in the
private equity business, companies are bought and sold based on
multiples of EBITDA, cash flow, net income, revenues or, in
limited instances, book value. The private equity industry uses
financial measures such as EBITDA or EBITDAM (Earnings Before
Interest, Taxes, Depreciation, Amortization and, in some
instances, Management fees) in order to assess a portfolio
companys financial performance and to value a portfolio
company. EBITDA and EBITDAM are not intended to represent cash
flow from operations as defined by U.S. generally accepted
accounting principles and such information should not be
considered as an alternative to net income, cash flow from
operations, or any other measure of performance prescribed by
U.S. generally accepted accounting principles. When using EBITDA
to determine enterprise value, we may adjust EBITDA for
non-recurring items. Such adjustments are intended to normalize
EBITDA to reflect the portfolio companys earnings power.
Adjustments to EBITDA may include compensation to previous
owners, acquisition, recapitalization, or restructuring related
items or one-time non-recurring income or expense items.

In determining a multiple to use for valuation
purposes, we look to private merger and acquisition statistics,
discounted public trading multiples or industry practices. In
estimating a reasonable multiple, we consider not only the fact
that our portfolio company may be a private company relative to
a peer group of public comparables, but we also consider the
size and scope of

64



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##### 



our portfolio company and its specific strengths
and weaknesses. In some cases, the best valuation methodology
may be a discounted cash flow analysis based on future
projections. If a portfolio company is distressed, a liquidation
analysis may provide the best indication of enterprise value.


If there is adequate enterprise value to support
the repayment of our debt, the fair value of our loan or debt
security normally corresponds to cost unless the borrowers
condition or other factors lead to a determination of fair value
at a different amount. The fair value of equity interests in
portfolio companies is determined based on various factors,
including the enterprise value remaining for equity holders
after the repayment of the portfolio companys debt and
other preference capital, and other pertinent factors such as
recent offers to purchase a portfolio company, recent
transactions involving the purchase or sale of the portfolio
companys equity securities, or other liquidation events.
The determined equity values are generally discounted when we
have a minority position, restrictions on resale, specific
concerns about the receptivity of the capital markets to a
specific company at a certain time, or other factors.

In connection with our valuation process to
determine the fair value of a private finance investment, we may
receive independent assessments of a particular private finance
portfolio companys value in the ordinary course of
business, most often in the context of a prospective sale
transaction or in the context of the bankruptcy process, or we
may work with independent third-party consultants to obtain
assistance and advice as additional support in the preparation
of our internal valuation analysis. The valuation analysis
prepared by management using these independent valuation
resources is submitted to our Board of Directors for its
determination of fair value of the portfolio in good faith.

We received valuation assistance from S&P
Corporate Value Consulting (S&P CVC) for the first, second
and third quarters of 2004, including assistance with the
valuation of Business Loan Express or BLX in the third quarter
of 2004. On a year to date basis, S&P CVC has reviewed 83
investments. For portfolio company investments that were in our
portfolio at December 31, 2003, and were still in the
portfolio at September 30, 2004, S&P CVC has assisted
us in valuing approximately 85% of the dollar value of those
investments. In addition, S&P CVC has assisted us with the
valuation of $54 million in new 2004 portfolio company
investments that have been added to the portfolio.

We also received valuation assistance from JMP
Securities for our investment in BLX in the first, second and
third quarters of 2004.

Valuation Methodology  CMBS Bonds
and CDO Bonds and Preferred Shares.CMBS bonds and CDO bonds and preferred
shares are carried at fair value, which is based on a discounted
cash flow model that utilizes prepayment and loss assumptions
based on historical experience and projected performance,
economic factors, the characteristics of the underlying cash
flow and comparable yields for similar CMBS bonds and CDO bonds
and preferred shares. Our assumption with regard to discount
rate is based on the yield of comparable securities. We
recognize unrealized appreciation or depreciation on our CMBS
bonds and CDO bonds and preferred shares as comparable yields in
the market change and/or based on changes in estimated cash
flows resulting from changes in prepayment or loss assumptions
in the underlying collateral pool.

65



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For the total portfolio, net change in unrealized
appreciation or depreciation for the three months ended
September 30, 2004 and 2003, consisted of the following:

|                                                                                            |                                                           |         |       |         |  |   |       |       |  
|------------------------------------------------------------------------------------------- | --------------------------------------------------------- | ------- | ----- | ------- |  | - | ----- | ----- | -
|                                                                                            |                                                           | 2004(1) |       | 2003(1)
|($ in millions)                                                                             |                                                           |         |       |        
|Net unrealized appreciation or depreciation                                                 |                                                           | $       | 15.0  |         |  | $ | (20.8 | )    
|Reversal of previously recorded unrealized
    appreciation associated with realized gains  |                                                           |         | (20.6 | )       |  |   | (2.0  | )    
|Reversal of previously recorded unrealized
    depreciation associated with realized losses |                                                           |         | 37.6  |         |  |   | 9.4   |      
|                                                                                            |                                                           |         |       |         |  |   |       |      
|                                                                                            | Net change in unrealized appreciation or
    depreciation |         | $     | 32.0    |  |   | $     | (13.4 | )
|                                                                                            |                                                           |         |       |         |  |   |       |      



---



|    |                                                                                                                                                                               
|--- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(1) | The net change in unrealized appreciation or
    depreciation can fluctuate significantly from period to period.
    As a result, quarterly comparisons may not be meaningful.

At September 30, 2004, our most significant
portfolio investment was in BLX. The following is a simplified
summary of the methodology that we used to determine the fair
value of this investment.

Business Loan Express, LLC.To determine the value of our
investment in BLX at September 30, 2004, we performed four
separate valuation analyses to determine a range of values:
(1) analysis of comparable public company trading
multiples, (2) analysis of BLXs value assuming an
initial public offering, (3) analysis of merger and
acquisition transactions for financial services companies, and
(4) a discounted dividend analysis. We performed the
analyses with the assistance of JMP Securities. In addition, we
received valuation assistance from S&P CVC for our
investment in BLX at September 30, 2004.

With respect to the analysis of comparable public
company trading multiples and the analysis of BLXs value
assuming an initial public offering, we compute a median
trailing and forward price earnings multiple to apply to
BLXs pro-forma net income adjusted for certain capital
structure changes that we believe would likely occur should the
company be sold. Each quarter we evaluate which public
commercial finance companies should be included in the
comparable group. The comparable group at September 30,
2004, was made up of CapitalSource, Inc., CIT Group, Inc.,
Financial Federal Corporation, GATX Corporation, and Marlin
Business Services Corporation, which is consistent with the
comparable group at June 30, 2004.

Our investment in BLX at September 30, 2004,
was valued at $352.1 million. This fair value was within
the range of values determined by the four valuation analyses.
Unrealized appreciation on our investment was $80.9 million
at September 30, 2004. This is an increase of
$3.1 million from June 30, 2004.

OTHER MATTERS

Per Share Amounts.All per share amounts included in
the Managements Discussion and Analysis of Financial
Condition and Results of Operations section have been computed
using the weighted average common shares used to compute diluted
earnings per common share, which were 131.2 million and
120.9 million for the three months ended September 30,
2004 and 2003, respectively.

Regulated Investment Company Status.We have elected to be taxed as a
regulated investment company under Subchapter M of the
Internal Revenue Code of 1986. As long as we qualify as a
regulated investment company, we are not taxed on our investment
company taxable income or realized capital gains, to the extent
that such taxable income or gains are distributed, or deemed to
be distributed, as dividends to our shareholders on a timely
basis. Annual tax distributions generally differ from net income
for the fiscal year due to temporary and permanent differences
in the

66



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##### 



recognition of income and expenses, returns of
capital and net unrealized appreciation or depreciation, which
are not included in taxable income.


In order to maintain our status as a regulated
investment company, we must, in general, (1) continue to
qualify as a business development company; (2) derive at
least 90% of our gross income from dividends, interest, gains
from the sale of securities and other specified types of income;
(3) meet investment diversification requirements as defined
in the Internal Revenue Code; and (4) distribute annually
to shareholders at least 90% of our investment company taxable
income as defined in the Internal Revenue Code. We intend to
take all steps necessary to continue to qualify as a regulated
investment company. However, there can be no assurance that we
will continue to qualify for such treatment in future years.

67



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##### 



RESULTS OF OPERATIONS

Comparison of Nine Months Ended
September 30, 2004 and 2003

The following table summarizes our condensed
operating results for the nine months ended September 30,
2004 and 2003.

|                                                         |                                                           |                                             |         |          |         |            |         |         |         |   |        |         |        |  |    |     |    |  
|-------------------------------------------------------- | --------------------------------------------------------- | ------------------------------------------- | ------- | -------- | ------- | ---------- | ------- | ------- | ------- | - | ------ | ------- | ------ |  | -- | --- | -- | -
|                                                         |                                                           |                                             |         |          |         |           
|                                                         |                                                           | For the Nine                                |         |          |         |           
|                                                         |                                                           | Months Ended                                |         |          |         |           
|                                                         |                                                           | September 30,                               |         |          |         |           
|                                                         |                                                           |                                             |         |          |         | Percentage
|                                                         |                                                           | 2004                                        |         | 2003     |         | Change     |         | Change 
|($ in thousands, except per share amounts)               |                                                           |                                             |         |          |         |            |         |        
|                                                         |                                                           |                                             |         |          |         |           
|                                                         |                                                           | (unaudited)                                 |         |          |         |           
|Interest and Related Portfolio Income                    |                                                           |                                             |         |          |         |            |         |         |         |   |        |         |        |  |    |    
|                                                         | Interest and dividends                                    |                                             | $       | 233,540  |         |            | $       | 211,553 |         |   | $      | 21,987  |        |  |    | 10  | % 
|                                                         | Loan prepayment premiums                                  |                                             |         | 4,210    |         |            |         | 5,281   |         |   |        | (1,071  | )      |  |    | (20 | )%
|                                                         | Fees and other income                                     |                                             |         | 28,378   |         |            |         | 22,380  |         |   |        | 5,998   |        |  |    | 27  | % 
|                                                         |                                                           |                                             |         |          |         |            |         |         |         |   |        |         |        |  |    |    
|                                                         |                                                           | Total interest and related portfolio income |         |          | 266,128 |            |         |         | 239,214 |   |        |         | 26,914 |  |    |     | 11 | %
|                                                         |                                                           |                                             |         |          |         |            |         |         |         |   |        |         |        |  |    |    
|Expenses                                                 |                                                           |                                             |         |          |         |            |         |         |         |   |        |         |        |  |    |    
|                                                         | Interest                                                  |                                             |         | 57,349   |         |            |         | 57,614  |         |   |        | (265    | )      |  |    |    | % 
|                                                         | Employee                                                  |                                             |         | 28,710   |         |            |         | 26,859  |         |   |        | 1,851   |        |  |    | 7   | % 
|                                                         | Individual performance award                              |                                             |         | 9,461    |         |            |         |        |         |   |        | 9,461   |        |  |    |     | **
|                                                         | Administrative                                            |                                             |         | 25,072   |         |            |         | 15,395  |         |   |        | 9,677   |        |  |    | 63  | % 
|                                                         |                                                           |                                             |         |          |         |            |         |         |         |   |        |         |        |  |    |    
|                                                         |                                                           | Total operating expenses                    |         |          | 120,592 |            |         |         | 99,868  |   |        |         | 20,724 |  |    |     | 21 | %
|                                                         |                                                           |                                             |         |          |         |            |         |         |         |   |        |         |        |  |    |    
|Net investment income before income taxes                |                                                           |                                             | 145,536 |          |         |            | 139,346 |         |         |   | 6,190  |         |        |  | 4  | %  
|Income tax benefit                                       |                                                           |                                             | (744    | )        |         |            | (1,530  | )       |         |   | 786    |         |        |  |    | ** 
|                                                         |                                                           |                                             |         |          |         |            |         |         |         |   |        |         |        |  |    |    
|Net investment income                                    |                                                           |                                             | 146,280 |          |         |            | 140,876 |         |         |   | 5,404  |         |        |  | 4  | %  
|                                                         |                                                           |                                             |         |          |         |            |         |         |         |   |        |         |        |  |    |    
|Net Realized and Unrealized Gains (Losses)               |                                                           |                                             |         |          |         |            |         |         |         |   |        |         |        |  |    |    
|                                                         | Net realized gains (losses)                               |                                             |         | 175,753  |         |            |         | 50,441  |         |   |        | 125,312 |        |  |    |     | * 
|                                                         | Net change in unrealized appreciation
    or depreciation |                                             |         | (120,384 | )       |            |         | (77,760 | )       |   |        | (42,624 | )      |  |    |     | * 
|                                                         |                                                           |                                             |         |          |         |            |         |         |         |   |        |         |        |  |    |    
|                                                         |                                                           | Total net gains (losses)                    |         |          | 55,369  |            |         |         | (27,319 | ) |        |         | 82,688 |  |    |     |    | *
|                                                         |                                                           |                                             |         |          |         |            |         |         |         |   |        |         |        |  |    |    
|Net income                                               |                                                           | $                                           | 201,649 |          |         | $          | 113,557 |         |         | $ | 88,092 |         |        |  | 78 | %  
|                                                         |                                                           |                                             |         |          |         |            |         |         |         |   |        |         |        |  |    |    
|Diluted earnings per common share                        |                                                           | $                                           | 1.53    |          |         | $          | 0.98    |         |         | $ | 0.55   |         |        |  | 56 | %  
|                                                         |                                                           |                                             |         |          |         |            |         |         |         |   |        |         |        |  |    |    
|Weighted average common shares
    outstanding  diluted |                                                           |                                             | 131,487 |          |         |            | 115,228 |         |         |   | 16,259 |         |        |  | 14 | %  



