##### 









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 March 31, 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 May 6, 2004, there were 128,761,348 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 March 31,
    2004 (unaudited) and
    December 31, 2003                                |    | 1 
|                              |                                                                                                   | Consolidated Statement of Operations
    (unaudited)  For the Three Months Ended
    March 31, 2004 and 2003            |    | 2 
|                              |                                                                                                   | Consolidated Statement of Changes in Net Assets
    (unaudited)  For the Three Months Ended
    March 31, 2004 and 2003 |    | 3 
|                              |                                                                                                   | Consolidated Statement of Cash Flows
    (unaudited)  For the Three Months Ended
    March 31, 2004 and 2003            |    | 4 
|                              |                                                                                                   | Consolidated Statement of Investments as of
    March 31, 2004 (unaudited)                                               |    | 5 
|                              |                                                                                                   | Notes to Consolidated Financial Statements                                                                               |    | 16
|                              |                                                                                                   | Independent Accountants Review Report                                                                                   |    | 38
|                              | Item 2. Managements Discussion
    and Analysis of Financial Condition and Results of Operations |                                                                                                                          | 39
|                              | Item 3. Quantitative and Qualitative
    Disclosures About Market Risk                            |                                                                                                                          | 74
|                              | Item 4. Controls and Procedures                                                                   |                                                                                                                          | 74
|                             
|PART II. OTHER INFORMATION    |                                                                                                   |                                                                                                                         
|                              | Item 1. Legal Proceedings                                                                         |                                                                                                                          | 75
|                              | Item 2. Changes in Securities, Use of
    Proceeds and Issuer Purchases of Equity Securities      |                                                                                                                          | 75
|                              | Item 3. Defaults Upon Senior Securities                                                           |                                                                                                                          | 75
|                              | Item 4. Submission of Matters to a Vote
    of Security Holders                                   |                                                                                                                          | 75
|                              | Item 5. Other Information                                                                         |                                                                                                                          | 75
|                              | Item 6. Exhibits and Reports on
    Form 8-K                                                      |                                                                                                                          | 76
|                              | Signatures                                                                                        |                                                                                                                          | 79





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##### 



PART I: FINANCIAL INFORMATION

Item 1.  Financial
Statements

ALLIED CAPITAL CORPORATION AND
SUBSIDIARIES

CONSOLIDATED BALANCE SHEET

|                                                                    |                                                                                                                                                                                              |                                                                        |                                            |              |         |           |         |           |         |           | 
|------------------------------------------------------------------- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- | ---------------------------------------------------------------------- | ------------------------------------------ | ------------ | ------- | --------- | ------- | --------- | ------- | --------- | 
|                                                                    |                                                                                                                                                                                              | March 31,                                                              |                                            | 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-$680,131; 2003-$755,024) |                                            | $            | 655,324 |           |         | $         | 900,317 |          
|                                                                    |                                                                                                                                                                                              | Companies 5% to 25% owned (cost: 2004-$192,738;
    2003-$195,600)     |                                            |              | 209,781 |           |         |           | 218,305 |          
|                                                                    |                                                                                                                                                                                              | Companies less than 5% owned (cost:
    2004-$987,261; 2003-$955,507)  |                                            |              | 820,459 |           |         |           | 784,050 |          
|                                                                    |                                                                                                                                                                                              |                                                                        |                                            |              |         |           |         |          
|                                                                    |                                                                                                                                                                                              |                                                                        | Total private finance                      |              |         | 1,685,564 |         |           |         | 1,902,672 | 
|                                                                    | Commercial real estate finance (cost:
    2004-$724,167; 2003-$694,929)                                                                                                                      |                                                                        |                                            | 714,000      |         |           |         | 681,927   |        
|                                                                    |                                                                                                                                                                                              |                                                                        |                                            |              |         |           |         |          
|                                                                    |                                                                                                                                                                                              |                                                                        | Total portfolio at value                   |              |         | 2,399,564 |         |           |         | 2,584,599 | 
|                                                                    |                                                                                                                                                                                              |                                                                        |                                            |              |         |           |         |          
|Deposits of proceeds from sales of borrowed
    Treasury securities |                                                                                                                                                                                              |                                                                        | 111,738                                    |              |         |           | 98,527  |          
|Accrued interest and dividends receivable                           |                                                                                                                                                                                              |                                                                        | 58,831                                     |              |         |           | 53,079  |          
|Other assets                                                        |                                                                                                                                                                                              |                                                                        | 65,110                                     |              |         |           | 69,498  |          
|Cash and cash equivalents                                           |                                                                                                                                                                                              |                                                                        | 375,277                                    |              |         |           | 214,167 |          
|                                                                    |                                                                                                                                                                                              |                                                                        |                                            |              |         |           |         |          
|                                                                    |                                                                                                                                                                                              |                                                                        | Total assets                               |              | $       | 3,010,520 |         |           | $       | 3,019,870 | 
|                                                                    |                                                                                                                                                                                              |                                                                        |                                            |              |         |           |         |          
|LIABILITIES AND SHAREHOLDERS
    EQUITY                           
|Liabilities:                                                        |                                                                                                                                                                                              |                                                                        |                                            |              |         |           |         |          
|                                                                    | Notes payable and debentures (maturing within one
    year: 2004-$214,000; 2003-$221,000)                                                                                                    |                                                                        | $                                          | 962,420      |         |           | $       | 954,200   |        
|                                                                    | Revolving line of credit                                                                                                                                                                     |                                                                        |                                            |             |         |           |         |          |        
|                                                                    | Obligations to replenish borrowed Treasury
    securities                                                                                                                                    |                                                                        |                                            | 111,737      |         |           |         | 98,525    |        
|                                                                    | Accounts payable and other liabilities                                                                                                                                                       |                                                                        |                                            | 50,393       |         |           |         | 46,568    |        
|                                                                    |                                                                                                                                                                                              |                                                                        |                                            |              |         |           |         |          
|                                                                    |                                                                                                                                                                                              |                                                                        | Total liabilities                          |              |         | 1,124,550 |         |           |         | 1,099,293 | 
|                                                                    |                                                                                                                                                                                              |                                                                        |                                            |              |         |           |         |          
|Commitments and contingencies                                       |                                                                                                                                                                                              |                                                                        |                                            |              |         |           |         |          
|Preferred stock                                                     |                                                                                                                                                                                              |                                                                        | 6,000                                      |              |         |           | 6,000   |          
|Shareholders equity:                                               |                                                                                                                                                                                              |                                                                        |                                            |              |         |           |         |          
|                                                                    | Common stock, $0.0001 par value, 200,000,000
    shares authorized; 128,761,348 and 128,117,985 shares issued and
    outstanding at March 31, 2004, and December 31, 2003,
    respectively |                                                                        |                                            | 13           |         |           |         | 13        |        
|                                                                    | Additional paid-in capital                                                                                                                                                                   |                                                                        |                                            | 1,998,947    |         |           |         | 1,985,652 |        
|                                                                    | Notes receivable from sale of common stock                                                                                                                                                   |                                                                        |                                            | (13,440      | )       |           |         | (18,632   | )      
|                                                                    | Net unrealized appreciation (depreciation) on
    portfolio                                                                                                                                  |                                                                        |                                            | (211,142     | )       |           |         | (39,055   | )      
|                                                                    | Undistributed (distributions in excess of)
    earnings                                                                                                                                      |                                                                        |                                            | 105,592      |         |           |         | (13,401   | )      
|                                                                    |                                                                                                                                                                                              |                                                                        |                                            |              |         |           |         |          
|                                                                    |                                                                                                                                                                                              |                                                                        | Total shareholders equity                 |              |         | 1,879,970 |         |           |         | 1,914,577 | 
|                                                                    |                                                                                                                                                                                              |                                                                        |                                            |              |         |           |         |          
|                                                                    |                                                                                                                                                                                              |                                                                        | Total liabilities and shareholders equity |              | $       | 3,010,520 |         |           | $       | 3,019,870 | 
|                                                                    |                                                                                                                                                                                              |                                                                        |                                            |              |         |           |         |          
|Net asset value per common share                                    |                                                                                                                                                                                              | $                                                                      | 14.60                                      |              |         | $         | 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         
|                                                         |                                                           | Ended March 31,              
|                                                         |                                                           |                              
|                                                         |                                                           | 2004                          |                                             | 2003    
|(in thousands, except per share amounts)                 |                                                           |                               |                                             |         
|                                                         |                                                           |                              
|                                                         |                                                           | (unaudited)                  
|Interest and Related Portfolio Income:                   |                                                           |                               |                                             |          |         |         |         |        
|                                                         | Interest and dividends                                    |                               |                                             |          |         |         |         |         |       
|                                                         |                                                           | Companies more than 25% owned |                                             | $        | 15,952  |         |         | $       | 15,203 |        
|                                                         |                                                           | Companies 5% to 25% owned     |                                             |          | 5,986   |         |         |         | 6,493  |        
|                                                         |                                                           | Companies less than 5% owned  |                                             |          | 51,601  |         |         |         | 43,825 |        
|                                                         |                                                           |                               |                                             |          |         |         |         |        
|                                                         |                                                           |                               | Total interest and dividends                |          |         | 73,539  |         |         |        | 65,521  |  
|                                                         |                                                           |                               |                                             |          |         |         |         |        
|                                                         | Loan prepayment premiums                                  |                               |                                             |          |         |         |         |         |       
|                                                         |                                                           | Companies more than 25% owned |                                             |          |        |         |         |         | 108    |        
|                                                         |                                                           | Companies 5% to 25% owned     |                                             |          |        |         |         |         | 485    |        
|                                                         |                                                           | Companies less than 5% owned  |                                             |          | 950     |         |         |         | 528    |        
|                                                         |                                                           |                               |                                             |          |         |         |         |        
|                                                         |                                                           |                               | Total loan prepayment premiums              |          |         | 950     |         |         |        | 1,121   |  
|                                                         |                                                           |                               |                                             |          |         |         |         |        
|                                                         | Fees and other income                                     |                               |                                             |          |         |         |         |         |       
|                                                         |                                                           | Companies more than 25% owned |                                             |          | 4,489   |         |         |         | 5,709  |        
|                                                         |                                                           | Companies 5% to 25% owned     |                                             |          | 347     |         |         |         | 53     |        
|                                                         |                                                           | Companies less than 5% owned  |                                             |          | 2,440   |         |         |         | 726    |        
|                                                         |                                                           |                               |                                             |          |         |         |         |        
|                                                         |                                                           |                               | Total fees and other income                 |          |         | 7,276   |         |         |        | 6,488   |  
|                                                         |                                                           |                               |                                             |          |         |         |         |        
|                                                         |                                                           |                               | Total interest and related portfolio income |          |         | 81,765  |         |         |        | 73,130  |  
|                                                         |                                                           |                               |                                             |          |         |         |         |        
|Expenses:                                                |                                                           |                               |                                             |          |         |         |         |        
|                                                         | Interest                                                  |                               |                                             | 19,113   |         |         |         | 17,922  |       
|                                                         | Employee                                                  |                               |                                             | 8,862    |         |         |         | 8,121   |       
|                                                         | Individual performance award                              |                               |                                             | 3,493    |         |         |         |        |       
|                                                         | Administrative                                            |                               |                                             | 5,827    |         |         |         | 4,417   |       
|                                                         |                                                           |                               |                                             |          |         |         |         |        
|                                                         |                                                           |                               | Total operating expenses                    |          |         | 37,295  |         |         |        | 30,460  |  
|                                                         |                                                           |                               |                                             |          |         |         |         |        
|Net investment income before income taxes                |                                                           |                               | 44,470                                      |          |         |         | 42,670  |        
|Income tax expense (benefit)                             |                                                           |                               | (75                                         | )        |         |         |        |        
|                                                         |                                                           |                               |                                             |          |         |         |         |        
|Net investment income                                    |                                                           |                               | 44,545                                      |          |         |         | 42,670  |        
|                                                         |                                                           |                               |                                             |          |         |         |         |        
|Net Realized and Unrealized Gains (Losses):              |                                                           |                               |                                             |          |         |         |         |        
|                                                         | Net realized gains (losses)                               |                               |                                             |          |         |         |         |         |       
|                                                         |                                                           | Companies more than 25% owned |                                             |          | 146,683 |         |         |         |       |        
|                                                         |                                                           | Companies 5% to 25% owned     |                                             |          | 4,628   |         |         |         | 16,688 |        
|                                                         |                                                           | Companies less than 5% owned  |                                             |          | (3,461  | )       |         |         | 31,651 |        
|                                                         |                                                           |                               |                                             |          |         |         |         |        
|                                                         |                                                           |                               | Total net realized gains (losses)           |          |         | 147,850 |         |         |        | 48,339  |  
|                                                         | Net change in unrealized appreciation or
    depreciation |                               |                                             | (172,087 | )       |         |         | (71,136 | )     
|                                                         |                                                           |                               |                                             |          |         |         |         |        
|                                                         |                                                           |                               | Total net gains (losses)                    |          |         | (24,237 | )       |         |        | (22,797 | )
|                                                         |                                                           |                               |                                             |          |         |         |         |        
|Net increase in net assets resulting from
    operations |                                                           | $                             | 20,308                                      |          |         | $       | 19,873  |        
|                                                         |                                                           |                               |                                             |          |         |         |         |        
|Basic earnings per common share                          |                                                           | $                             | 0.16                                        |          |         | $       | 0.18    |        
|                                                         |                                                           |                               |                                             |          |         |         |         |        
|Diluted earnings per common share                        |                                                           | $                             | 0.15                                        |          |         | $       | 0.18    |        
|                                                         |                                                           |                               |                                             |          |         |         |         |        
|Weighted average common shares
    outstanding  basic   |                                                           |                               | 128,314                                     |          |         |         | 109,458 |        
|                                                         |                                                           |                               |                                             |          |         |         |         |        
|Weighted average common shares
    outstanding  diluted |                                                           |                               | 131,968                                     |          |         |         | 110,098 |        
|                                                         |                                                           |                               |                                             |          |         |         |         |        

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 Three Months                                                    
|                                           |                                                                 | Ended March 31,                                                         
|                                           |                                                                 |                                                                         
|                                           |                                                                 | 2004                                                                     |           | 2003    
|(in thousands, except per share amounts)   |                                                                 |                                                                          |           |         
|                                           |                                                                 |                                                                         
|                                           |                                                                 | (unaudited)                                                             
|Operations:                                |                                                                 |                                                                          |           |          |         |   |           |        
|                                           | Net investment income                                           |                                                                          | $         | 44,545   |         |   | $         | 42,670  |        
|                                           | Net realized gains                                              |                                                                          |           | 147,850  |         |   |           | 48,339  |        
|                                           | Net change in unrealized appreciation or
    depreciation       |                                                                          |           | (172,087 | )       |   |           | (71,136 | )      
|                                           |                                                                 |                                                                          |           |          |         |   |           |        
|                                           |                                                                 | Net increase in net assets resulting from
    operations                 |           |          | 20,308  |   |           |         | 19,873  |  
|                                           |                                                                 |                                                                          |           |          |         |   |           |        
|Shareholder distributions:                 |                                                                 |                                                                          |           |          |         |   |           |        
|                                           | Common stock dividends                                          |                                                                          |           | (73,357  | )       |   |           | (62,972 | )      
|                                           | Preferred stock dividends                                       |                                                                          |           | (45      | )       |   |           | (55     | )      
|                                           |                                                                 |                                                                          |           |          |         |   |           |        
|                                           |                                                                 | Net decrease in net assets resulting from
    shareholder distributions  |           |          | (73,402 | ) |           |         | (63,027 | )
|                                           |                                                                 |                                                                          |           |          |         |   |           |        
|Capital share transactions:                |                                                                 |                                                                          |           |          |         |   |           |        
|                                           | Sale of common stock                                            |                                                                          |           |         |         |   |           | 82,362  |        
|                                           | Issuance of common stock upon the exercise of
    stock options |                                                                          |           | 11,782   |         |   |           | 510     |        
|                                           | Issuance of common stock in lieu of cash
    distributions      |                                                                          |           | 1,484    |         |   |           | 1,690   |        
|                                           | Net decrease in notes receivable from sale of
    common stock  |                                                                          |           | 5,192    |         |   |           | 814     |        
|                                           | Other                                                           |                                                                          |           | 29       |         |   |           |        |        
|                                           |                                                                 |                                                                          |           |          |         |   |           |        
|                                           |                                                                 | Net increase in net assets resulting from capital
    share transactions |           |          | 18,487  |   |           |         | 85,376  |  
|                                           |                                                                 |                                                                          |           |          |         |   |           |        
|                                           |                                                                 | Total increase (decrease) in net assets                                  |           |          | (34,607 | ) |           |         | 42,222  |  
|Net assets at beginning of period          |                                                                 |                                                                          | 1,914,577 |          |         |   | 1,546,071 |        
|                                           |                                                                 |                                                                          |           |          |         |   |           |        
|Net assets at end of period                |                                                                 | $                                                                        | 1,879,970 |          |         | $ | 1,588,293 |        
|                                           |                                                                 |                                                                          |           |          |         |   |           |        
|Net asset value per common share           |                                                                 | $                                                                        | 14.60     |          |         | $ | 14.05     |        
|                                           |                                                                 |                                                                          |           |          |         |   |           |        
|Common shares outstanding at end of period |                                                                 |                                                                          | 128,761   |          |         |   | 113,056   |        
|                                           |                                                                 |                                                                          |           |          |         |   |           |        

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

3



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##### 



ALLIED CAPITAL CORPORATION AND
SUBSIDIARIES

CONSOLIDATED STATEMENT OF CASH FLOWS

|                                                         |                                                               |                                                                     |                                                         |         |          |         |        |          |          |          |  
|-------------------------------------------------------- | ------------------------------------------------------------- | ------------------------------------------------------------------- | ------------------------------------------------------- | ------- | -------- | ------- | ------ | -------- | -------- | -------- | -
|                                                         |                                                               |                                                                    
|                                                         |                                                               | For the Three Months                                               
|                                                         |                                                               | Ended March 31,                                                    
|                                                         |                                                               |                                                                    
|                                                         |                                                               | 2004                                                                |                                                         | 2003   
|(in thousands)                                           |                                                               |                                                                     |                                                         |        
|                                                         |                                                               |                                                                    
|                                                         |                                                               | (unaudited)                                                        
|Cash flows from operating activities:                    |                                                               |                                                                     |                                                         |         |          |         |        |         
|                                                         | Net increase in net assets resulting from
    operations      |                                                                     | $                                                       | 20,308  |          |         | $      | 19,873   |         
|                                                         | Adjustments                                                   |                                                                     |                                                         |         |          |         |        |          |         
|                                                         |                                                               | Portfolio investments                                               |                                                         |         | (170,252 | )       |        |          | (269,007 | )       
|                                                         |                                                               | Principal collections related to investment
    repayments or sales |                                                         |         | 237,140  |         |        |          | 320,071  |         
|                                                         |                                                               | Change in accrued or reinvested interest and
    dividends          |                                                         |         | (13,098  | )       |        |          | (11,087  | )       
|                                                         |                                                               | Amortization of discounts and fees                                  |                                                         |         | (1,873   | )       |        |          | (3,631   | )       
|                                                         |                                                               | Changes in other assets and liabilities                             |                                                         |         | 3,352    |         |        |          | (3,755   | )       
|                                                         |                                                               | Depreciation and amortization                                       |                                                         |         | 409      |         |        |          | 412      |         
|                                                         |                                                               | Notes received as consideration from sale of
    investments        |                                                         |         | (48,318  | )       |        |          | (3,876   | )       
|                                                         |                                                               | Realized losses                                                     |                                                         |         | 8,152    |         |        |          | 212      |         
|                                                         |                                                               | Net change in unrealized appreciation or
    depreciation           |                                                         |         | 172,087  |         |        |          | 71,136   |         
|                                                         |                                                               |                                                                     |                                                         |         |          |         |        |         
|                                                         |                                                               |                                                                     | Net cash provided by (used in) operating
    activities |         |          | 207,907 |        |          |          | 120,348  |  
|                                                         |                                                               |                                                                     |                                                         |         |          |         |        |         
|Cash flows from financing activities:                    |                                                               |                                                                     |                                                         |         |          |         |        |         
|                                                         | Sale of common stock                                          |                                                                     |                                                         |        |          |         |        | 82,362   |         
|                                                         | Sale of common stock upon the exercise of stock
    options   |                                                                     |                                                         | 11,782  |          |         |        | 510      |         
|                                                         | Collections of notes receivable from sale of
    common stock |                                                                     |                                                         | 5,192   |          |         |        | 814      |         
|                                                         | Borrowings under notes payable and debentures                 |                                                                     |                                                         | 15,212  |          |         |        |         |         
|                                                         | Repayments on notes payable and debentures                    |                                                                     |                                                         | (7,000  | )        |         |        |         |         
|                                                         | Net repayments on revolving line of credit                    |                                                                     |                                                         |        |          |         |        | (142,500 | )       
|                                                         | Other financing activities                                    |                                                                     |                                                         | (110    | )        |         |        | (97      | )       
|                                                         | Common stock dividends and distributions paid                 |                                                                     |                                                         | (71,873 | )        |         |        | (64,464  | )       
|                                                         | Preferred stock dividends paid                                |                                                                     |                                                         |        |          |         |        | (55      | )       
|                                                         |                                                               |                                                                     |                                                         |         |          |         |        |         
|                                                         |                                                               |                                                                     | Net cash provided by (used in) financing
    activities |         |          | (46,797 | )      |          |          | (123,430 | )
|                                                         |                                                               |                                                                     |                                                         |         |          |         |        |         
|Net increase (decrease) in cash and cash
    equivalents |                                                               |                                                                     | 161,110                                                 |         |          |         | (3,082 | )       
|Cash and cash equivalents at beginning of period         |                                                               |                                                                     | 214,167                                                 |         |          |         | 11,186 |         
|                                                         |                                                               |                                                                     |                                                         |         |          |         |        |         
|Cash and cash equivalents at end of period               |                                                               | $                                                                   | 375,277                                                 |         |          | $       | 8,104  |         
|                                                         |                                                               |                                                                     |                                                         |         |          |         |        |         