---



|  |                                                                                                                                                                                                                                          
|- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|* | Net realized gains (losses) and net change in
    unrealized appreciation or depreciation can fluctuate
    significantly from period to period. As a result, year-to-date
    comparisons of net gains and losses may not be meaningful.



|   |                                     
|-- | ------------------------------------
|** | Percentage change is not meaningful.

Interest and Related Portfolio
Income.Total interest and related
portfolio income includes interest and dividend income, loan
prepayment premiums, and fees and other income.

Interest and dividend income for the nine months
ended September 30, 2004 and 2003, was composed of the
following:

|                |                              |      |       |       |  |   |       |       | 
|--------------- | ---------------------------- | ---- | ----- | ----- |  | - | ----- | ----- | 
|                |                              | 2004 |       | 2003 
|($ in millions) |                              |      |       |      
|Interest        |                              | $    | 221.4 |       |  | $ | 203.1 |      
|Dividends       |                              |      | 12.2  |       |  |   | 8.5   |      
|                |                              |      |       |       |  |   |       |      
|                | Total interest and dividends |      | $     | 233.6 |  |   | $     | 211.6 | 
|                |                              |      |       |       |  |   |       |      

68



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The level of interest income, which includes
interest paid in cash and in kind, is directly related to the
balance of the interest-bearing investment portfolio outstanding
during the period multiplied by the weighted average yield. The
weighted average yield varies from period to period based on the
current stated interest rate earned on interest-bearing
investments and the amount of loans and debt securities for
which interest is not accruing. The interest-bearing investments
in the portfolio at value and the weighted average yield on the
interest-bearing investments in the portfolio at
September 30, 2004 and 2003, were as follows:

|                           |  |      |         |      |  |   |         |  
|-------------------------- |  | ---- | ------- | ---- |  | - | ------- | -
|                           |  | 2004 |         | 2003
|($ in millions)            |  |      |         |     
|Interest-bearing portfolio |  | $    | 2,341.2 |      |  | $ | 1,946.1 |  
|Portfolio yield            |  |      | 14.2    | %    |  |   | 14.5    | %

Dividend income results from the dividend yield
on preferred equity interests, if any, or the declaration of
dividends by a portfolio company on preferred or common equity
interests. Dividend income will vary from period to period
depending upon the level of yield on our preferred equity
interests and the timing and amount of dividends that are
declared by a portfolio company on preferred or common equity
interests. Dividend income for the nine months ended
September 30, 2004 and 2003, includes $8.3 million and
$3.0 million, respectively, of dividends from BLX on the
Class B equity interests held by us. These dividends were
paid in kind through the issuance of additional Class B
equity interests.

Loan prepayment premiums were $4.2 million
and $5.3 million for the nine months ended
September 30, 2004 and 2003, respectively. While the
scheduled maturities of private finance and commercial real
estate loans range from five to ten years, it is not unusual for
our borrowers to refinance or pay off their debts to us ahead of
schedule. Therefore, we generally structure our loans to require
a prepayment premium for the first three to five years of the
loan. Accordingly, the amount of prepayment premiums will vary
depending on the level of repayments and the age of the loans at
the time of repayment.

Fees and other income primarily include fees
related to financial structuring, diligence, transaction
services, management services to portfolio companies,
guarantees, and other advisory services. As a business
development company, we are required to make significant
managerial assistance available to the companies in our
investment portfolio. Managerial assistance includes management
and consulting services including, but not limited to, corporate
finance, information technology, marketing, human resources,
personnel and board member recruiting, corporate governance, and
risk management.

Fees and other income for the nine months ended
September 30, 2004 and 2003, included fees relating to the
following:

|                                                                                                   |                             |      |      |      |  |   |      |      | 
|-------------------------------------------------------------------------------------------------- | --------------------------- | ---- | ---- | ---- |  | - | ---- | ---- | 
|                                                                                                   |                             | 2004 |      | 2003
|($ in millions)                                                                                    |                             |      |      |     
|Structuring and diligence                                                                          |                             | $    | 11.5 |      |  | $ | 4.1  |     
|Transaction and other services provided to
    portfolio companies                                 |                             |      | 2.2  |      |  |   | 3.4  |     
|Management services provided to portfolio
    companies, other advisory services and guaranty fees |                             |      | 13.1 |      |  |   | 14.2 |     
|Other income                                                                                       |                             |      | 1.6  |      |  |   | 0.7  |     
|                                                                                                   |                             |      |      |      |  |   |      |     
|                                                                                                   | Total fees and other income |      | $    | 28.4 |  |   | $    | 22.4 | 
|                                                                                                   |                             |      |      |      |  |   |      |     

Fees and other income are generally related to
specific transactions or services and therefore may vary
substantially from period to period depending on the level and
types of services provided. Loan

69



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##### 



origination fees that represent yield enhancement
on a loan are capitalized and amortized into interest income
over the life of the loan. Fees and other income for the nine
months ended September 30, 2004, include structuring fees
from Advantage, Financial Pacific and Mercury totaling
$6.7 million.


BLX and Advantage were our most significant
investments at September 30, 2004, and together represented
17.7% of our total assets. Total interest and related portfolio
income earned from BLX and Advantage for the nine months ended
September 30, 2004, was $35.1 million and
$10.4 million, respectively. Total interest and related
portfolio income for the nine months ended September 30,
2004, included $2.5 million of income earned from Hillman
prior to the sale of our investment on March 31, 2004 as
discussed above.

BLX and Hillman were our most significant
investments at September 30, 2003, and together represented
17.7% of our total assets. Total interest and related portfolio
income earned from BLX and Hillman for the nine months ended
September 30, 2003, was $32.8 million and
$7.2 million, respectively.

Operating
Expenses.Operating expenses
include interest, employee, and administrative expenses. Our
single largest expense is interest on our indebtedness. The
fluctuations in interest expense during the nine months ended
September 30, 2004 and 2003, were primarily attributable to
changes in the level of our borrowings under various notes
payable and debentures and our revolving line of credit. Our
borrowing activity and weighted average cost of debt, including
fees and closing costs, at and for the nine months ended
September 30, 2004 and 2003, were as follows:

|                         |  |                   |         |      |  |   |       | 
|------------------------ |  | ----------------- | ------- | ---- |  | - | ----- | 
|                         |  |                  
|                         |  | At and for the   
|                         |  | Nine Months Ended
|                         |  | September 30,    
|                         |  |                  
|                         |  | 2004              |         | 2003
|($ in millions)          |  |                   |         |     
|Total Outstanding Debt   |  | $                 | 1,167.7 |      |  | $ | 954.2 | 
|Average Outstanding Debt |  | $                 | 973.5   |      |  | $ | 939.9 | 
|Weighted Average Cost(1) |  |                   | 6.3%    |      |  |   | 7.5%  | 



---



|    |                                                                                                                                                                                                                                                                                                                                                                  
|--- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(1) | The weighted average annual interest cost is
    computed as the (a) annual stated interest rate on the debt plus
    the annual amortization of commitment fees and other facility
    fees that are recognized into interest expense over the
    contractual life of the respective borrowings, divided by
    (b) debt outstanding on the balance sheet date.

In addition to interest on indebtedness, interest
expense includes interest on our obligations to replenish
borrowed Treasury securities related to our hedging activities
of $4.3 million and $4.5 million for the nine months
ended September 30, 2004 and 2003, respectively.

Employee expenses include salaries and employee
benefits. The change in employee expenses reflects the effect of
wage increases, increased staffing, and the change in mix of
employees given their area of responsibility and relevant
experience level. Total employees were 159 and 117 at
September 30, 2004 and 2003, respectively. During 2003,
employee expenses included a retention award program whereby
senior officers received cash awards as part of their
compensation. The retention award component for the nine months
ended September 30, 2003, was $6.4 million. Beginning
January 1, 2004, we no longer provided retention awards.

In the first quarter of 2004, we established the
Individual Performance Award (IPA) as a long-term incentive
compensation program for our senior officers. In conjunction
with the program, the Board has approved a non-qualified
deferred compensation plan (DCP II), which is administered
through a trust. See Operating Expenses included in
the Comparison of Three Months Ended September 30,
2004 and 2003 for a description of the DCP II. For
the nine months ended

70



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##### 



September 30, 2004, we accrued
$10.2 million in IPA expense, or $0.08 per share. In
addition, we are required to mark to market the liability to pay
the employees in our stock and this adjustment is recorded to
the IPA compensation expense. The effect of this adjustment for
the nine months ended September 30, 2004, was to reduce the
individual performance award expense by $0.7 million.


Administrative expenses include legal and
accounting fees, valuation assistance fees, insurance premiums,
the cost of leases for our headquarters in Washington, DC, and
our regional offices, stock record expenses, directors
fees, and various other expenses. Administrative expenses were
$25.1 million for the nine months ended September 30,
2004, a $9.7 million increase over administrative expenses
of $15.4 million for the nine months ended
September 30, 2003.

A large component of the increase in expenses
results from the costs of operating as a public company. Legal,
accounting, valuation assistance, insurance, and directors
fees were $4.3 million higher for the nine months ended
September 30, 2004, than for the same period in the prior
year.