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

4



---



##### 



ALLIED CAPITAL CORPORATION AND
SUBSIDIARIES

CONSOLIDATED STATEMENT OF
INVESTMENTS

|                                        |                       |                                                       |                                 |                |         |        |  |   |         |        | 
|--------------------------------------- | --------------------- | ----------------------------------------------------- | ------------------------------- | -------------- | ------- | ------ |  | - | ------- | ------ | 
|                                        |                       |                                                       |                                 |               
|                                        |                       |                                                       |                                 | March 31, 2004
|                                        |                       |                                                       |                                 |               
|Private Finance                         |                       |                                                       |                                 |               
|Portfolio Company                       |                       |                                                       |                                 | (unaudited)   
|(in thousands, except number of shares) |                       | Investment(1)                                         |                                 | Cost           |         | Value 
|                                        |                       |                                                       |                                 |                |         |       
|Companies More Than 25% Owned           |                       |                                                       |                                 |                |         |        |  |  
|                                       
|ACE Products, Inc.                      |                       | Loan                                                  |                                 | $              | 17,164  |        |  | $ | 50      |       
|                                        | (Industrial Products) |                                                       | Common Stock (5,000 shares)     |                |         |       |  |   |         |       | 
|                                       
|Acme Paging, L.P.(3)                    |                       | Loan                                                  |                                 |                | 4,578   |        |  |   | 4,578   |       
|                                        | (Telecommunications)  |                                                       | Equity Interests                |                |         | 13,274 |  |   |         | 2,427  | 
|                                        |                       | Common Stock (4,057 shares)                           |                                 |                | 27      |        |  |   |        |       
|                                       
|Alaris Consulting, LLC                  |                       | Loan                                                  |                                 |                | 19,937  |        |  |   | 4,817   |       
|                                        | (Business Services)   |                                                       | Equity Interests                |                |         | 5,165  |  |   |         |       | 
|                                        |                       | Guaranty ($1,100)                                     |                                 |                |         |        |  |   |         |       
|                                       
|American Healthcare Services, Inc.      |                       | Loan                                                  |                                 |                | 26,201  |        |  |   | 19,300  |       
|                                        | (Healthcare Services) |                                                       | Debt Securities                 |                |         | 17,311 |  |   |         |       | 
|                                        |                       | Common Stock (7,956,704 shares)                       |                                 |                | 1,000   |        |  |   |        |       
|                                        |                       | Guaranty ($1,193)                                     |                                 |                |         |        |  |   |         |       
|                                       
|Avborne, Inc.                           |                       | Loan                                                  |                                 |                | 1,269   |        |  |   | 1,269   |       
|                                        | (Business Services)   |                                                       | Preferred Stock (12,500 shares) |                |         | 14,138 |  |   |         | 1,980  | 
|                                        |                       | Common Stock (27,500 shares)                          |                                 |                |        |        |  |   |        |       
|                                        |                       | Standby Letter of Credit ($6,978)                     |                                 |                |         |        |  |   |         |       
|                                       
|Business Loan Express, LLC              |                       | Debt Securities                                       |                                 |                | 41,141  |        |  |   | 41,141  |       
|                                        | (Financial Services)  |                                                       | Class A Equity Interests        |                |         | 49,248 |  |   |         | 49,248 | 
|                                        |                       | Class B Equity Interests                              |                                 |                | 59,911  |        |  |   | 96,940  |       
|                                        |                       | Class C Equity Interests                              |                                 |                | 109,340 |        |  |   | 150,069 |       
|                                        |                       | Guaranty ($74,609  See Note 3)                       |                                 |                |         |        |  |   |         |       
|                                        |                       | Standby Letters of Credit
    ($35,550   See Note 3) |                                 |                |         |        |  |   |         |       
|                                       
|Callidus Capital Corporation            |                       | Loan                                                  |                                 |                | 275     |        |  |   | 275     |       
|                                        | (Financial Services)  |                                                       | Debt Securities                 |                |         | 3,500  |  |   |         | 3,500  | 
|                                        |                       | Common Stock (10 shares)                              |                                 |                | 1,768   |        |  |   | 1,768   |       
|                                       
|Chickasaw Sales & Marketing, Inc.       |                       | Preferred Stock (1,000,000 shares)                    |                                 |                | 1,000   |        |  |   | 956     |       
|                                        | (Consumer Services)   |                                                       | Common Stock (37,000 shares)    |                |         | 2,812  |  |   |         |       | 
|                                       
|The Color Factory, Inc.                 |                       | Loan                                                  |                                 |                | 16,189  |        |  |   | 2,525   |       
|                                        | (Consumer Products)   |                                                       | Preferred Stock (1,000 shares)  |                |         | 1,002  |  |   |         |       | 
|                                        |                       | Common Stock (980 shares)                             |                                 |                | 6,535   |        |  |   |        |       
|                                        |                       | Guaranty ($283)                                       |                                 |                |         |        |  |   |         |       
|                                       
|Foresite Towers, LLC                    |                       | Equity Interests                                      |                                 |                | 18,579  |        |  |   | 18,685  |       
|                                        | (Tower Leasing)       |                                                       |                                 |                |         |        |  |   |         |        | 
|                                       
|Global Communications, LLC              |                       | Loan                                                  |                                 |                | 2,755   |        |  |   | 2,755   |       
|                                        | (Business Services)   |                                                       | Debt Securities                 |                |         | 17,541 |  |   |         | 17,541 | 
|                                        |                       | Preferred Equity Interest                             |                                 |                | 14,067  |        |  |   | 18,705  |       
|                                        |                       | Options                                               |                                 |                | 1,639   |        |  |   | 1,300   |       
|                                       

|                                                                                                                                     |  |  |  |  |  |  |  |  |  | 
|------------------------------------------------------------------------------------------------------------------------------------ |  |  |  |  |  |  |  |  |  | 
|(1)Common
    stock, preferred stock, warrants, options, and equity interests
    are generally non-income producing and restricted.
|(2)Public
    company.                                                                                                              
|(3)Non-U.S. company
    or principal place of business outside the U.S.                                                             
|(4)Non-registered
    investment company.                                                                                           



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


5



---



##### 



|                                        |                       |                                    |                                    |                |        |        |         |   |        |        | 
|--------------------------------------- | --------------------- | ---------------------------------- | ---------------------------------- | -------------- | ------ | ------ | ------- | - | ------ | ------ | 
|                                        |                       |                                    |                                    |               
|                                        |                       |                                    |                                    | March 31, 2004
|                                        |                       |                                    |                                    |               
|Private Finance                         |                       |                                    |                                    |               
|Portfolio Company                       |                       |                                    |                                    | (unaudited)   
|(in thousands, except number of shares) |                       | Investment(1)                      |                                    | Cost           |        | Value 
|                                        |                       |                                    |                                    |                |        |       
|Gordian Group, Inc.                     |                       | Loan                               |                                    | $              | 11,796 |        |         | $ | 11,796 |       
|                                        | (Business Services)   |                                    | Common Stock (1,000 shares)        |                |        | 2,885  |         |   |        | 3,800  | 
|                                       
|HealthASPex, Inc.                       |                       | Preferred Stock (1,000,000 shares) |                                    |                | 700    |        |         |   | 700    |       
|                                        | (Business Services)   |                                    | Preferred Stock (1,451,380 shares) |                |        | 4,900  |         |   |        | 2,040  | 
|                                        |                       | Common Stock (1,451,380 shares)    |                                    |                | 4      |        |         |   |       |       
|                                       
|HMT, Inc.                               |                       | Debt Securities                    |                                    |                | 9,216  |        |         |   | 9,216  |       
|                                        | (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                               |                                    |                | 15,333 |        |         |   | 15,333 |       
|                                        | (Healthcare Services) |                                    | Preferred Stock (3,890,344 shares) |                |        | 3,889  |         |   |        | 3,889  | 
|                                        |                       | Common Stock (864,000 shares)      |                                    |                | 86     |        |         |   | 25,000 |       
|                                       
|Jakel, Inc.                             |                       | Loan                               |                                    |                | 3,427  |        |         |   | 3,427  |       
|                                        | (Industrial Products) |                                    | Debt Securities                    |                |        | 7,927  |         |   |        | 7,927  | 
|                                        |                       |                                    | Preferred Stock (6,460 shares)     |                |        | 6,460  |         |   |        | 3,817  | 
|                                        |                       |                                    | Common Stock (158,061 shares)      |                |        | 9,347  |         |   |        |       | 
|                                        |                       |                                    | Standby Letter of Credit ($1,608)  |                |        |        |         |   |        |        | 
|                                       
|Litterer Beteiligungs-GmbH(3)           |                       | Debt Securities                    |                                    |                | 1,386  |        |         |   | 1,338  |       
|                                        | (Business Services)   |                                    | Equity Interest                    |                |        | 835    |         |   |        |       | 
|                                       
|MVL Group, Inc.                         |                       | Loan                               |                                    |                | 18,913 |        |         |   | 18,913 |       
|                                        | (Business Services)   |                                    | Debt Securities                    |                |        | 17,141 |         |   |        | 17,141 | 
|                                        |                       | Common Stock (648,661 shares)      |                                    |                | 643    |        |         |   | 709    |       
|                                       
|Powell Plant Farms, Inc.                |                       | Loan                               |                                    |                | 28,967 |        |         |   | 28,967 |       
|                                        | (Consumer Products)   |                                    | Debt Securities                    |                |        | 19,224 |         |   |        | 11,067 | 
|                                        |                       | Preferred Stock (1,483 shares)     |                                    |                |       |        |         |   |       |       
|                                        |                       | Warrants                           |                                    |                |       |        |         |   |       |       
|                                       
|Redox Brands, Inc.                      |                       | Loan                               |                                    |                | 3,176  |        |         |   | 3,176  |       
|                                        | (Consumer Products)   |                                    | Debt Securities                    |                |        | 10,348 |         |   |        | 10,348 | 
|                                        |                       | Preferred Stock (2,726,444 shares) |                                    |                | 7,903  |        |         |   | 7,903  |       
|                                        |                       | Warrants                           |                                    |                | 584    |        |         |   | 584    |       
|                                        |                       | Guaranty ($125)                    |                                    |                |        |        |         |   |        |       
|                                       
|Staffing Partners Holding               |                       | Debt Securities                    |                                    |                | 6,009  |        |         |   | 6,009  |       
|                                        | Company, Inc.         |                                    | Preferred Stock (414,600 shares)   |                |        | 4,968  |         |   |        | 2,983  | 
|                                        | (Business Services)   |                                    | Common Stock (50,200 shares)       |                |        | 50     |         |   |        |       | 
|                                        |                       | Warrants                           |                                    |                | 10     |        |         |   |       |       
|                                       
|STS Operating, Inc.                     |                       | Preferred Stock (5,769,424 shares) |                                    |                | 6,818  |        |         |   | 6,818  |       
|                                        | (Industrial Products) |                                    | Common Stock (3,000,000 shares)    |                |        | 3,177  |         |   |        | 3,700  | 
|                                        |                       |                                    | Options                            |                |        |       |         |   |        |       | 
|                                       
|Total
    companies more than 25% owned |                       | $                                  | 680,131                            |                |        | $      | 655,324 |  
|                                       