During the second quarter of 2004, we opened an
office in Los Angeles, CA, and expanded our office space in New
York, NY. We also expect to expand our Chicago office.
Accordingly, occupancy costs and the costs associated with
staffing these offices were $1.6 million higher for the
nine months ended September 30, 2004, than for the same
period in the prior year.

We have also incurred increased deal costs
related to evaluating potential new investments. Costs related
to mezzanine lending are generally paid by the borrower,
however, costs related to buyout investments are generally
funded by us. Accordingly, if a prospective deal does not close,
we incur expenses that are not recoverable. As a result, these
related costs were $1.1 million higher for the nine months
ended September 30, 2004, than for the same period in the
prior year. We have increased our focus on managing
buyout-related costs, however we expect that there will be some
increased costs from this activity going forward.

In addition, administrative expenses related to
portfolio development and workouts were $1.5 million higher
for the nine months ended September 30, 2004, versus the
prior year period. We expect the costs related to workouts to
decline given the declining level of workout assets in the
portfolio.

Realized Gains and
Losses.Net realized gains result
from the sale of equity securities associated with certain
private finance investments, the sale of CMBS bonds, and the
realization of unamortized discount resulting from the sale and
early repayment of private finance loans and commercial mortgage
loans, offset by losses on investments. Net realized gains for
the nine months ended September 30, 2004 and 2003, were as
follows:

|                   |  |                   |       |      |  |   |       |  
|------------------ |  | ----------------- | ----- | ---- |  | - | ----- | -
|                   |  |                  
|                   |  | For the          
|                   |  | Nine Months Ended
|                   |  | September 30,    
|                   |  |                  
|                   |  | 2004              |       | 2003
|($ in millions)    |  |                   |       |     
|Realized gains     |  | $                 | 241.6 |      |  | $ | 64.7  |  
|Realized losses    |  |                   | (65.8 | )    |  |   | (14.3 | )
|                   |  |                   |       |      |  |   |       |  
|Net realized gains |  | $                 | 175.8 |      |  | $ | 50.4  |  
|                   |  |                   |       |      |  |   |       |  

Realized gains and losses for the nine months
ended September 30, 2004 and 2003, resulted from various
private finance and commercial real estate finance transactions.

Realized gains for the nine months ended
September 30, 2004, primarily resulted from transactions
involving 11 private finance portfolio companies  The
Hillman Companies, Inc. ($150.2 million), CorrFlex
Graphics, LLC ($25.6 million), Professional Paint, Inc.
($13.7 million),

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Impact Innovations Group, LLC
($9.4 million), The Hartz Mountain Corporation
($8.2 million), Housecall Medical Resources, Inc.
($7.2 million), International Fiber Corporation
($5.2 million), CBA-Mezzanine Capital Finance, LLC
($3.9 million), United Pet Group, Inc. ($3.7 million),
Matrics, Inc. ($2.1 million), and SmartMail, LLC
($2.1 million) and one transaction involving a commercial
mortgage loan ($1.8 million).


Realized gains for the nine months ended
September 30, 2003, primarily resulted from transactions
involving seven private finance portfolio companies, including
Morton Grove Pharmaceuticals, Inc. ($8.5 million), CyberRep
($8.3 million), Woodstream Corporation ($6.6 million),
Blue Rhino Corporation ($4.7 million), Kirklands Inc.
($3.0 million), GC-Sun Holdings II, LP
($2.5 million), and Interline Brands, Inc.
($1.7 million). In addition, gains were also realized on
CMBS bonds ($24.6 million, net of a realized loss of
$6.7 million from hedges related to the CMBS bonds sold).

For the nine months ended September 30, 2004
and 2003, we reversed previously recorded unrealized
appreciation totaling $189.0 million and
$52.8 million, respectively, when gains were realized. When
we exit an investment and realize a gain, we make an accounting
entry to reverse any unrealized appreciation we had previously
recorded to reflect the appreciated value of the investment.

Realized losses for the nine months ended
September 30, 2004, primarily resulted from transactions
involving six private finance portfolio companies 
The Color Factory, Inc. ($24.5 million), Executive
Greetings, Inc. ($19.3 million), Prosperco Finanz Holding
AG ($7.5 million), Logic Bay Corporation
($5.0 million), Sure-Tel, Inc. ($2.3 million), and
Startec Global Communications Corporation ($1.1 million),
and two transactions involving commercial mortgage loans
($2.0 million).

Realized losses for the nine months ended
September 30, 2003, primarily resulted from transactions
involving two private finance portfolio companies, including
Allied Office Products, Inc. ($7.7 million) and North
American Archery, LLC ($2.1 million), and five transactions
involving commercial mortgage loans ($4.0 million).

For the nine months ended September 30, 2004
and 2003, we reversed previously recorded unrealized
depreciation totaling $67.2 million and $14.3 million,
respectively, when losses were realized. When we exit an
investment and realize a loss, we make an accounting entry to
reverse any unrealized depreciation we had previously recorded
to reflect the depreciated value of the investment.

Change in Unrealized Appreciation or
Depreciation.For a discussion of
our fair value methodology, see Change in Unrealized
Appreciation or Depreciation included in the
Comparison of Three Months Ended September 30, 2004
and 2003.

For the portfolio, net change in unrealized
appreciation or depreciation for the nine months ended
September 30, 2004 and 2003, consisted of the following:

|                                                                                            |  |         |        |         |  |   |       |  
|------------------------------------------------------------------------------------------- |  | ------- | ------ | ------- |  | - | ----- | -
|                                                                                            |  | 2004(1) |        | 2003(1)
|($ in millions)                                                                             |  |         |        |        
|Net unrealized appreciation or depreciation                                                 |  | $       | 1.4    |         |  | $ | (39.3 | )
|Reversal of previously recorded unrealized
    appreciation associated with realized gains  |  |         | (189.0 | )       |  |   | (52.8 | )
|Reversal of previously recorded unrealized
    depreciation associated with realized losses |  |         | 67.2   |         |  |   | 14.3  |  
|                                                                                            |  |         |        |         |  |   |       |  
|Net change in unrealized appreciation or
    depreciation                                   |  | $       | (120.4 | )       |  | $ | (77.8 | )
|                                                                                            |  |         |        |         |  |   |       |  



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|    |                                                                                                                                                                                 
|--- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(1) | The net change in unrealized appreciation or
    depreciation can fluctuate significantly from period to period.
    As a result year-to-date comparisons may not be meaningful.

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Net change in unrealized appreciation or
depreciation for the nine months ended September 30, 2004
included a net decrease in unrealized appreciation of
$6.2 million on our investment in BLX.

Per Share
Amounts.All per share amounts
included in the Managements Discussion and Analysis of
Financial Condition and Results of Operations section have been
computed using the weighted average common shares used to
compute diluted earnings per common share, which were
131.5 million and 115.2 million for the nine months
ended September 30, 2004 and 2003, respectively.

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FINANCIAL CONDITION, LIQUIDITY AND CAPITAL
RESOURCES

Cash Flow From Operating Activities

Our portfolio has historically generated
significant cash flow from which we pay dividends to
shareholders and fund new investment activity. Cash generated
from the portfolio includes cash flow from net investment income
and net realized gains and principal collections related to
investment repayments or sales. Cash flow provided by our
operating activities before new investment activity for the nine
months ended September 30, 2004 and 2003, was as follows:

|                                                        |                                                                        |      |         |       |  |   |       |       | 
|------------------------------------------------------- | ---------------------------------------------------------------------- | ---- | ------- | ----- |  | - | ----- | ----- | 
|($ in millions)                                         |                                                                        | 2004 |         | 2003 
|                                                        |                                                                        |      |         |      
|Net cash provided by (used in) operating
    activities |                                                                        | $    | (189.1  | )     |  | $ | (5.8  | )    
|Add: portfolio investments funded                       |                                                                        |      | 1,056.2 |       |  |   | 664.8 |      
|                                                        |                                                                        |      |         |       |  |   |       |      
|                                                        | Total cash provided by operating activities
    before new investments |      | $       | 867.1 |  |   | $     | 659.0 | 
|                                                        |                                                                        |      |         |       |  |   |       |      

Because of the significant amount of cash
provided by operating activities before new investments, we
generate sufficient cash flow to fund our operating activities
as well as pay dividends to shareholders.

Dividends to common shareholders for the nine
months ended September 30, 2004 and 2003, were
$220.8 million and $196.2 million, respectively, or
$1.71 per common share for both periods. An extra cash dividend
of $0.03 per common share was declared during 2002 and was paid
to shareholders on January 9, 2003. For the fourth quarter
of 2004, the Board of Directors has declared a dividend of
$0.57 per common share payable on December 30, 2004.

Dividends are generally determined based upon an
estimate of annual taxable income, which includes our taxable
interest, dividend and fee income, as well as taxable net
capital gains. Taxable income generally differs from net income
for financial reporting purposes due to temporary and permanent
differences in the recognition of income and expenses and
excludes net unrealized appreciation or depreciation, as gains
or losses are not included in taxable income until they are
realized. Taxable income includes non-cash income, such as
changes in accrued and reinvested interest and dividends and the
amortization of discounts and fees. Non-cash taxable income is
reduced by non-cash expenses, such as realized losses and
depreciation and amortization expense.

Our Board of Directors evaluates whether to
retain or distribute taxable net capital gains on an annual
basis. Our dividend policy allows us to continue to distribute
capital gains, but will also allow us to retain gains to support
future growth. Our Board of Directors reviews the dividend rate
quarterly, and may adjust the quarterly dividend throughout the
year.

At September 30, 2004, we had outstanding
commitments to fund investments totaling $399.4 million. We
intend to fund these commitments and prospective investment
opportunities with existing cash, through cash flow from
operations before new investments, through borrowings under our
line of credit or other long-term debt agreements, or through
the sale or issuance of new equity capital.

Debt and Equity Capital

Because we are a regulated investment company, we
distribute our taxable income and, therefore, require external
capital for asset growth. As a result, from time to time we will
raise growth capital in the form of new debt or equity capital.

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At September 30, 2004, and December 31,
2003, our total assets, total debt outstanding, total
shareholders equity, debt to equity ratio and asset
coverage for senior indebtedness were as follows:

|                           |  |      |         |      |  |   |         |  
|-------------------------- |  | ---- | ------- | ---- |  | - | ------- | -
|($ in millions)            |  | 2004 |         | 2003
|                           |  |      |         |     
|Total assets               |  | $    | 3,438.5 |      |  | $ | 3,019.9 |  
|Total debt outstanding     |  | $    | 1,167.7 |      |  | $ | 954.2   |  
|Total shareholders equity |  | $    | 1,935.7 |      |  | $ | 1,914.6 |  
|Debt to equity ratio       |  |      | 0.60    |      |  |   | 0.50    |  
|Asset coverage ratio(1)    |  |      | 278     | %    |  |   | 322     | %



---

|    |                                                                                                                                              
|--- | ---------------------------------------------------------------------------------------------------------------------------------------------
|(1) | As a business development company, we are
    generally required to maintain a minimum ratio of 200% of total
    assets to total borrowings.

We currently target a debt to equity ratio
ranging between 0.50:1.00 to 0.65:1.00, and are currently in the
middle of the target debt to equity ratio range. We did not sell
equity during the nine months ended September 30, 2004. For
the nine months ended September 30, 2003, and the year
ended December 31, 2003, we sold equity of
$298.2 million and $422.9 million, respectively. In
addition, shareholders equity increased by
$47.1 million, $13.8 million and $21.2 million
through the exercise of employee options, the collection of
notes receivable from the sale of common stock, and the issuance
of shares through our dividend reinvestment plan for the nine
months ended September 30, 2004 and 2003, and the year
ended December 31, 2003, respectively.