|                                                                                                                                     |  |  |  |  |  |  |  |  |  | 
|------------------------------------------------------------------------------------------------------------------------------------ |  |  |  |  |  |  |  |  |  | 
|(1)Common
    stock, preferred stock, warrants, options, and equity interests
    are generally non-income producing and restricted.
|(2)Public
    company.                                                                                                              
|(3)Non-U.S. company
    or principal place of business outside the U.S.                                                             
|(4)Non-registered
    investment company.                                                                                           



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


6



---



##### 



|                                        |                       |                                    |                                 |                |        |        |  |   |        |        | 
|--------------------------------------- | --------------------- | ---------------------------------- | ------------------------------- | -------------- | ------ | ------ |  | - | ------ | ------ | 
|                                        |                       |                                    |                                 |               
|                                        |                       |                                    |                                 | March 31, 2004
|                                        |                       |                                    |                                 |               
|Private Finance                         |                       |                                    |                                 |               
|Portfolio Company                       |                       |                                    |                                 | (unaudited)   
|(in thousands, except number of shares) |                       | Investment(1)                      |                                 | Cost           |        | Value 
|                                        |                       |                                    |                                 |                |        |       
|Companies 5% to 25% Owned              
|                                       
|Aspen Pet Products, Inc.                |                       | Loans                              |                                 | $              | 17,948 |        |  | $ | 17,948 |       
|                                        | (Consumer Products)   |                                    | Preferred Stock (2,333 shares)  |                |        | 2,154  |  |   |        | 909    | 
|                                        |                       | Common Stock (1,400 shares)        |                                 |                | 140    |        |  |   |       |       
|                                        |                       | Warrants                           |                                 |                |       |        |  |   |       |       
|                                       
|Border Foods, Inc.                      |                       | Loan                               |                                 |                | 3,000  |        |  |   | 3,000  |       
|                                        | (Consumer Products)   |                                    | Debt Securities                 |                |        | 9,467  |  |   |        | 9,467  | 
|                                        |                       | Preferred Stock (50,919 shares)    |                                 |                | 2,000  |        |  |   | 2,000  |       
|                                        |                       | Common Stock (1,810 shares)        |                                 |                | 45     |        |  |   | 71     |       
|                                        |                       | Warrants                           |                                 |                | 665    |        |  |   | 1,059  |       
|                                       
|CorrFlex Graphics, LLC                  |                       | Debt Securities                    |                                 |                | 11,957 |        |  |   | 11,957 |       
|                                        | (Business Services)   |                                    | Warrants                        |                |        |       |  |   |        | 19,332 | 
|                                        |                       | Options                            |                                 |                |       |        |  |   | 1,669  |       
|                                       
|The Debt Exchange Inc.                  |                       | Preferred Stock (921,875 shares)   |                                 |                | 1,250  |        |  |   | 1,373  |       
|                                        | (Business Services)   |                                    |                                 |                |        |        |  |   |        |        | 
|                                       
|EDM Consulting, LLC                     |                       | Debt Securities                    |                                 |                | 1,802  |        |  |   | 196    |       
|                                        | (Business Services)   |                                    | Equity Interests                |                |        | 250    |  |   |        |       | 
|                                       
|International Fiber Corporation         |                       | Debt Securities                    |                                 |                | 22,885 |        |  |   | 22,885 |       
|                                        | (Industrial Products) |                                    | Common Stock (1,029,069 shares) |                |        | 5,483  |  |   |        | 6,816  | 
|                                        |                       | Warrants                           |                                 |                | 550    |        |  |   | 684    |       
|                                       
|Liberty-Pittsburgh Systems, Inc.        |                       | Debt Securities                    |                                 |                | 3,384  |        |  |   | 1,304  |       
|                                        | (Business Services)   |                                    | Common Stock (123,929 shares)   |                |        | 142    |  |   |        |       | 
|                                       
|MasterPlan, Inc.                        |                       | Loan                               |                                 |                | 959    |        |  |   | 959    |       
|                                        | (Business Services)   |                                    | Common Stock (1,350 shares)     |                |        | 42     |  |   |        | 200    | 
|                                       
|MortgageRamp, Inc.                      |                       | Common Stock (772,000 shares)      |                                 |                | 3,860  |        |  |   | 2,084  |       
|                                        | (Business Services)   |                                    |                                 |                |        |        |  |   |        |        | 
|                                       
|Nexcel Synthetics, LLC                  |                       | Loan                               |                                 |                | 9,952  |        |  |   | 9,952  |       
|                                        | (Consumer Products)   |                                    | Equity Interests                |                |        | 1,690  |  |   |        | 1,690  | 
|                                       
|Nobel Learning Communities,             |                       | Preferred Stock (1,214,356 shares) |                                 |                | 2,764  |        |  |   | 2,764  |       
|                                        | Inc.(2)               |                                    | Warrants                        |                |        | 575    |  |   |        |       | 
|                                        | (Education)           |                                    |                                 |                |        |        |  |   |        |        | 
|                                       
|Packaging Advantage Corporation         |                       | Debt Securities                    |                                 |                | 14,350 |        |  |   | 13,563 |       
|                                        | (Business Services)   |                                    | Common Stock (232,168 shares)   |                |        | 2,386  |  |   |        |       | 
|                                        |                       | Warrants                           |                                 |                | 963    |        |  |   |       |       
|                                       
|Professional Paint, Inc.                |                       | Loan                               |                                 |                | 5,133  |        |  |   | 5,133  |       
|                                        | (Consumer Products)   |                                    | Debt Securities                 |                |        | 25,025 |  |   |        | 25,025 | 
|                                        |                       | Preferred Stock (15,000 shares)    |                                 |                | 23,596 |        |  |   | 23,596 |       
|                                        |                       | Common Stock (110,000 shares)      |                                 |                | 69     |        |  |   | 5,100  |       
|                                       

|                                                                                                                                     |  |  |  |  |  |  |  |  |  | 
|------------------------------------------------------------------------------------------------------------------------------------ |  |  |  |  |  |  |  |  |  | 
|(1)Common
    stock, preferred stock, warrants, options, and equity interests
    are generally non-income producing and restricted.
|(2)Public
    company.                                                                                                              
|(3)Non-U.S. company
    or principal place of business outside the U.S.                                                             
|(4)Non-registered
    investment company.                                                                                           



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


7



---



##### 



|                                               |                       |                               |                              |                |        |        |         |   |        |        | 
|---------------------------------------------- | --------------------- | ----------------------------- | ---------------------------- | -------------- | ------ | ------ | ------- | - | ------ | ------ | 
|                                               |                       |                               |                              |               
|                                               |                       |                               |                              | March 31, 2004
|                                               |                       |                               |                              |               
|Private Finance                                |                       |                               |                              |               
|Portfolio Company                              |                       |                               |                              | (unaudited)   
|(in thousands, except number of shares)        |                       | Investment(1)                 |                              | Cost           |        | Value 
|                                               |                       |                               |                              |                |        |       
|Progressive International                      |                       | Debt Securities               |                              | $              | 3,980  |        |         | $ | 3,980  |       
|                                               | Corporation           |                               | Preferred Stock (500 shares) |                |        | 500    |         |   |        | 717    | 
|                                               | (Consumer Products)   |                               | Common Stock (197 shares)    |                |        | 13     |         |   |        | 668    | 
|                                               |                       | Warrants                      |                              |                |       |        |         |   |       |       
|                                              
|Total Foam, Inc.                               |                       | Debt Securities               |                              |                | 159    |        |         |   | 90     |       
|                                               | (Industrial Products) |                               | Common Stock (164 shares)    |                |        | 10     |         |   |        |       | 
|                                              
|Universal Environmental Services,              |                       | Loan                          |                              |                | 12,090 |        |         |   | 12,090 |       
|                                               | LLC                   |                               | Equity Interests             |                |        | 1,500  |         |   |        | 1,500  | 
|                                               | (Business Services)   |                               |                              |                |        |        |         |   |        |        | 
|                                              
|Total
    companies 5% to 25% owned            |                       | $                             | 192,738                      |                |        | $      | 209,781 |  
|                                              
|                                               |                       |                               |                              |                |        |        |         |   |        |       
|Companies Less Than 5% Owned                  
|                                              
|Advantage Mayer, Inc.(5)                       |                       | Loan                          |                              | $              | 20,625 |        |         | $ | 20,625 |       
|                                               | (Business Services)   |                               | Debt Securities              |                |        | 10,662 |         |   |        | 10,662 | 
|                                              
|Alderwoods Group, Inc. (2)                     |                       | Common Stock (357,568 shares) |                              |                | 5,006  |        |         |   | 3,712  |       
|                                               | (Consumer Services)   |                               |                              |                |        |        |         |   |        |        | 
|                                              
|American Barbecue & Grill, Inc.                |                       | Warrants                      |                              |                | 125    |        |         |   |       |       
|                                               | (Retail)              |                               |                              |                |        |        |         |   |        |        | 
|                                              
|Advantage Sales and Marketing, LLC(5)          |                       | Loan                          |                              |                | 5,600  |        |         |   | 5,600  |       
|                                               | (Business Services)   |                               |                              |                |        |        |         |   |        |        | 
|                                              
|Aviation Technologies, Inc.                    |                       | Loan                          |                              |                | 20,419 |        |         |   | 20,419 |       
|                                               | (Industrial Products) |                               |                              |                |        |        |         |   |        |        | 
|                                              
|Benchmark Medical, Inc.                        |                       | Debt Securities               |                              |                | 13,541 |        |         |   | 13,541 |       
|                                               | (Healthcare Services) |                               | Warrants                     |                |        | 18     |         |   |        | 18     | 
|                                              
|Camden Partners Strategic Fund II,
    L.P.(4) |                       | Limited Partnership Interest  |                              |                | 3,123  |        |         |   | 3,275  |       
|                                               | (Private Equity Fund) |                               |                              |                |        |        |         |   |        |        | 
|                                              
|Catterton Partners V, L.P.(4)                  |                       | Limited Partnership Interest  |                              |                | 605    |        |         |   | 490    |       
|                                               | (Private Equity Fund) |                               |                              |                |        |        |         |   |        |        | 
|                                              
|Central Marketing, Inc.(5)                     |                       | Loan                          |                              |                | 10,948 |        |         |   | 10,948 |       
|                                               | (Business Services)   |                               |                              |                |        |        |         |   |        |        | 
|                                              
|Colibri Holding Corporation                    |                       | Debt Securities               |                              |                | 3,503  |        |         |   | 3,503  |       
|                                               | (Consumer Products)   |                               | Preferred Stock (459 shares) |                |        | 523    |         |   |        | 668    | 
|                                               |                       | Common Stock (3,362 shares)   |                              |                | 1,250  |        |         |   | 516    |       
|                                               |                       | Warrants                      |                              |                | 290    |        |         |   | 120    |       
|                                              
|Community Education
    Centers, Inc.          |                       | Loan                          |                              |                | 14,929 |        |         |   | 14,929 |       
|                                               | (Education Services)  |                               |                              |                |        |        |         |   |        |        | 
|                                              

|                                                                                                                                     |  |  |  |  |  |  |  |  |  | 
|------------------------------------------------------------------------------------------------------------------------------------ |  |  |  |  |  |  |  |  |  | 
|(1)Common
    stock, preferred stock, warrants, options, and equity interests
    are generally non-income producing and restricted.
|(2)Public
    company.                                                                                                              
|(3)Non-U.S. company
    or principal place of business outside the U.S.                                                             
|(4)Non-registered
    investment company.                                                                                           
|(5)Affiliates
    of Advantage Sales and Marketing, LLC.                                                                            



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


8



---



##### 



|                                        |                        |                                 |                                  |                |        |        |  |   |        |       | 
|--------------------------------------- | ---------------------- | ------------------------------- | -------------------------------- | -------------- | ------ | ------ |  | - | ------ | ----- | 
|                                        |                        |                                 |                                  |               
|                                        |                        |                                 |                                  | March 31, 2004
|                                        |                        |                                 |                                  |               
|Private Finance                         |                        |                                 |                                  |               
|Portfolio Company                       |                        |                                 |                                  | (unaudited)   
|(in thousands, except number of shares) |                        | Investment(1)                   |                                  | Cost           |        | Value 
|                                        |                        |                                 |                                  |                |        |       
|Component Hardware Group, Inc.          |                        | Preferred Stock (18,000 shares) |                                  | $              | 2,454  |        |  | $ | 2,454  |      
|                                        | (Industrial Products)  |                                 | Common Stock (2,000 shares)      |                |        | 200    |  |   |        | 750   | 
|                                       
|Cooper Natural Resources, Inc.          |                        | Loan                            |                                  |                | 120    |        |  |   | 120    |      
|                                        | (Industrial Products)  |                                 | Debt Securities                  |                |        | 2,000  |  |   |        | 2,000 | 
|                                        |                        | Preferred Stock (6,316 shares)  |                                  |                | 1,427  |        |  |   |       |      
|                                        |                        | Warrants                        |                                  |                | 832    |        |  |   |       |      
|                                       
|Coverall North America, Inc.            |                        | Loan                            |                                  |                | 14,847 |        |  |   | 14,847 |      
|                                        | (Business Services)    |                                 | Debt Securities                  |                |        | 7,675  |  |   |        | 7,675 | 
|                                       
|CTT Holdings                            |                        | Loan                            |                                  |                | 1,250  |        |  |   | 1,250  |      
|                                        | (Consumer Products)    |                                 |                                  |                |        |        |  |   |        |       | 
|                                       
|DCS Business Services, Inc.             |                        | Debt                            |                                  |                | 25,876 |        |  |   | 25,876 |      
|                                        | (Business Services)    |                                 | Preferred Stock (592,820 shares) |                |        | 1,534  |  |   |        | 1,534 | 
|                                       
|Drilltec Patents & Technologies         |                        | Loan                            |                                  |                | 10,918 |        |  |   |       |      
|                                        | Company, Inc.          |                                 | Debt Securities                  |                |        | 1,500  |  |   |        |      | 
|                                        | (Energy Services)      |                                 |                                  |                |        |        |  |   |        |       | 
|                                       
|eCentury Capital Partners, L.P.(4)      |                        | Limited Partnership Interest    |                                  |                | 4,375  |        |  |   | 571    |      
|                                        | (Private Equity Fund)  |                                 |                                  |                |        |        |  |   |        |       | 
|                                       
|Elexis Beta GmbH(3)                     |                        | Options                         |                                  |                | 426    |        |  |   | 245    |      
|                                        | (Industrial Products)  |                                 |                                  |                |        |        |  |   |        |       | 
|                                       
|Eparfin S.A.(3)                         |                        | Loan                            |                                  |                | 29     |        |  |   | 29     |      
|                                        | (Consumer Products)    |                                 |                                  |                |        |        |  |   |        |       | 
|                                       
|E-Talk Corporation                      |                        | Preferred Stock (133 shares)    |                                  |                | 10,009 |        |  |   |       |      
|                                        | (Business Services)    |                                 | Common Stock (8,656 shares)      |                |        |       |  |   |        |      | 
|                                       
|Executive Greetings, Inc.               |                        | Debt Securities                 |                                  |                | 18,830 |        |  |   | 50     |      
|                                        | (Business Services)    |                                 | Warrants                         |                |        | 360    |  |   |        |      | 
|                                       
|Fairchild Industrial Products           |                        | Loan                            |                                  |                | 7,166  |        |  |   | 7,166  |      
|                                        | Company                |                                 | Debt Securities                  |                |        | 5,954  |  |   |        | 2,942 | 
|                                        | (Industrial Products)  |                                 | Warrants                         |                |        | 280    |  |   |        |      | 
|                                       
|Frozen Specialties, Inc.                |                        | Debt Securities                 |                                  |                | 10,337 |        |  |   | 10,337 |      
|                                        | (Consumer Products)    |                                 | Warrants                         |                |        | 435    |  |   |        | 470   | 
|                                       
|Galaxy American                         |                        | Loan                            |                                  |                | 995    |        |  |   | 995    |      
|                                        | Communications, LLC    |                                 | Debt Securities                  |                |        | 49,702 |  |   |        | 9,685 | 
|                                        | (Broadcasting & Cable) |                                 | Common Stock (100 shares)        |                |        | 350    |  |   |        |      | 
|                                       
|Garden Ridge Corporation                |                        | Debt Securities                 |                                  |                | 27,271 |        |  |   | 20,323 |      
|                                        | (Retail)               |                                 | Preferred Stock (1,130 shares)   |                |        | 1,130  |  |   |        |      | 
|                                        |                        | Common Stock (847,800 shares)   |                                  |                | 613    |        |  |   |       |      
|                                       
|Geotrace Technologies, Inc.             |                        | Debt Securities                 |                                  |                | 16,056 |        |  |   | 16,056 |      
|                                        | (Energy Services)      |                                 | Warrants                         |                |        | 2,350  |  |   |        | 2,350 | 
|                                       
|Ginsey Industries, Inc.                 |                        | Loans                           |                                  |                | 5,000  |        |  |   | 5,000  |      
|                                        | (Consumer Products)    |                                 | Convertible Debentures           |                |        | 500    |  |   |        | 635   | 
|                                        |                        | Warrants                        |                                  |                |       |        |  |   | 1,440  |      
|                                       

|                                                                                                                                     |  |  |  |  |  |  |  |  |  | 
|------------------------------------------------------------------------------------------------------------------------------------ |  |  |  |  |  |  |  |  |  | 
|(1)Common
    stock, preferred stock, warrants, options, and equity interests
    are generally non-income producing and restricted.
|(2)Public
    company.                                                                                                              
|(3)Non-U.S. company
    or principal place of business outside the U.S.                                                             
|(4)Non-registered
    investment company.                                                                                           