We employ an asset-liability management strategy
that focuses on matching the estimated maturities of our loan
and investment portfolio to the estimated maturities of our
borrowings. We use our revolving line of credit facility as a
means to bridge to long-term financing in the form of debt or
equity capital, which may or may not result in temporary
differences in the matching of estimated maturities.
Availability on the revolving line of credit, net of amounts
committed for standby letters of credit issued under the line of
credit facility, was $180.0 million on September 30,
2004. We evaluate our interest rate exposure on an ongoing
basis. Generally, we seek to fund our primarily fixed-rate
investment portfolio with fixed-rate debt or equity capital. To
the extent deemed necessary, we may hedge variable and
short-term interest rate exposure through interest rate swaps or
other techniques.

On October 5, 2004, we sold 3.0 million
shares of our common stock for proceeds of $70.8 million,
net of underwriting discounts and estimated offering expenses.
In addition, on October 26, 2004, we sold BBB- through B+
rated CMBS and CDO bonds for cash proceeds of approximately
$291 million. We used the net proceeds of the equity
offering and bond sale to reduce borrowings under our revolving
line of credit, and expect to use net proceeds in excess of
borrowings under our revolving line of credit for investment in
the debt or equity securities of middle market companies,
non-investment grade CMBS bonds or CDO preferred shares and
other general corporate purposes. Availability on the revolving
line of credit, net of amounts committed for standby letters of
credit issued under the line of credit facility, was
$507.7 million on October 29, 2004.

We are currently in the process of raising
long-term unsecured five- and seven-year debt of approximately
$325.0 million. The new notes have been priced at a blended
fixed interest rate of 5.6% and will have substantially the same
terms as our existing unsecured notes. A portion of this new
debt will refinance maturing long-term debt of
$102.0 million with an interest cost of 8.5%. This debt
issuance is expected to close during the fourth quarter of 2004,
subject to final documentation.

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At September 30, 2004, we had outstanding
debt as follows:

|                              |                         |                                    |       |             |         |          |       |       |         |  |      |      |      |    
|----------------------------- | ----------------------- | ---------------------------------- | ----- | ----------- | ------- | -------- | ----- | ----- | ------- |  | ---- | ---- | ---- | ---
|                              |                         |                                    |       |             |         | Annual  
|                              |                         | Facility                           |       | Amount      |         | Interest
|                              |                         | Amount                             |       | Outstanding |         | Cost(1) 
|($ in millions)               |                         |                                    |       |             |         |         
|Notes payable and debentures: |                         |                                    |       |             |         |          |       |       |         |  |      |     
|                              | Unsecured notes payable |                                    | $     | 757.3       |         |          | $     | 757.3 |         |  |      | 7.1% |     
|                              | SBA debentures          |                                    |       | 84.8        |         |          |       | 77.5  |         |  |      | 8.2% |     
|                              | OPIC loan               |                                    |       | 5.7         |         |          |       | 5.7   |         |  |      | 6.6% |     
|                              |                         |                                    |       |             |         |          |       |       |         |  |      |     
|                              |                         | Total notes payable and debentures |       |             | 847.8   |          |       |       | 840.5   |  |      |      | 7.2% |    
|Revolving line of credit      |                         |                                    | 552.5 |             |         |          | 327.2 |       |         |  | 3.9% | (2) 
|                              |                         |                                    |       |             |         |          |       |       |         |  |      |     
|                              |                         | Total debt                         |       | $           | 1,400.3 |          |       | $     | 1,167.7 |  |      |      | 6.3% | (2)
|                              |                         |                                    |       |             |         |          |       |       |         |  |      |     



---

|    |                                                                                                                                                                                                                                                                                                                                                                                                                                              
|--- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(1) | The weighted average annual interest cost is
    computed as the (a) annual stated interest rate on the debt
    plus the annual amortization of commitment fees and other
    facility fees that are recognized into interest expense over the
    contractual life of the respective borrowings, divided by
    (b) debt outstanding on the balance sheet date.                                                                            
|   
|(2) | The current interest rate payable on the
    revolving line of credit was 3.2% at September 30, 2004,
    which excluded the annual cost of commitment fees and other
    facility fees of $2.2 million. The annual interest cost for
    total debt includes the annual cost of commitment fees and other
    facility fees on the revolving line of credit regardless of the
    amount drawn on the facility as of the balance sheet date.

Unsecured Notes Payable.We have issued long-term debt to
institutional lenders, primarily insurance companies. The notes
have five- or seven-year maturities, with maturity dates
beginning in 2004 and generally have fixed rates of interest.
The notes generally require payment of interest only
semi-annually, and all principal is due upon maturity.

On March 25, 2004, we issued five-year
unsecured long-term notes denominated in Euros and Sterling for
a total U.S. dollar equivalent of $15.2 million. The
notes have fixed interest rates and have substantially the same
terms as our existing unsecured notes. Simultaneous with issuing
the notes, we entered into a cross-currency swap with a
financial institution which fixed our interest and principal
payments in U.S. dollars for the life of the debt.

On April 30, 2004, we repaid
$112.0 million of unsecured notes payable that matured on
May 1, 2004.

Small Business Administration Debentures.We, through our small business
investment company subsidiary, have debentures payable to the
Small Business Administration with contractual maturities of ten
years. The notes require payment of interest only semi-annually,
and all principal is due upon maturity. During the first and
third quarters of 2004, we repaid $7.0 million and
$10.0 million, respectively, of this outstanding debt.
Under the small business investment company program, we may
borrow up to $116.0 million from the Small Business
Administration. At September 30, 2004, we had a commitment
from the Small Business Administration to borrow up to an
additional $7.3 million above the current amount
outstanding. The commitment expires on September 30, 2005.

Revolving Line of Credit.We have an unsecured revolving
line of credit with a committed amount of $552.5 million.
The line of credit may be expanded through new or additional
commitments up to $600.0 million at our option. The
revolving line of credit expires in April 2005, with the right
to extend the maturity for one additional year at our option
under substantially similar terms. The credit facility generally
bears interest at a rate, at our option, equal to (i) the
one month LIBOR plus 1.50%, (ii) the Bank of America, N.A.
cost of funds plus 1.50% or (iii) the higher of the Bank of
America, N.A. prime rate or the Federal Funds rate plus 0.50%.
The line of credit generally requires monthly payments of
interest, and all principal is due upon maturity.

Outstanding borrowings on the unsecured revolving
line of credit at September 30, 2004, were
$327.2 million. The amount available under the line at
September 30, 2004, was $180.0 million, net of amounts
committed for standby letters of credit of $45.3 million.

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We have various financial and operating covenants
required by the revolving line of credit and notes payable and
debentures. These covenants require us to maintain certain
financial ratios, including debt to equity and interest
coverage, and a minimum net worth. Our credit facilities limit
our ability to declare dividends if we default under certain
provisions. As of September 30, 2004, we were in compliance
with these covenants.

The following table shows our significant
contractual obligations for the repayment of debt and payment of
other contractual obligations as of September 30, 2004.

|                              |                         |                               |       |                      |         |       |     |       |       |      |     |       |       |      |       |       |       |  |     |   |     |  |     |       |       |  |      |       |       | 
|----------------------------- | ----------------------- | ----------------------------- | ----- | -------------------- | ------- | ----- | --- | ----- | ----- | ---- | --- | ----- | ----- | ---- | ----- | ----- | ----- |  | --- | - | --- |  | --- | ----- | ----- |  | ---- | ----- | ----- | 
|                              |                         |                               |       |                     
|                              |                         |                               |       | Payments Due By Year
|                              |                         |                               |       |                     
|                              |                         |                               |       |                      |         | After
|                              |                         | Total                         |       | 2004                 |         | 2005  |     | 2006  |       | 2007 |     | 2008  |       | 2008
|($ in millions)               |                         |                               |       |                      |         |       |     |       |       |      |     |       |       |     
|Notes payable and debentures: |                         |                               |       |                      |         |       |     |       |       |      |     |       |       |      |       |       |       |  |     |   |     |  |     |       |       |  |      |      
|                              | Unsecured notes payable |                               | $     | 757.3                |         |       | $   | 102.0 |       |      | $   | 165.0 |       |      | $     | 175.0 |       |  | $   |  |     |  | $   | 153.0 |       |  | $    | 162.3 |      
|                              | SBA debentures          |                               |       | 77.5                 |         |       |     |      |       |      |     | 4.0   |       |      |       |      |       |  |     |  |     |  |     |      |       |  |      | 73.5  |      
|                              | OPIC loan               |                               |       | 5.7                  |         |       |     |      |       |      |     |      |       |      |       | 5.7   |       |  |     |  |     |  |     |      |       |  |      |      |      
|Revolving line of credit(1)   |                         |                               | 327.2 |                      |         |       |    |       |       |      |    |       |       |      | 327.2 |       |       |  |    |   |     |  |    |       |       |  |     |      
|Operating leases              |                         |                               | 34.7  |                      |         |       | 1.1 |       |       |      | 4.6 |       |       |      | 4.5   |       |       |  | 4.4 |   |     |  | 4.4 |       |       |  | 15.7 |      
|                              |                         |                               |       |                      |         |       |     |       |       |      |     |       |       |      |       |       |       |  |     |   |     |  |     |       |       |  |      |      
|                              |                         | Total contractual obligations |       | $                    | 1,202.4 |       |     | $     | 103.1 |      |     | $     | 173.6 |      |       | $     | 512.4 |  |     | $ | 4.4 |  |     | $     | 157.4 |  |      | $     | 251.5 | 
|                              |                         |                               |       |                      |         |       |     |       |       |      |     |       |       |      |       |       |       |  |     |   |     |  |     |       |       |  |      |      



---

|    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             
|--- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(1) | The revolving line of credit expires in April
    2005 and may be extended under substantially similar terms for
    one additional year at our option. We assume that we would
    exercise our option to extend the revolving line of credit
    resulting in an assumed maturity of April 2006. At
    September 30, 2004, $180.0 million remains unused and
    available, net of amounts committed for standby letters of
    credit of $45.3 million issued under the credit facility.

The following table shows our contractual
commitments that may have the effect of creating, increasing, or
accelerating our liabilities as of September 30, 2004.

|                             |                   |       |       |                                          |  |       |     |      |  |      |     |      |  |      |      |      |  |   |       |       |  |   |   |   |  |   |     |     | 
|---------------------------- | ----------------- | ----- | ----- | ---------------------------------------- |  | ----- | --- | ---- |  | ---- | --- | ---- |  | ---- | ---- | ---- |  | - | ----- | ----- |  | - | - | - |  | - | --- | --- | 
|                             |                   |       |       |                                         
|                             |                   |       |       | Amount of Commitment Expiration Per Year
|                             |                   |       |       |                                         
|                             |                   |       |       |                                          |  | After
|                             |                   | Total |       | 2004                                     |  | 2005  |     | 2006 |  | 2007 |     | 2008 |  | 2008
|($ in millions)              |                   |       |       |                                          |  |       |     |      |  |      |     |      |  |     
|Guarantees                   |                   | $     | 107.4 |                                          |  | $     | 0.3 |      |  | $    | 0.6 |      |  | $    | 1.1  |      |  | $ | 101.8 |       |  | $ |  |   |  | $ | 3.6 |    
|Standby letters of credit(1) |                   |       | 45.3  |                                          |  |       |    |      |  |      | 1.2 |      |  |      | 44.1 |      |  |   |      |       |  |   |  |   |  |   |    |    
|                             |                   |       |       |                                          |  |       |     |      |  |      |     |      |  |      |      |      |  |   |       |       |  |   |   |   |  |   |     |    
|                             | Total commitments |       | $     | 152.7                                    |  |       | $   | 0.3  |  |      | $   | 1.8  |  |      | $    | 45.2 |  |   | $     | 101.8 |  |   | $ |  |  |   | $   | 3.6 | 
|                             |                   |       |       |                                          |  |       |     |      |  |      |     |      |  |      |      |      |  |   |       |       |  |   |   |   |  |   |     |    



---

|    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
|--- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(1) | Standby letters of credit are issued under our
    revolving line of credit that expires in April 2005 and may
    be extended under substantially similar terms for one additional
    year at our option, for an assumed maturity of April 2006.
    Therefore, unless a standby letter of credit is set to expire at
    an earlier date, we have assumed that the standby letters of
    credit will expire contemporaneously with the expiration of our
    line of credit in April 2006.

In addition, we had outstanding commitments to
fund investments totaling $399.4 million at
September 30, 2004, as discussed above.

CRITICAL ACCOUNTING POLICIES

The consolidated financial statements are based
on the selection and application of critical accounting
policies, which require management to make significant estimates
and assumptions. Critical accounting policies are those that are
both important to the presentation of our financial condition
and results of operations and require managements most
difficult, complex, or subjective judgments. Our critical
accounting policies are those applicable to the valuation of
investments and certain revenue recognition matters as discussed
below.

Valuation of Portfolio
Investments.As a business development company, we
invest in illiquid securities including debt and equity
securities of companies, non-investment grade CMBS, and the
bonds and preferred shares of CDOs. Our investments are
generally subject to restrictions on resale and generally have
no established trading market. We value substantially all of our
investments at fair value as determined in good faith by the
Board of Directors in accordance with our valuation policy. We
determine fair value to be the amount for which an investment
could be exchanged in an orderly

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disposition over a reasonable period of time
between willing parties other than in a forced or liquidation
sale. Our valuation policy considers the fact that no ready
market exists for substantially all of the securities in which
we invest. Our valuation policy is intended to provide a
consistent basis for determining the fair value of the
portfolio. We will record unrealized depreciation on investments
when we believe that an investment has become impaired,
including where collection of a loan or realization of an equity
security is doubtful, or when the enterprise value of the
portfolio company does not currently support the cost of our
debt or equity investments. Enterprise value means the entire
value of the company to a potential buyer, including the sum of
the values of debt and equity securities used to capitalize the
enterprise at a point in time. We will record unrealized
appreciation if we believe that the underlying portfolio company
has appreciated in value and, therefore, our equity security has
also appreciated in value. The value of investments in publicly
traded securities is determined using quoted market prices
discounted for restrictions on resale, if any.


Loans and Debt Securities.For loans and debt securities, fair value generally
approximates cost unless the borrowers enterprise value,
overall financial condition or other factors lead to a
determination of fair value at a different amount.

When we receive nominal cost warrants or free
equity securities (nominal cost equity), we allocate
our cost basis in our investment between debt securities and
nominal cost equity at the time of origination. At that time,
the original issue discount basis of the nominal cost equity is
recorded by increasing the cost basis in the equity and
decreasing the cost basis in the related debt securities.

Interest income is recorded on an accrual basis
to the extent that such amounts are expected to be collected.
For loans and debt securities with contractual payment-in-kind
interest, which represents contractual interest accrued and
added to the loan balance that generally becomes due at
maturity, we will not accrue payment-in-kind interest if the
portfolio company valuation indicates that the payment-in-kind
interest is not collectible. Interest on loans and debt
securities is not accrued if we have doubt about interest
collection. Loans in workout status that are classified as
Grade 4 or 5 assets under our internal grading system
do not accrue interest. In addition, interest may not accrue on
loans or debt securities to portfolio companies that are more
than 50% owned by us depending on such companys capital
requirements. Loan origination fees, original issue discount,
and market discount are capitalized and then amortized into
interest income using the effective interest method. Upon the
prepayment of a loan or debt security, any unamortized loan
origination fees are recorded as interest income and any
unamortized original issue discount or market discount is
recorded as a realized gain. Prepayment premiums are recorded on
loans and debt securities when received.

Equity Securities.Our
equity interests in portfolio companies for which there is no
liquid public market are valued at fair value based on the
enterprise value of the portfolio company, which is determined
using various factors, including cash flow from operations of
the portfolio company and other pertinent factors, such as
recent offers to purchase a portfolio company, recent
transactions involving the purchase or sale of the portfolio
companys equity securities, or other liquidation events.
The determined equity values are generally discounted to account
for restrictions on resale and minority ownership positions.

The value of our equity interests in public
companies for which market quotations are readily available is
based on the closing public market price on the balance sheet
date. Securities that carry certain restrictions on sale are
typically valued at a discount from the public market value of
the security.

Dividend income is recorded on preferred equity
securities on an accrual basis to the extent that such amounts
are expected to be collected, and on common equity securities on
the record date for private companies or on the ex-dividend date
for publicly traded companies.

Commercial Mortgage-Backed Securities
(CMBS) and Collateralized Debt Obligations (CDO).CMBS bonds and CDO bonds and
preferred shares are carried at fair value, which is based on a

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discounted cash flow model that utilizes
prepayment and loss assumptions based on historical experience
and projected performance, economic factors, the characteristics
of the underlying cash flow, and comparable yields for similar
CMBS bonds and CDO bonds and preferred shares. We recognize
unrealized appreciation or depreciation on our CMBS bonds and
CDO bonds and preferred shares as comparable yields in the
market change and/or based on changes in estimated cash flows
resulting from changes in prepayment or loss assumptions in the
underlying collateral pool.


We recognize income from the amortization of
original issue discount using the effective interest method,
using the anticipated yield over the projected life of the
investment. Yields are revised when there are changes in actual
and estimated prepayment speeds or actual and estimated credit
losses. Changes in estimated yield are recognized as an
adjustment to the estimated yield over the remaining life of the
CMBS bonds and CDO bonds and preferred shares from the date the
estimated yield is changed.

Net Realized Gains or Losses and Net Change
in Unrealized Appreciation or Depreciation.Realized gains or losses are
measured by the difference between the net proceeds from the
repayment or sale and the cost basis of the investment without
regard to unrealized appreciation or depreciation previously
recognized, and include investments charged off during the year,
net of recoveries. Net change in unrealized appreciation or
depreciation reflects the change in portfolio investment values
during the reporting period, including the reversal of
previously recorded unrealized appreciation or depreciation when
gains or losses are realized.

Fee Income.Fee income includes fees for
guarantees and services rendered by us to portfolio companies
and other third parties such as diligence, structuring,
transaction services, management services, and other advisory
services. Guaranty fees are recognized as income over the
related period of the guaranty. Diligence, structuring, and
transaction services fees are generally recognized as income
when services are rendered or when the related transactions are
completed. Management and other advisory services fees are
generally recognized as income as the services are rendered.

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RISK FACTORS

Investing in Allied Capital involves a number
of significant risks relating to our business and investment
objective. As a result, there can be no assurance that we will
achieve our investment objective.

Our portfolio of investments is
illiquid.We generally acquire our
investments directly from the issuer in privately negotiated
transactions. The majority of the investments in our portfolio
are typically subject to restrictions on resale or otherwise
have no established trading market. We typically exit our
investments when the portfolio company has a liquidity event
such as a sale, recapitalization, or initial public offering of
the company. The illiquidity of our investments may adversely
affect our ability to dispose of debt and equity securities at
times when it may be otherwise advantageous for us to liquidate
such investments. In addition, if we were forced to immediately
liquidate some or all of the investments in the portfolio, the
proceeds of such liquidation would be significantly less than
the current value of such investments.

Investing in private companies involves a high
degree of risk.Our portfolio consists
of primarily long-term loans to and investments in private
companies. Investments in private businesses involve a high
degree of business and financial risk, which can result in
substantial losses and accordingly should be considered
speculative. There is generally no publicly available
information about the companies in which we invest, and we rely
significantly on the diligence of our employees and agents to
obtain information in connection with our investment decisions.
In addition, some smaller businesses have narrower product lines
and market shares than their competition and may be more
vulnerable to customer preferences, market conditions, loss of
key personnel, or economic downturns, which may adversely affect
the return on, or the recovery of, our investment in such
businesses.

Substantially all of our portfolio investments
are recorded at fair value as determined in good faith by our
Board of Directors and, as a result, there is uncertainty
regarding the value of our portfolio
investments.At September 30,
2004, portfolio investments recorded at fair value were
approximately 87% of our total assets. Pursuant to the
requirements of the 1940 Act, we value substantially all of our
investments at fair value as determined in good faith by our
Board of Directors on a quarterly basis. Since there is
typically no readily available market value for the investments
in our portfolio, our Board of Directors determines in good
faith the fair value of these investments pursuant to a
valuation policy and a consistently applied valuation process.

There is no single standard for determining fair
value in good faith. As a result, determining fair value
requires that judgment be applied to the specific facts and
circumstances of each portfolio investment while employing a
consistently applied valuation process for the types of
investments we make. Unlike banks, we are not permitted to
provide a general reserve for anticipated loan losses; we are
instead required by the 1940 Act to specifically value each
individual investment on a quarterly basis and record unrealized
depreciation for an investment that we believe has become
impaired, including where collection of a loan or realization of
an equity security is doubtful, or when the enterprise value of
the portfolio company does not currently support the cost of our
debt or equity investment. Enterprise value means the entire
value of the company to a potential buyer, including the sum of
the values of debt and equity securities used to capitalize the
enterprise at a point in time. We will record unrealized
appreciation if we believe that the underlying portfolio company
has appreciated in value and, therefore, our equity security has
also appreciated in value. Without a readily available market
value and because of the inherent uncertainty of valuation, the
fair value of our investments determined in good faith by the
Board of Directors may differ significantly from the values that
would have been used had a ready market existed for the
investments, and the differences could be material.

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We adjust quarterly the valuation of our
portfolio to reflect the Board of Directors determination
of the fair value of each investment in our portfolio. Any
changes in fair value are recorded in our statement of
operations as net change in unrealized appreciation or
depreciation.

Economic recessions or downturns could impair
our portfolio companies and harm our operating
results.Many of the companies in
which we have made or will make investments may be susceptible
to economic slowdowns or recessions. An economic slowdown may
affect the ability of a company to engage in a liquidity event
such as a sale, recapitalization, or initial public offering.
Our nonperforming assets are likely to increase and the value of
our portfolio is likely to decrease during these periods. These
conditions could lead to financial losses in our portfolio and a
decrease in our revenues, net income, and assets.

Our business of making private equity investments
and positioning them for liquidity events also may be affected
by current and future market conditions. The absence of an
active senior lending environment may slow the amount of private
equity investment activity generally. As a result, the pace of
our investment activity may slow. In addition, significant
changes in the capital markets could have an effect on the
valuations of private companies and on the potential for
liquidity events involving such companies. This could affect the
amount and timing of gains realized on our investments.