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


9



---



##### 



|                                        |                        |                                  |                               |                |        |       |  |   |        |       | 
|--------------------------------------- | ---------------------- | -------------------------------- | ----------------------------- | -------------- | ------ | ----- |  | - | ------ | ----- | 
|                                        |                        |                                  |                               |               
|                                        |                        |                                  |                               | March 31, 2004
|                                        |                        |                                  |                               |               
|Private Finance                         |                        |                                  |                               |               
|Portfolio Company                       |                        |                                  |                               | (unaudited)   
|(in thousands, except number of shares) |                        | Investment(1)                    |                               | Cost           |        | Value
|                                        |                        |                                  |                               |                |        |      
|Grant Broadcasting Systems II           |                        | Warrants                         |                               | $              | 87     |       |  | $ | 2,750  |      
|                                        | (Broadcasting & Cable) |                                  |                               |                |        |       |  |   |        |       | 
|                                       
|Griffith Energy, Inc.                   |                        | Loan                             |                               |                | 16,561 |       |  |   | 16,561 |      
|                                        | (Energy Services)      |                                  |                               |                |        |       |  |   |        |       | 
|                                       
|Grotech Partners, VI, L.P.(4)           |                        | Limited Partnership Interest     |                               |                | 3,599  |       |  |   | 2,232  |      
|                                        | (Private Equity Fund)  |                                  |                               |                |        |       |  |   |        |       | 
|                                       
|The Hartz Mountain Corporation          |                        | Debt Securities                  |                               |                | 27,927 |       |  |   | 27,927 |      
|                                        | (Consumer Products)    |                                  | Common Stock (200,000 shares) |                |        | 2,000 |  |   |        | 1,636 | 
|                                        |                        | Warrants                         |                               |                | 2,613  |       |  |   | 2,137  |      
|                                       
|Haven Eldercare of New England, LLC     |                        | Loans                            |                               |                | 46,664 |       |  |   | 47,860 |      
|                                        | (Healthcare Services)  |                                  |                               |                |        |       |  |   |        |       | 
|                                       
|HealthMarket, Inc.                      |                        | Debt Securities                  |                               |                | 9,893  |       |  |   | 9,893  |      
|                                        | (Health Insurance)     |                                  | Warrants                      |                |        | 439   |  |   |        | 439   | 
|                                       
|The Hillman Companies, Inc.(2)          |                        | Loan                             |                               |                | 47,263 |       |  |   | 47,263 |      
|                                        | (Consumer Products)    |                                  |                               |                |        |       |  |   |        |       | 
|                                       
|Homax Holdings, Inc.                    |                        | Debt                             |                               |                | 10,032 |       |  |   | 10,032 |      
|                                        | (Consumer Products)    |                                  | Warrants                      |                |        | 927   |  |   |        | 927   | 
|                                       
|Icon International, Inc.                |                        | Common Stock (25,707 shares)     |                               |                | 76     |       |  |   |       |      
|                                        | (Business Services)    |                                  |                               |                |        |       |  |   |        |       | 
|                                       
|Impact Innovations Group, LLC           |                        | Debt Securities                  |                               |                | 7,278  |       |  |   | 50     |      
|                                        | (Business Services)    |                                  | Warrants                      |                |        | 1,674 |  |   |        |      | 
|                                       
|Insight Pharmaceuticals Corporation     |                        | Loan                             |                               |                | 10,167 |       |  |   | 10,167 |      
|                                        | (Consumer Products)    |                                  |                               |                |        |       |  |   |        |       | 
|                                       
|Interline Brands, Inc.                  |                        | Preferred Stock (199,313 shares) |                               |                | 1,849  |       |  |   | 1,849  |      
|                                        | (Business Services)    |                                  | Common Stock (15,615 shares)  |                |        | 139   |  |   |        |      | 
|                                        |                        | Warrants                         |                               |                | 1,181  |       |  |   |       |      
|                                       
|JRI Industries, Inc.                    |                        | Debt Securities                  |                               |                | 1,560  |       |  |   | 1,560  |      
|                                        | (Industrial Products)  |                                  | Warrants                      |                |        | 74    |  |   |        | 39    | 
|                                       
|Julius Koch USA, Inc.                   |                        | Loan                             |                               |                | 500    |       |  |   | 500    |      
|                                        | (Industrial Products)  |                                  |                               |                |        |       |  |   |        |       | 
|                                       
|Kirker Enterprises, Inc.                |                        | Equity Interest                  |                               |                | 4      |       |  |   | 4      |      
|                                        | (Industrial Products)  |                                  | Warrants                      |                |        | 348   |  |   |        | 2,184 | 
|                                       
|Love Funding Corporation                |                        | Preferred Stock (26,000 shares)  |                               |                | 359    |       |  |   | 359    |      
|                                        | (Financial Services)   |                                  |                               |                |        |       |  |   |        |       | 
|                                       
|Matrics, Inc.                           |                        | Preferred Stock (511,876 shares) |                               |                | 500    |       |  |   | 876    |      
|                                        | (Industrial Products)  |                                  | Warrants                      |                |        |      |  |   |        |      | 
|                                       
|MedAssets, Inc.                         |                        | Preferred Stock (237,514 shares) |                               |                | 2,049  |       |  |   | 2,049  |      
|                                        | (Business Services)    |                                  | Warrants                      |                |        | 136   |  |   |        |      | 
|                                       

|                                                                                                                                     |  |  |  |  |  |  |  |  |  | 
|------------------------------------------------------------------------------------------------------------------------------------ |  |  |  |  |  |  |  |  |  | 
|(1)Common
    stock, preferred stock, warrants, options, and equity interests
    are generally non-income producing and restricted.
|(2)Public
    company.                                                                                                              
|(3)Non-U.S. company
    or principal place of business outside the U.S.                                                             
|(4)Non-registered
    investment company.                                                                                           



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


10



---



##### 



|                                               |                        |                              |                              |                |        |        |  |   |        |        | 
|---------------------------------------------- | ---------------------- | ---------------------------- | ---------------------------- | -------------- | ------ | ------ |  | - | ------ | ------ | 
|                                               |                        |                              |                              |               
|                                               |                        |                              |                              | March 31, 2004
|                                               |                        |                              |                              |               
|Private Finance                                |                        |                              |                              |               
|Portfolio Company                              |                        |                              |                              | (unaudited)   
|(in thousands, except number of shares)        |                        | Investment(1)                |                              | Cost           |        | Value 
|                                               |                        |                              |                              |                |        |       
|Mercury Air Group, Inc.(2)                     |                        | Debt Securities              |                              | $              | 24,103 |        |  | $ | 24,103 |       
|                                               | (Business Services)    |                              | Warrants                     |                |        | 427    |  |   |        |       | 
|                                              
|Mid-Atlantic Venture Fund IV,
    L.P.(4)      |                        | Limited Partnership Interest |                              |                | 5,100  |        |  |   | 2,542  |       
|                                               | (Private Equity Fund)  |                              |                              |                |        |        |  |   |        |        | 
|                                              
|Midview Associates, L.P.                       |                        | Warrants                     |                              |                |       |        |  |   |       |       
|                                               | (Housing)              |                              |                              |                |        |        |  |   |        |        | 
|                                              
|Mogas Energy, LLC                              |                        | Debt Securities              |                              |                | 16,687 |        |  |   | 16,687 |       
|                                               | (Energy Services)      |                              | Warrants                     |                |        | 1,774  |  |   |        | 2,300  | 
|                                              
|Norstan Apparel Shops, Inc.                    |                        | Debt Securities              |                              |                | 12,960 |        |  |   | 10,983 |       
|                                               | (Retail)               |                              | Common Stock (29,663 shares) |                |        | 4,750  |  |   |        |       | 
|                                               |                        | Warrants                     |                              |                | 655    |        |  |   |       |       
|                                              
|Novak Biddle Venture Partners III,
    L.P.(4) |                        | Limited Partnership Interest |                              |                | 1,200  |        |  |   | 914    |       
|                                               | (Private Equity Fund)  |                              |                              |                |        |        |  |   |        |        | 
|                                              
|Nursefinders, Inc.                             |                        | Loan                         |                              |                | 47     |        |  |   | 47     |       
|                                               | (Healthcare Services)  |                              | Debt Securities              |                |        | 11,356 |  |   |        | 11,356 | 
|                                               |                        | Warrants                     |                              |                | 900    |        |  |   | 644    |       
|                                              
|Oahu Waste Services, Inc.                      |                        | Debt Securities              |                              |                | 8,613  |        |  |   | 8,613  |       
|                                               | (Business Services)    |                              | Stock Appreciation Rights    |                |        | 239    |  |   |        | 395    | 
|                                              
|Onyx Television GmbH(3)                        |                        | Preferred Units              |                              |                | 201    |        |  |   |       |       
|                                               | (Broadcasting & Cable) |                              |                              |                |        |        |  |   |        |        | 
|                                              
|Opinion Research Corporation(2)                |                        | Debt Securities              |                              |                | 14,401 |        |  |   | 14,401 |       
|                                               | (Business Services)    |                              | Warrants                     |                |        | 996    |  |   |        | 940    | 
|                                              
|Oriental Trading Company, Inc.                 |                        | Common Stock (13,820 shares) |                              |                | 10     |        |  |   | 4,000  |       
|                                               | (Consumer Products)    |                              |                              |                |        |        |  |   |        |        | 
|                                              
|Polaris Pool Systems, Inc.                     |                        | Debt Securities              |                              |                | 11,093 |        |  |   | 11,093 |       
|                                               | (Consumer Products)    |                              | Warrants                     |                |        | 1,145  |  |   |        | 1,250  | 
|                                              
|Prosperco Finanz Holding AG(3)                 |                        | Convertible Debentures       |                              |                | 8,045  |        |  |   | 50     |       
|                                               | (Financial Services)   |                              | Common Stock (1,528 shares)  |                |        | 1,059  |  |   |        |       | 
|                                               |                        |                              | Warrants                     |                |        |       |  |   |        |       | 
|                                              
|RadioVisa Corporation                          |                        | Loan                         |                              |                | 24,878 |        |  |   | 24,878 |       
|                                               | (Broadcasting & Cable) |                              |                              |                |        |        |  |   |        |        | 
|                                              
|Resun Leasing, Inc.                            |                        | Loan                         |                              |                | 30,000 |        |  |   | 30,000 |       
|                                               | (Business Services)    |                              |                              |                |        |        |  |   |        |        | 
|                                              
|S.B. Restaurant Company                        |                        | Debt Securities              |                              |                | 9,387  |        |  |   | 9,387  |       
|                                               | (Retail)               |                              | Warrants                     |                |        | 619    |  |   |        | 619    | 
|                                              
|SBBUT, LLC                                     |                        | Equity Interests             |                              |                | 500    |        |  |   | 500    |       
|                                               | (Consumer Products)    |                              | Warrants                     |                |        | 54     |  |   |        | 54     | 
|                                               |                        | Guaranty ($49)               |                              |                |        |        |  |   |        |       
|                                              

|                                                                                                                                     |  |  |  |  |  |  |  |  |  | 
|------------------------------------------------------------------------------------------------------------------------------------ |  |  |  |  |  |  |  |  |  | 
|(1)Common
    stock, preferred stock, warrants, options, and equity interests
    are generally non-income producing and restricted.
|(2)Public
    company.                                                                                                              
|(3)Non-U.S. company
    or principal place of business outside the U.S.                                                             
|(4)Non-registered
    investment company.                                                                                           