Our borrowers may default on their payments,
which may have an effect on our financial
performance.We make long-term
unsecured, subordinated loans and invest in equity securities,
which may involve a higher degree of repayment risk. We
primarily invest in companies that may have limited financial
resources and that may be unable to obtain financing from
traditional sources. Numerous factors may affect a
borrowers ability to repay its loan, including the failure
to meet its business plan, a downturn in its industry, or
negative economic conditions. Deterioration in a borrowers
financial condition and prospects may be accompanied by
deterioration in any related collateral.

Our private finance investments may not
produce current returns or capital
gains.Private finance investments are
typically structured as debt securities with a relatively high
fixed rate of interest and with equity features such as
conversion rights, warrants, or options. As a result, private
finance investments are generally structured to generate
interest income from the time they are made and may also produce
a realized gain from an accompanying equity feature. We cannot
be sure that our portfolio will generate a current return or
capital gains.

Our financial results could be negatively
affected if Business Loan Express fails to perform as
expected.Business Loan Express, LLC
(BLX) is our largest portfolio investment. Our financial results
could be negatively affected if BLX, as a portfolio company,
fails to perform as expected or if government funding for, or
regulations related to the Small Business
Administration 7(a) Guaranteed Loan Program change. At
September 30, 2004, the investment totaled
$352.1 million at value, or 10.2% of total assets.

In addition, as controlling equity owner of BLX,
we have provided an unconditional guaranty to BLXs senior
credit facility lenders in an amount equal to 50% of BLXs
total obligations on its $275.0 million revolving credit
facility. The amount we have guaranteed at September 30,
2004, was $101.6 million. This guaranty can only be called
in the event of a default by BLX. At September 30, 2004, we
had also provided four standby letters of credit totaling
$35.6 million in connection with four term securitization
transactions completed by BLX.

Our financial results could be negatively
affected if a significant portfolio investment fails to perform
as expected.We purchase controlling
equity positions in companies and our total debt and equity
investment in controlled companies may be significant
individually or in the aggregate.

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Investments in controlled portfolio companies are
generally larger and in fewer companies than our investments in
companies that we do not control. As a result, if a significant
investment in one or more controlled companies fails to perform
as expected, our financial results could be more negatively
affected and the magnitude of the loss could be more significant
than if we had made smaller investments in more companies.


Investments in non-investment grade commercial
mortgage-backed securities and collateralized debt obligations
may be illiquid, may have a higher risk of default, and may not
produce current returns.The
commercial mortgage-backed securities and collateralized debt
obligation bonds and preferred shares in which we invest are not
investment grade, which means that nationally recognized
statistical rating organizations rate them below the top four
investment-grade rating categories (i.e., AAA
through BBB), and are sometimes referred to as
junk bonds. Non-investment grade commercial
mortgage-backed securities and collateralized debt obligation
bonds and preferred shares tend to be less liquid, may have a
higher risk of default and may be more difficult to value.
Non-investment grade securities usually provide a higher yield
than do investment grade securities, but with the higher return
comes greater risk of default. In addition, the fair value of
these securities may change as interest rates change over time.
Economic recessions or downturns may cause defaults or losses on
collateral securing these securities to increase. Non-investment
grade securities are considered speculative, and their capacity
to pay principal and interest in accordance with the terms of
their issue is not ensured.

We may not borrow money unless we maintain
asset coverage for indebtedness of at least 200%, which may
affect returns to shareholders.We
must maintain asset coverage for total borrowings of at least
200%. Our ability to achieve our investment objective may depend
in part on our continued ability to maintain a leveraged capital
structure by borrowing from banks, insurance companies or other
lenders on favorable terms. There can be no assurance that we
will be able to maintain such leverage. If asset coverage
declines to less than 200%, we may be required to sell a portion
of our investments when it is disadvantageous to do so. As of
September 30, 2004, our asset coverage for senior
indebtedness was 278%.

We borrow money, which magnifies the potential
for gain or loss on amounts invested and may increase the risk
of investing in us.Borrowings, also
known as leverage, magnify the potential for gain or loss on
amounts invested and, therefore, increase the risks associated
with investing in our securities. We borrow from and issue
senior debt securities to banks, insurance companies, and other
lenders. Lenders of these senior securities have fixed dollar
claims on our consolidated assets that are superior to the
claims of our common shareholders. If the value of our
consolidated assets increases, then leveraging would cause the
net asset value attributable to our common stock to increase
more sharply than it would have had we not leveraged.
Conversely, if the value of our consolidated assets decreases,
leveraging would cause net asset value to decline more sharply
than it otherwise would have had we not leveraged. Similarly,
any increase in our consolidated income in excess of
consolidated interest payable on the borrowed funds would cause
our net income to increase more than it would without the
leverage, while any decrease in our consolidated income would
cause net income to decline more sharply than it would have had
we not borrowed. Such a decline could negatively affect our
ability to make common stock dividend payments. Leverage is
generally considered a speculative investment technique.

At September 30, 2004, we had
$1,167.7 million of outstanding indebtedness bearing a
weighted average annual interest cost of 6.3%. In order for us
to cover these annual interest payments on indebtedness, we must
achieve annual returns on our assets of at least 2.1%.

Changes in interest rates may affect our cost
of capital and net investment income.Because we borrow money to make investments, our net investment
income is dependent upon the difference

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between the rate at which we borrow funds and the
rate at which we invest these funds. As a result, there can be
no assurance that a significant change in market interest rates
will not have a material adverse effect on our net investment
income. In periods of rising interest rates, our cost of funds
would increase, which would reduce our net investment income. We
use a combination of long-term and short-term borrowings and
equity capital to finance our investing activities. We utilize
our revolving line of credit as a means to bridge to long-term
financing. Our long-term fixed-rate investments are financed
primarily with long-term fixed-rate debt and equity. We may use
interest rate risk management techniques in an effort to limit
our exposure to interest rate fluctuations. Such techniques may
include various interest rate hedging activities to the extent
permitted by the 1940 Act. We have analyzed the potential impact
of changes in interest rates on interest income net of interest
expense. Assuming that the balance sheet were to remain constant
and no actions were taken to alter the existing interest rate
sensitivity, a hypothetical immediate 1% change in interest
rates would have affected the net income by less than 1% over a
one year horizon. Although management believes that this measure
is indicative of our sensitivity to interest rate changes, it
does not adjust for potential changes in credit quality, size
and composition of the assets on the balance sheet and other
business developments that could affect net increase in net
assets resulting from operations, or net income. Accordingly, no
assurances can be given that actual results would not differ
materially from the potential outcome simulated by this estimate.


We will continue to need additional capital to
grow because we must distribute our
income.We will continue to need
capital to fund growth in our investments. Historically, we have
borrowed from financial institutions and have issued equity
securities. A reduction in the availability of new capital could
limit our ability to grow. We must distribute at least 90% of
our taxable ordinary income, which excludes realized net
long-term capital gains, to our shareholders to maintain our
regulated investment company status. As a result, such earnings
will not be available to fund investment originations. We expect
to continue to borrow from financial institutions and issue
additional debt and equity securities. If we fail to obtain
funds from such sources or from other sources to fund our
investments, it could limit our ability to grow, which could
have a material adverse effect on the value of our common stock.
In addition, as a business development company, we are generally
required to maintain a ratio of at least 200% of total assets to
total borrowings, which may restrict our ability to borrow in
certain circumstances.

Loss of regulated investment company tax
treatment would substantially reduce net assets and income
available for dividends.We have
operated so as to qualify as a regulated investment company
under Subchapter M of the Code. If we meet source of
income, asset diversification, and distribution requirements, we
will not be subject to corporate level income taxation on income
we timely distribute to our stockholders as dividends. We would
cease to qualify for such tax treatment if we were unable to
comply with these requirements. In addition, we may have
difficulty meeting the requirement to make distributions to our
shareholders because in certain cases we may recognize income
before or without receiving cash representing such income. If we
fail to qualify as a regulated investment company, we will have
to pay corporate-level taxes on all of our income whether or not
we distribute it, which would substantially reduce the amount of
income available for distribution to our stockholders. Even if
we qualify as a regulated investment company, we generally will
be subject to a corporate-level income tax on the income we do
not distribute. Moreover, if we do not distribute at least 98%
of our taxable income, we generally will be subject to a 4%
excise tax.

There is a risk that you may not receive
dividends or distributions.We intend
to make distributions on a quarterly basis to our stockholders.
We may not be able to achieve operating results that will allow
us to make distributions at a specific level or to increase the
amount of these distributions from time to time. In addition,
due to the asset coverage test applicable to us as a business
development company, we may be limited in our ability to make
distributions. Also, our

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credit facilities limit our ability to declare
dividends if we default under certain provisions. If we do not
distribute a certain percentage of our income annually, we will
suffer adverse tax consequences, including possible loss of our
status as a regulated investment company. In addition, in
accordance with U.S. generally accepted accounting principles
and tax regulations, we include in income certain amounts that
we have not yet received in cash, such as contractual
payment-in-kind interest which represents contractual interest
added to the loan balance that becomes due at the end of the
loan term. The increases in loan balances as a result of
contractual payment-in-kind arrangements are included in income
in advance of receiving cash payment and are separately included
in the change in accrued or reinvested interest and dividends in
our consolidated statement of cash flows. Since we may recognize
income before or without receiving cash representing such
income, we may have difficulty meeting the requirement to
distribute at least 90% of our investment company taxable income
to maintain our status as a regulated investment company.


We operate in a competitive market for
investment opportunities.We compete
for investments with a large number of private equity funds and
mezzanine funds, investment banks and other equity and
non-equity based investment funds, and other sources of
financing, including traditional financial services companies
such as commercial banks. Some of our competitors have greater
resources than we do. Increased competition would make it more
difficult for us to purchase or originate investments at
attractive prices. As a result of this competition, sometimes we
may be precluded from making otherwise attractive investments.

We depend on key
personnel.We depend on the continued
services of our executive officers and other key management
personnel. If we were to lose any of these officers or other
management personnel, such a loss could result in inefficiencies
in our operations and lost business opportunities.

Changes in the law or regulations that govern
us could have a material impact on us or our
operations.We are regulated by the
SEC and the Small Business Administration. In addition, changes
in the laws or regulations that govern business development
companies, regulated investment companies, real estate
investment trusts, and small business investment companies may
significantly affect our business. Any change in the law or
regulations that govern our business could have a material
impact on us or our operations. Laws and regulations may be
changed from time to time, and the interpretations of the
relevant laws and regulations also are subject to change.

Our ability to invest in private companies may
be limited in certain circumstances.If we are to maintain our status as a business development
company, we must not acquire any assets other than
qualifying assets unless, at the time of and after
giving effect to such acquisition, at least 70% of our total
assets are qualifying assets. If we acquire debt or equity
securities from an issuer that has outstanding marginable
securities at the time we make an investment, these acquired
assets cannot be treated as qualifying assets. This result is
dictated by the definition of eligible portfolio
company under the 1940 Act, which in part looks to whether
a company has outstanding marginable securities.

Amendments promulgated in 1998 by the Federal
Reserve expanded the definition of a marginable security under
the Federal Reserves margin rules to include any
non-equity security. Thus, any debt securities issued by any
entity are marginable securities under the Federal
Reserves current margin rules. As a result, the staff of
the SEC has raised the question as to whether a private company
that has outstanding debt securities would qualify as an
eligible portfolio company under the 1940 Act.

Until the question raised by the staff of the SEC
pertaining to the Federal Reserves 1998 change to its
margin rules has been addressed by legislative, administrative
or judicial action, we intend to treat as qualifying assets only
those debt and equity securities that are issued by a private
company that has no marginable securities outstanding at the
time we purchase such securities. As a

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result, we will not invest in a private company
with outstanding debt securities unless at the time of and after
giving effect to such investment, at least 70% of our total
assets are qualifying assets.


The SEC has recently issued proposed rules to
correct the unintended consequence of the Federal Reserves
1998 margin rule amendments of apparently limiting the
investment opportunities of business development companies. In
general, the SECs proposed rules would define an eligible
portfolio company as any company that does not have securities
listed on a national securities exchange or association. We are
currently in the process of reviewing the SECs proposed
rules and assessing its impact, to the extent such proposed
rules are subsequently approved by the SEC, on our investment
activities. We do not believe that these proposed rules will
have a material adverse effect on our operations.

Results may fluctuate and may not be
indicative of future performance.Our
operating results may fluctuate and, therefore, you should not
rely on current or historical period results to be indicative of
our performance in future reporting periods. Factors that could
cause operating results to fluctuate include, among others,
variations in the investment origination volume and fee income
earned, variation in timing of prepayments, variations in and
the timing of the recognition of net realized gains or losses
and changes in unrealized appreciation or depreciation, the
degree to which we encounter competition in our markets, and
general economic conditions.

Our common stock price may be
volatile.The trading price of our
common stock may fluctuate substantially. The price of the
common stock may be higher or lower than the price you pay for
your shares, depending on many factors, some of which are beyond
our control and may not be directly related to our operating
performance. These factors include the following:



| |   |                                                                                                                                                                                                          
| | - | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | price and volume fluctuations in the overall
    stock market from time to time;                                                                                                                         
|
| |  | significant volatility in the market price and
    trading volume of securities of business development companies
    or other financial services companies;                                             
|
| |  | volatility resulting from trading in derivative
    securities related to our common stock including puts, calls,
    long-term equity anticipation securities, or LEAPs, or short
    trading positions;
|
| |  | changes in regulatory policies or tax guidelines
    with respect to business development companies or regulated
    investment companies;                                                               
|
| |  | actual or anticipated changes in our earnings or
    fluctuations in our operating results or changes in the
    expectations of securities analysts;                                                    
|
| |  | general economic conditions and trends;                                                                                                                                                                  
|
| |  | loss of a major funding source; or                                                                                                                                                                       
|
| |  | departures of key personnel.                                                                                                                                                                             

Item 3.  Quantitative and
Qualitative Disclosures About Market Risk

There has been no material change in quantitative
or qualitative disclosures about market risk since
December 31, 2003.

Item 4.  Controls and
Procedures

(a) As of the end of the period covered by
this quarterly report on Form 10-Q, the Companys
chief executive officer and chief financial officer conducted an
evaluation of the Companys disclosure controls and
procedures (as defined in Rules 13a-15 and 15d-15 of the
Securities Exchange Act of 1934). Based upon this evaluation,
the Companys chief executive officer and chief financial
officer concluded that the Companys disclosure controls
and procedures are effective in timely alerting them

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of any material information relating to the
Company that is required to be disclosed by the Company in the
reports it files or submits under the Securities Exchange Act of
1934.


(b) There have been no changes in the
Companys internal control over financial reporting that
occurred during the quarter ended September 30, 2004, that
have materially affected, or are reasonably likely to materially
affect, the Companys internal control over financial
reporting.

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PART II. OTHER INFORMATION

Item 1.     Legal
Proceedings

On June 23, 2004, we were notified by the
SEC that they are conducting an informal investigation of us.
Based on the documentation requested by the SEC, the nature of
the inquiry appears to pertain to matters related to our
portfolio company, Business Loan Express, LLC and allegations
made by short sellers over the last two years. We have
voluntarily agreed to cooperate fully with the SECs
investigation.

On May 28, 2004, Ferolie Corporation, a food
broker with business and contractual relationships with an
entity that is now affiliated with one of our portfolio
companies, Advantage Sales & Marketing Inc., filed suit
against us, Advantage Sales & Marketing and the
affiliated entity in the United States District Court for the
District of Columbia alleging that, among other things, we and
Advantage Sales & Marketing had tortiously interfered
with Ferolies contract with the affiliated entity by
causing the affiliated entity (i) to breach its obligations
to Ferolie regarding Ferolies participation in a
reorganization transaction involving the affiliated entity and
(ii) to induce clients of Ferolie to transfer their
business to the affiliated entity. Ferolie seeks actual and
punitive damages against us and Advantage Sales &
Marketing and declaratory and injunctive relief. On
July 15, 2004, the United States District Court for the
District of Columbia dismissed the lawsuit for lack of
jurisdiction. On August 17, 2004, Ferolie filed a
Petition to Compel Arbitration in the United States
District Court for the Northern District of Illinois naming us,
Advantage Sales & Marketing and the affiliated entity as
respondents. Ferolie attached to its petition an Amended
Demand for Arbitration and Statement of Claims that
asserts essentially the same claims as were asserted in the
lawsuit that was dismissed by the United States District Court
for the District of Columbia. On October 29, 2004, the
United States District Court for the Northern District of
Illinois dismissed Ferolies petition after finding that
Ferolie had failed to adequately allege the existence of subject
matter jurisdiction.

In addition to the above matters, we are party to
certain lawsuits in the normal course of business.

While the outcome of these legal proceedings and
other matters cannot at this time be predicted with certainty,
we do not expect that these matters will have a material effect
upon our financial condition or results of operations.

Item 2.  Unregistered Sales
of Equity Securities and Use of Proceeds

During the three months ended September 30,
2004, we issued a total of 56,855 shares of common stock
under our dividend reinvestment plan pursuant to an exemption
from the registration requirements of the Securities Act of
1933. The aggregate offering price for the shares of common
stock sold under the dividend reinvestment plan was
approximately $1.4 million.

The following table provides information as of
and for the quarter ended September 30, 2004, regarding
shares of our common stock that were purchased under our
Non-Qualified Deferred

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Compensation Plan I (DCP I) and
Non-Qualified Deferred Compensation Plan II (DCP II),
which are administered by independent third-party trustees.


|          |                       |              |         |                |  |   |       |       | 
|--------- | --------------------- | ------------ | ------- | -------------- |  | - | ----- | ----- | 
|          |                       | Total Number |         |               
|          |                       | of Shares    |         | Average Price 
|          |                       | Purchased    |         | Paid Per Share
|          |                       |              |         |               
|DCP I(1)  |                       |              |         |                |  |   |       |      
|          | 7/1/2004 to 7/31/2004 |              |         | 29             |  |   | $     | 24.87 | 
|          | 8/1/2004 to 8/31/2004 |              |         |               |  |   |       |      | 
|          | 9/1/2004 to 9/30/2004 |              |         |               |  |   |       |      | 
|DCP II(2) |                       |              |         |                |  |   |       |      
|          | 7/1/2004 to 7/31/2004 |              |         | 3,073          |  |   |       | 24.87 | 
|          | 8/1/2004 to 8/31/2004 |              |         |               |  |   |       |      | 
|          | 9/1/2004 to 9/30/2004 |              |         | 123,935        |  |   | $     | 25.54 | 
|          |                       |              |         |                |  |   |       |      
|Total     |                       |              | 127,037 |                |  | $ | 25.52 |      
|          |                       |              |         |                |  |   |       |      



---



|    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
|--- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(1) | The DCP I is an unfunded plan, as defined by
    the Internal Revenue Code of 1986, that provides for the
    deferral of compensation by our directors, employees, and
    consultants. Our directors, employees, or consultants are
    eligible to participate in the plan at such time and for such
    period as designated by the Board of Directors. The DCP I
    is administered through a trust by an independent third-party
    trustee, and we fund this plan through cash contributions.
    Directors may choose to defer directors fees through the
    DCP I, and may choose to invest such deferred income in
    shares of our common stock. To the extent a director elects to
    invest in our common stock, the trustee of the DCP I will be
    required to use such deferred directors fees to purchase
    shares of our common stock in the market.
|   
|(2) | We have established a long-term incentive
    compensation program whereby we will generally determine an
    individual performance award for certain officers annually at
    the beginning of each year. In conjunction with the program, we
    instituted the DCP II, which is an unfunded plan (as
    defined by the Internal Revenue Code of 1986) that is
    administered through a trust by an independent third-party
    trustee. The individual performance awards will be deposited in
    the trust in four equal installments, generally on a quarterly
    basis in the form of cash and the DCP II requires the
    trustee to use the cash exclusively to purchase shares of our
    common stock in the market.                                                                                                                                            

Item 3.  Defaults Upon
Senior Securities

Not applicable.

Item 4.  Submission of
Matters to a Vote of Security Holders

None.

Item 5.  Other
Information

Not applicable.

Item 6.  Exhibits

|        |     |             |  |                                                                                                                                                                                                                                                                           
|------- | --- | ----------- |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|Exhibit |     |            
|Number  |     | Description
|        |     |            
|        | 3.1 |             |  | Restated Articles of Incorporation.
    (Incorporated by reference to Exhibit a.1 filed with
    Allied Capitals Post-Effective Amendment No. 2 to
    registration statement on Form N-2 (File
    No. 333-67336) filed on March 22, 2002).                             
|        | 3.2 |             |  | Amended and Restated Bylaws. (Incorporated by
    reference to Exhibit 3.2. filed with Allied Capitals
    Form 10-K for the year ended December 31, 2003).                                                                                                              
|        | 4.1 |             |  | Specimen Certificate of Allied Capitals
    Common Stock, par value $0.0001 per share. (Incorporated by
    reference to Exhibit d. filed with Allied Capitals
    registration statement on Form N-2 (File
    No. 333-51899) filed on May 6, 1998).                   
|        | 4.2 |             |  | Form of debenture between certain subsidiaries of
    Allied Capital and the U.S. Small Business Administration.
    (Incorporated by reference to Exhibit 4.2 filed by a
    predecessor entity to Allied Capital on Form 10-K for the
    year ended December 31, 1996).