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


11



---



##### 



|                                        |                        |                                 |                                  |                |        |        |  |   |        |       | 
|--------------------------------------- | ---------------------- | ------------------------------- | -------------------------------- | -------------- | ------ | ------ |  | - | ------ | ----- | 
|                                        |                        |                                 |                                  |               
|                                        |                        |                                 |                                  | March 31, 2004
|                                        |                        |                                 |                                  |               
|Private Finance                         |                        |                                 |                                  |               
|Portfolio Company                       |                        |                                 |                                  | (unaudited)   
|(in thousands, except number of shares) |                        | Investment(1)                   |                                  | Cost           |        | Value 
|                                        |                        |                                 |                                  |                |        |       
|Sidarus Holdings, Inc.                  |                        | Debt Securities                 |                                  | $              | 4,978  |        |  | $ | 4,978  |      
|                                        | (Business Services)    |                                 | Preferred Stock (270,008 shares) |                |        | 2,700  |  |   |        | 2,700 | 
|                                        |                        | Common Stock (1,256,452 shares) |                                  |                | 50     |        |  |   | 1,597  |      
|                                        |                        | Warrants                        |                                  |                |       |        |  |   | 3      |      
|                                       
|SmartMail, LLC                          |                        | Loan                            |                                  |                | 3,276  |        |  |   | 3,276  |      
|                                        | (Business Services)    |                                 | Debt Securities                  |                |        | 4,570  |  |   |        | 4,570 | 
|                                        |                        |                                 | Equity Interests                 |                |        | 1,070  |  |   |        | 1,070 | 
|                                        |                        |                                 | Warrants                         |                |        | 3      |  |   |        | 3     | 
|                                       
|Soff-Cut Holdings, Inc.                 |                        | Debt Securities                 |                                  |                | 10,229 |        |  |   | 10,229 |      
|                                        | (Industrial Products)  |                                 | Preferred Stock (300 shares)     |                |        | 300    |  |   |        | 294   | 
|                                        |                        | Common Stock (2,000 shares)     |                                  |                | 200    |        |  |   |       |      
|                                       
|SPP Mezzanine Fund, L.P.(4)             |                        | Limited Partnership Interest    |                                  |                | 248    |        |  |   | 238    |      
|                                        | (Private Equity Fund)  |                                 |                                  |                |        |        |  |   |        |       | 
|                                       
|Startec Global Communications           |                        | Loan                            |                                  |                | 25,715 |        |  |   | 22,144 |      
|                                        | Corporation(2)         |                                 | Debt Securities                  |                |        | 20,663 |  |   |        |      | 
|                                        | (Telecommunications)   |                                 |                                  |                |        |        |  |   |        |       | 
|                                       
|SunStates Refrigerated Services,        |                        | Loans                           |                                  |                | 4,492  |        |  |   | 1,255  |      
|                                        | Inc.                   |                                 | Debt Securities                  |                |        | 2,445  |  |   |        |      | 
|                                        | (Warehouse Facilities) |                                 |                                  |                |        |        |  |   |        |       | 
|                                       
|Sydran Food Services II, L.P.           |                        | Debt Securities                 |                                  |                | 12,973 |        |  |   | 50     |      
|                                        | (Retail)               |                                 | Equity Interests                 |                |        | 3,747  |  |   |        |      | 
|                                        |                        | Warrants                        |                                  |                | 162    |        |  |   |       |      
|                                       
|United Pet Group, Inc.                  |                        | Debt Securities                 |                                  |                | 9,225  |        |  |   | 9,225  |      
|                                        | (Consumer Products)    |                                 | Warrants                         |                |        | 85     |  |   |        | 1,700 | 
|                                       
|United Site Services, Inc.              |                        | Loan                            |                                  |                | 15,338 |        |  |   | 15,338 |      
|                                        | (Business Services)    |                                 |                                  |                |        |        |  |   |        |       | 
|                                       
|Updata Venture Partners II,
    L.P.(4) |                        | Limited Partnership Interest    |                                  |                | 2,305  |        |  |   | 2,192  |      
|                                        | (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(4)              |                        | Equity Interest                 |                                  |                | 1,000  |        |  |   | 397    |      
|                                        | (Private Equity Fund)  |                                 |                                  |                |        |        |  |   |        |       | 
|                                       
|VICORP Restaurants, Inc.                |                        | Debt Securities                 |                                  |                | 24,270 |        |  |   | 24,270 |      
|                                        | (Retail)               |                                 | Warrants                         |                |        | 33     |  |   |        | 33    | 
|                                       
|Walker Investment Fund II, LLLP(4)      |                        | Limited Partnership Interest    |                                  |                | 1,246  |        |  |   | 285    |      
|                                        | (Private Equity Fund)  |                                 |                                  |                |        |        |  |   |        |       | 
|                                       

|                                                                                                                                     |  |  |  |  |  |  |  |  |  | 
|------------------------------------------------------------------------------------------------------------------------------------ |  |  |  |  |  |  |  |  |  | 
|(1)Common
    stock, preferred stock, warrants, options, and equity interests
    are generally non-income producing and restricted.
|(2)Public
    company.                                                                                                              
|(3)Non-U.S. company
    or principal place of business outside the U.S.                                                             
|(4)Non-registered
    investment company.                                                                                           



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


12



---



##### 



|                                                    |                     |                           |                 |                |        |        |           |   |        |        | 
|--------------------------------------------------- | ------------------- | ------------------------- | --------------- | -------------- | ------ | ------ | --------- | - | ------ | ------ | 
|                                                    |                     |                           |                 |               
|                                                    |                     |                           |                 | March 31, 2004
|                                                    |                     |                           |                 |               
|Private Finance                                     |                     |                           |                 |               
|Portfolio Company                                   |                     |                           |                 | (unaudited)   
|(in thousands, except number of shares)             |                     | Investment(1)             |                 | Cost           |        | Value 
|                                                    |                     |                           |                 |                |        |       
|Wear Me Apparel Corporation                         |                     | Debt Securities           |                 | $              | 48,659 |        |           | $ | 48,659 |       
|                                                    | (Consumer Products) |                           | Warrants        |                |        | 1,219  |           |   |        | 1,219  | 
|                                                   
|Weston Solutions, Inc.                              |                     | Loan                      |                 |                | 7,318  |        |           |   | 7,318  |       
|                                                    | (Business Services) |                           |                 |                |        |        |           |   |        |        | 
|                                                   
|Wilshire Restaurant Group, Inc.                     |                     | Debt Securities           |                 |                | 17,221 |        |           |   | 16,982 |       
|                                                    | (Retail)            |                           | Warrants        |                |        | 735    |           |   |        |       | 
|                                                   
|Wilton Industries, Inc.                             |                     | Loan                      |                 |                | 9,600  |        |           |   | 9,600  |       
|                                                    | (Consumer Products) |                           |                 |                |        |        |           |   |        |        | 
|                                                   
|Woodstream Corporation                              |                     | Loan                      |                 |                | 252    |        |           |   | 252    |       
|                                                    | (Consumer Products) |                           | Debt Securities |                |        | 16,621 |           |   |        | 16,621 | 
|                                                    |                     | Common Stock (180 shares) |                 |                | 1,800  |        |           |   | 2,300  |       
|                                                    |                     | Warrants                  |                 |                | 587    |        |           |   | 751    |       
|                                                   
|Total
    companies less than 5% owned              |                     | $                         | 987,261         |                |        | $      | 820,459   |  
|                                                   
|Total
    private finance (121 portfolio companies) |                     | $                         | 1,860,130       |                |        | $      | 1,685,564 |  
|                                                   

|                                                                                                                                     |  |  |  |  |  |  |  |  |  | 
|------------------------------------------------------------------------------------------------------------------------------------ |  |  |  |  |  |  |  |  |  | 
|(1)Common
    stock, preferred stock, warrants, options, and equity interests
    are generally non-income producing and restricted.
|(2)Public
    company.                                                                                                              
|(3)Non-U.S. company
    or principal place of business outside the U.S.                                                             
|(4)Non-registered
    investment company.                                                                                           