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|        |          |             |  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         
|------- | -------- | ----------- |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|Exhibit |          |            
|Number  |          | Description
|        |          |            
|        | 10.1     |             |  | Dividend Reinvestment Plan, as amended.
    (Incorporated by reference to Exhibit e. filed with
    Allied Capitals registration statement on Form N-2
    (File No. 333-87862) filed on May 8, 2002).                                                                                                                                                                                                                                                                                                                                                                                                                                                 
|        | 10.2     |             |  | Third Amended and Restated Credit Agreement,
    dated April 18, 2003. (Incorporated by reference to
    Exhibit 10.2 filed with Allied Capitals
    Form 10-Q for the period ended March 31, 2003).                                                                                                                                                                                                                                                                                                                                                                                                                                                   
|        | 10.2(a)  |             |  | First Amendment to Credit Agreement, dated as of
    October 6, 2003.(Incorporated by reference to
    Exhibit 10.2(a) filed with Allied Capitals
    Form 10-Q for the period ended September 30, 2003).                                                                                                                                                                                                                                                                                                                                                                                                                                              
|        | 10.2(b)  |             |  | Second Amendment to Credit Agreement, dated as of
    December 17, 2003. (Incorporated by reference to
    Exhibit 10.2(b) filed with Allied Capitals
    Form 10-K for the year ended December 31, 2003).                                                                                                                                                                                                                                                                                                                                                                                                                                             
|        | 10.2(c)  |             |  | Third Amendment to Credit Agreement, dated
    May 28, 2004. (Incorporated by reference to
    Exhibit 10.2(c) filed with Allied Capitals
    Form 10-Q for the period ended June 30, 2004).                                                                                                                                                                                                                                                                                                                                                                                                                                                           
|        | 10.3     |             |  | Note Agreement, dated as of April 30, 1998.
    (Incorporated by reference to Exhibit 10.2 filed with
    Allied Capitals Form 10-Q for the period ended
    June 30, 1998).                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
|        | 10.4     |             |  | Loan Agreement between a predecessor entity to
    Allied Capital and Overseas Private Investment Corporation,
    dated April 10, 1995. (Incorporated by reference to
    Exhibit f.7 filed by a predecessor entity to Allied Capital
    to Pre-Effective Amendment No. 2 to registration statement
    on Form N-2 (File No. 333-64629) filed on
    January 24, 1996). Letter, dated December 11,
    1997, evidencing assignment of Loan Agreement from the
    predecessor entity of Allied Capital to Allied Capital.
    (Incorporated by reference to Exhibit 10.3 to Allied
    Capitals Form 10-K for the year ended
    December 31, 1997).
|        | 10.5     |             |  | Note Agreement, dated as of May 1, 1999.
    (Incorporated by reference to Exhibit 10.5 filed with
    Allied Capital Form 10-Q for the period ended June 30,
    1999).                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|        | 10.11    |             |  | Note Agreement, dated as of November 15,
    1999. (Incorporated by reference to Exhibit 10.4a of
    Allied Capitals Form 10-K for the year ended
    December 31, 1999).                                                                                                                                                                                                                                                                                                                                                                                                                                                                             
|        | 10.12    |             |  | Note Agreement, dated as of October 15,
    2000. (Incorporated by reference to Exhibit 10.4b filed
    with Allied Capitals Form 10-Q for the period ended
    September 30, 2000).                                                                                                                                                                                                                                                                                                                                                                                                                                                                   
|        | 10.13    |             |  | Note Agreement, dated as of October 15,
    2001. (Incorporated by reference to Exhibit f.10 filed
    with Allied Capitals Post-Effective Amendment No. 1
    to registration statement on Form N-2 (File
    No. 333-67336) filed on November 14, 2001).                                                                                                                                                                                                                                                                                                                                                                                             
|        | 10.15    |             |  | Control Investor Guaranty Agreement, dated as of
    March 28, 2001, between Allied Capital and Fleet National
    Bank and Business Loan Express, Inc. (Incorporated by
    reference to Exhibit f.14 filed with Allied Capitals
    Post-Effective Amendment No. 3 to registration statement on
    Form N-2 (File No. 333-43534) filed on May 15,
    2001).                                                                                                                                                                                                                                                                                        
|        | 10.17    |             |  | Non-Qualified Deferred Compensation Plan II.
    (Incorporated by reference to Exhibit A filed with
    Allied Capitals Proxy Statement filed on March 30,
    2004).                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  
|        | 10.18    |             |  | Amended and Restated Deferred Compensation Plan,
    dated January 30, 2004. (Incorporated by reference to
    Exhibit 10.16 filed with Allied Capitals
    Form 10-K for the year ended December 31, 2003).                                                                                                                                                                                                                                                                                                                                                                                                                                           
|        | 10.19    |             |  | Amended Stock Option Plan. (Incorporated by
    reference to Exhibit B of Allied Capitals definitive
    proxy statement for Allied Capitals 2004 Annual
    Meeting of Stockholders filed on March 30, 2004).                                                                                                                                                                                                                                                                                                                                                                                                                                        
|        | 10.20(a) |             |  | Allied Capital Corporation 401(k) Plan, dated
    September 1, 1999. (Incorporated by reference to
    Exhibit 4.4 filed with Allied Capitals registration
    statement on Form S-8 (File No. 333-88681) filed on
    October 8, 1999).                                                                                                                                                                                                                                                                                                                                                                                                               

89



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##### 



|        |          |             |  |                                                                                                                                                                                                                                                                                                                            
|------- | -------- | ----------- |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|Exhibit |          |            
|Number  |          | Description
|        |          |            
|        | 10.20(b) |             |  | Amendment to Allied Capital Corporation 401(k)
    Plan, dated April 15, 2004. (Incorporated by reference
    to Exhibit 10.20(b) filed with Allied Capitals
    Form 10-Q for the period ended June 30, 2004).                                                                                                           
|        | 10.21    |             |  | Employment Agreement, dated January 1, 2004,
    between Allied Capital and William L. Walton. (Incorporated
    by reference to Exhibit 10.21 filed with Allied
    Capitals Form 10-K for the year ended
    December 31, 2003).                                                                                        
|        | 10.22    |             |  | Employment Agreement, dated January 1, 2004,
    between Allied Capital and Joan M. Sweeney. (Incorporated by
    reference to Exhibit 10.22 filed with Allied Capitals
    Form 10-K for the year ended December 31, 2003).                                                                                              
|        | 10.25    |             |  | Form of Custody Agreement with Riggs Bank N.A.
    (Incorporated by reference to Exhibit j.1 filed with
    Allied Capitals registration statement on Form N-2
    (File No. 333-51899) filed on May 6, 1998).                                                                                                            
|        | 10.26    |             |  | Form of Custody Agreement with LaSalle National
    Bank. (Incorporated by reference to Exhibit j.2 filed
    with Allied Capitals registration statement on
    Form N-2 (File No. 333-51899) filed on May 6,
    1998).                                                                                                 
|        | 10.27    |             |  | Custodian Agreement with LaSalle National Bank
    Association dated July 9, 2001. (Incorporated by
    reference to Exhibit j.3 filed with Allied Capitals
    registration statement on Form N-2 (File
    No. 333-67336) filed on August 10, 2001).                                                                    
|        | 10.28    |             |  | Code of Ethics. (Incorporated by reference to
    Exhibit 10.28 filed with Allied Capitals
    Form 10-K for the year ended December 31, 2003.)                                                                                                                                                                           
|        | 10.30    |             |  | Agreement and Plan of Merger by and among Allied
    Capital, Allied Capital Lock Acquisition Corporation, and
    Sunsource, Inc dated June 18, 2001. (Incorporated by
    reference to Exhibit k.1 filed with Allied Capitals
    registration statement on Form N-2 (File
    No. 333-67336) filed on August 10, 2001).
|        | 10.31    |             |  | Note Agreement, dated as of May 14, 2003.
    (Incorporated by reference to Exhibit 10.31 filed with
    Allied Capitals Form 10-Q for the period ended
    March 31, 2003).                                                                                                                                              
|        | 10.32    |             |  | Amendment, dated as of April 30, 2003, to
    Note Agreement, dated as of April 30, 1998.
    (Incorporated by reference to Exhibit 10.32 filed with
    Allied Capitals Form 10-Q for the period ended
    March 31, 2003).                                                                                              
|        | 10.33    |             |  | Amendment, dated as of April 30, 2003, to
    Note Agreement, dated as of May 1, 1999. (Incorporated
    by reference to Exhibit 10.33 filed with Allied
    Capitals Form 10-Q for the period ended
    March 31, 2003).                                                                                                 
|        | 10.34    |             |  | Amendment, dated as of April 30, 2003, to
    Note Agreement, dated as of November 15, 1999.
    (Incorporated by reference to Exhibit 10.34 filed with
    Allied Capitals Form 10-Q for the period ended
    March 31, 2003).                                                                                           
|        | 10.35    |             |  | Amendment, dated as of April 30, 2003, to
    Note Agreement, dated as of October 15, 2000.
    (Incorporated by reference to Exhibit 10.35 filed with
    Allied Capitals Form 10-Q for the period ended
    March 31, 2003).                                                                                            
|        | 10.36    |             |  | Amendment, dated as of April 30, 2003, to
    Note Agreement, dated as of October 15, 2001.
    (Incorporated by reference to Exhibit 10.36 filed with
    Allied Capitals Form 10-Q for the period ended
    March 31, 2003).                                                                                            
|        | 10.37    |             |  | Form of Indemnification Agreement between Allied
    Capital and its directors and certain officers. (Incorporated
    by reference to Exhibit 10.37 filed with Allied
    Capitals Form 10-K for the year ended
    December 31, 2003).                                                                                  
|        | 10.38    |             |  | Note Agreement, dated as of March 25, 2004.
    (Incorporated by reference to Exhibit 10.38 filed with
    Allied Capitals Form 10-Q for the period ended
    March 31, 2004.)                                                                                                                                            
|        | 15.*     |             |  | Letter regarding Unaudited Interim Financial
    Information                                                                                                                                                                                                                                                               
|        | 31.1*    |             |  | Certification of Chief Executive Officer Pursuant
    to Rule 13a-14 of the Securities Exchange Act of 1934.                                                                                                                                                                                                               

90



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##### 



|        |       |             |  |                                                                                                                                    
|------- | ----- | ----------- |  | -----------------------------------------------------------------------------------------------------------------------------------
|Exhibit |       |            
|Number  |       | Description
|        |       |            
|        | 31.2* |             |  | Certification of Chief Financial Officer Pursuant
    Rule 13a-14 of the Securities Exchange Act of 1934.                          
|        | 32.1* |             |  | Certification of Chief Executive Officer Pursuant
    to Section 906 of the Sarbanes-Oxley Act of 2002,
    18 U.S.C. Section 1350.
|        | 32.2* |             |  | Certification of Chief Financial Officer Pursuant
    to Section 906 of the Sarbanes-Oxley Act of 2002,
    18 U.S.C. Section 1350.




* Filed herewith.

91



---



##### 



SIGNATURES

Pursuant to the requirements of the Securities
Exchange Act of 1934, the Registrant has duly caused this report
to be signed on its behalf by the undersigned thereunder duly
authorized.

|                        |  |                                                                                                                                             
|----------------------- |  | --------------------------------------------------------------------------------------------------------------------------------------------
|                        |  | ALLIED CAPITAL CORPORATION                                                                                                                  
|                        |  | (Registrant)                                                                                                                                
|                       
|Dated: November 5, 2004 |  | /s/ WILLIAM L. WALTON
    ---------------------------------------------------
    William L. Walton
    Chairman and Chief Executive Officer
|                       
|                        |  | /s/ PENNI F. ROLL
    ---------------------------------------------------
    Penni F. Roll
    Chief Financial Officer                     

92



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##### 



EXHIBIT INDEX

|        |       |             |  |                                                                                                                                    
|------- | ----- | ----------- |  | -----------------------------------------------------------------------------------------------------------------------------------
|Exhibit |       |            
|Number  |       | Description
|        |       |            
|        | 15.*  |             |  | Letter regarding Unaudited Interim Financial
    Information                                                                       
|        | 31.1* |             |  | Certification of Chief Executive Officer Pursuant
    to Rule 13a-14 of the Securities Exchange Act of 1934.                       
|        | 31.2* |             |  | Certification of Chief Financial Officer Pursuant
    to Rule 13a-14 of the Securities Exchange Act of 1934.                       
|        | 32.1* |             |  | Certification of Chief Executive Officer Pursuant
    to Section 906 of the Sarbanes-Oxley Act of 2002,
    18 U.S.C. Section 1350.
|        | 32.2* |             |  | Certification of Chief Financial Officer Pursuant
    to Section 906 of the Sarbanes-Oxley Act of 2002,
    18 U.S.C. Section 1350.



---

* Filed herewith.