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


13



---



##### 



|                                          |                                                                                 |                                                                |  |      |   |                |   |        |           |  |   |        |         |  |   |        |         | 
|----------------------------------------- | ------------------------------------------------------------------------------- | -------------------------------------------------------------- |  | ---- | - | -------------- | - | ------ | --------- |  | - | ------ | ------- |  | - | ------ | ------- | 
|                                          |                                                                                 |                                                                |  |      |   |               
|                                          |                                                                                 |                                                                |  |      |   | March 31, 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 |           |  | $ | 34,685 |         |  | $ | 28,145 |        
|                                          | Morgan Stanley Capital I, Series 1999-RM1                                       |                                                                |  | 6.4  | % |                |   | 28,865 |           |  |   | 9,880  |         |  |   | 9,880  |        
|                                          | COMM 1999-1                                                                     |                                                                |  | 5.7  | % |                |   | 56,477 |           |  |   | 27,518 |         |  |   | 28,232 |        
|                                          | Morgan Stanley Capital I, Series 1999-FNV1                                      |                                                                |  | 6.1  | % |                |   | 25,085 |           |  |   | 12,968 |         |  |   | 10,868 |        
|                                          | DLJ Commercial Mortgage Trust 1999-CG2                                          |                                                                |  | 6.1  | % |                |   | 43,131 |           |  |   | 14,224 |         |  |   | 13,528 |        
|                                          | Commercial Mortgage Acceptance Corp.,
    Series 1999-C1                        |                                                                |  | 6.8  | % |                |   | 18,643 |           |  |   | 5,100  |         |  |   | 7,054  |        
|                                          | LB Commercial Mortgage Trust, Series 1999-C2                                    |                                                                |  | 6.7  | % |                |   | 11,603 |           |  |   | 1,709  |         |  |   | 1,762  |        
|                                          | Chase Commercial Mortgage Securities Corp.,
    Series 1999-2                   |                                                                |  | 6.5  | % |                |   | 20,950 |           |  |   | 5,557  |         |  |   | 8,243  |        
|                                          | FUNB CMT, Series 1999-C4                                                        |                                                                |  | 6.5  | % |                |   | 21,125 |           |  |   | 8,014  |         |  |   | 7,211  |        
|                                          | Heller Financial, HFCMC Series 2000 PH-1                                        |                                                                |  | 6.6  | % |                |   | 24,040 |           |  |   | 9,193  |         |  |   | 8,660  |        
|                                          | SBMS VII, Inc., Series 2000-NL1                                                 |                                                                |  | 7.2  | % |                |   | 8,289  |           |  |   | 4,628  |         |  |   | 4,028  |        
|                                          | DLJ Commercial Mortgage Trust,
    Series 2000-CF1                              |                                                                |  | 7.0  | % |                |   | 26,708 |           |  |   | 11,102 |         |  |   | 11,014 |        
|                                          | Deutsche Bank Alex. Brown, Series Comm
    2000-C1                              |                                                                |  | 6.9  | % |                |   | 18,068 |           |  |   | 4,660  |         |  |   | 2,963  |        
|                                          | LB-UBS Commercial Mortgage Trust,
    Series 2000-C4                            |                                                                |  | 6.9  | % |                |   | 16,665 |           |  |   | 3,701  |         |  |   | 3,701  |        
|                                          | Credit Suisse First Boston Mortgage Securities
    Corp., Series 2001-CK1       |                                                                |  | 5.9  | % |                |   | 17,502 |           |  |   | 4,585  |         |  |   | 5,251  |        
|                                          | JP Morgan-CIBC-Deutsche 2001                                                    |                                                                |  | 5.8  | % |                |   | 25,398 |           |  |   | 7,296  |         |  |   | 7,294  |        
|                                          | Lehman Brothers-UBS Warburg 2001-C2                                             |                                                                |  | 6.4  | % |                |   | 23,426 |           |  |   | 6,831  |         |  |   | 6,828  |        
|                                          | SBMS VII, Inc., Series 2001-C1                                                  |                                                                |  | 6.1  | % |                |   | 20,333 |           |  |   | 5,550  |         |  |   | 1,948  |        
|                                          | GE Capital Commercial Mortgage Securities Corp.,
    Series 2001-2              |                                                                |  | 6.1  | % |                |   | 21,799 |           |  |   | 6,975  |         |  |   | 6,973  |        
|                                          | Credit Suisse First Boston Mortgage Securities
    Corp.,
    Series 2001-CKN5  |                                                                |  | 5.2  | % |                |   | 22,292 |           |  |   | 6,837  |         |  |   | 6,827  |        
|                                          | JP Morgan Chase Commercial Mortgage Securities
    Corp.,
    Series 2001-C1    |                                                                |  | 5.6  | % |                |   | 25,050 |           |  |   | 6,151  |         |  |   | 6,149  |        
|                                          | SBMS VII, Inc., Series 2001-C2                                                  |                                                                |  | 6.2  | % |                |   | 23,217 |           |  |   | 7,186  |         |  |   | 7,176  |        
|                                          | FUNB CMT, Series 2002-C1                                                        |                                                                |  | 6.0  | % |                |   | 22,097 |           |  |   | 9,060  |         |  |   | 7,895  |        
|                                          | GE Capital Commercial Mortgage Corp.,
    Series 2002-1                         |                                                                |  | 6.2  | % |                |   | 40,325 |           |  |   | 17,467 |         |  |   | 19,579 |        
|                                          | GMAC Commercial Mortgage Securities, Inc.,
    Series 2002-C2                   |                                                                |  | 5.8  | % |                |   | 27,926 |           |  |   | 10,891 |         |  |   | 11,236 |        
|                                          | GE Capital Commercial Mortgage Corp.,
    Series 2002-3                         |                                                                |  | 5.1  | % |                |   | 38,047 |           |  |   | 13,345 |         |  |   | 13,709 |        
|                                          | Morgan Stanley Dean Witter Capital I Trust
    2002-IQ3                         |                                                                |  | 6.0  | % |                |   | 15,919 |           |  |   | 3,807  |         |  |   | 3,807  |        
|                                          | LB-UBS Commercial Mortgage Trust 2003-C1                                        |                                                                |  | 4.6  | % |                |   | 37,896 |           |  |   | 12,315 |         |  |   | 12,467 |        
|                                          | GS Mortgage Securities Corporation II
    Series 2003-C1                        |                                                                |  | 4.7  | % |                |   | 26,189 |           |  |   | 9,123  |         |  |   | 9,123  |        
|                                          | J.P. Morgan Chase Commercial Mortgage Securities
    Corp.,
    Series 2003-ML1 |                                                                |  | 4.9  | % |                |   | 2,947  |           |  |   | 2,304  |         |  |   | 2,451  |        
|                                          | Credit Suisse First Boston Mortgage Securities
    Corp., Series 2003-CK2       |                                                                |  | 4.9  | % |                |   | 56,680 |           |  |   | 28,176 |         |  |   | 29,112 |        
|                                          | COMM 2003-LNB1                                                                  |                                                                |  | 4.4  | % |                |   | 24,324 |           |  |   | 5,731  |         |  |   | 5,731  |        
|                                          | Wachovia Bank Commercial Mortgage Trust,
    Series 2003-C5                     |                                                                |  | 4.3  | % |                |   | 48,202 |           |  |   | 17,653 |         |  |   | 17,812 |        
|                                          | GE Commercial Mortgage Corporation,
    Series 2003-C2                          |                                                                |  | 5.1  | % |                |   | 9,389  |           |  |   | 7,529  |         |  |   | 8,153  |        
|                                          | GMAC Commercial Mortgage Securities, Inc.,
    Series 2003-C2                   |                                                                |  | 5.5  | % |                |   | 56,441 |           |  |   | 25,120 |         |  |   | 26,372 |        
|                                          | GMAC Commercial Mortgage Securities, Inc.,
    Series 2003-C3                   |                                                                |  | 5.3  | % |                |   | 6,535  |           |  |   | 5,443  |         |  |   | 5,855  |        
|                                          | LB-UBS Commercial Mortgage Trust 2003-C8                                        |                                                                |  | 5.4  | % |                |   | 12,999 |           |  |   | 10,371 |         |  |   | 11,267 |        
|                                          | Wachovia Bank Commercial Mortgage Trust, Series
    2003-C9                     |                                                                |  | 5.3  | % |                |   | 46,793 |           |  |   | 22,516 |         |  |   | 23,189 |        
|                                          | COMM 2004-LNB2                                                                  |                                                                |  | 5.0  | % |                |   | 4,770  |           |  |   | 3,478  |         |  |   | 3,629  |        
|                                          | GE Commercial Mortgage Corporation, Series 2004-C1                              |                                                                |  | 5.0  | % |                |   | 48,049 |           |  |   | 21,826 |         |  |   | 22,290 |        
|                                          | LB-UBS Commercial Mortgage Trust 2004-C1                                        |                                                                |  | 4.9  | % |                |   | 35,400 |           |  |   | 14,804 |         |  |   | 15,057 |        
|                                          | MezzCapp Commercial Mortgage Trust,
    Series 2004-C1                          |                                                                |  | 10.0 | % |                |   | 1,990  |           |  |   | 823    |         |  |   | 823    |        
|                                          | Wachovia Bank Commercial Mortgage Trust, Series
    2004-C10                    |                                                                |  | 5.0  | % |                |   | 7,110  |           |  |   | 5,282  |         |  |   | 5,580  |        
|                                         
|                                          |                                                                                 | Total commercial mortgage-backed securities
    (43 issuances) |  |      |   |                |   | $      | 1,121,794 |  |   | $      | 451,414 |  |   | $      | 448,872 | 
|                                         

|    |                                                                                                                                  
|--- | ---------------------------------------------------------------------------------------------------------------------------------
|(1) | Common stock, preferred stock, warrants, options,
    and equity interests are generally non-income producing and
    restricted.
|(2) | Public company.                                                                                                                  
|(3) | Non-U.S. company or principal place of
    business outside the U.S.                                                             
|(4) | Non-registered investment company.                                                                                               





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


14



---



##### 



|                                           |                                            |                                           |   |        |         |  |   |        |         | 
|------------------------------------------ | ------------------------------------------ | ----------------------------------------- | - | ------ | ------- |  | - | ------ | ------- | 
|                                           |                                            |                                          
|                                           |                                            | March 31, 2004                           
|                                           |                                            |                                          
|                                           |                                            |                                          
|                                           |                                            | (unaudited)                              
|                                           |                                            | Cost                                      |   | Value 
|                                           |                                            |                                           |   |       
|Commercial Real Estate Finance             |                                            |                                           |   |        |         |  |   |       
|(in thousands, except number of
    loans) |                                            |                                           |   |        |         |  |   |       
|Collateralized Debt Obligations            |                                            |                                           |   |        |         |  |   |       
|                                           | Crest 2001-1,
    Ltd.(3)                  |                                           | $ | 22,524 |         |  | $ | 22,524 |        
|                                           | Crest 2002-1,
    Ltd.(3)                  |                                           |   | 23,922 |         |  |   | 23,922 |        
|                                           | Crest 2002-IG,
    Ltd.(3)                 |                                           |   | 4,440  |         |  |   | 4,440  |        
|                                           | Crest Clarendon Street
    2002-1, Ltd.(3) |                                           |   | 947    |         |  |   | 947    |        
|                                           | Crest 2003-1,
    Ltd.(3)                  |                                           |   | 91,887 |         |  |   | 91,756 |        
|                                           | Crest 2003-2,
    Ltd.(3)                  |                                           |   | 25,920 |         |  |   | 25,920 |        
|                                           | TIAA Real Estate CDO
    2003-1, Ltd.(3)   |                                           |   | 1,949  |         |  |   | 1,949  |        
|                                          
|                                           |                                            | Total
    collateralized debt obligations |   | $      | 171,589 |  |   | $      | 171,458 | 
|                                          

|                                      |                                      |                  |               |           |   |  |    |    |       |   |           |         |       |   |           |         | 
|------------------------------------- | ------------------------------------ | ---------------- | ------------- | --------- | - |  | -- | -- | ----- | - | --------- | ------- | ----- | - | --------- | ------- | 
|                                      |                                      | Interest         |               | Number of |   |  |    |   
|                                      |                                      | Rate Ranges      |               | Loans     |   |  |    |   
|                                      |                                      |                  |               |           |   |  |    |   
|Commercial Mortgage Loans             |                                      |                  |               |           |   |  |    |    |       |   |           |         |       |   |           |        
|                                      |                                      |                  | Up to 6.99%   |           |   |  | 16 |    |       | $ | 13,807    |         |       | $ | 14,189    |        
|                                      |                                      |                  | 7.00%8.99%   |           |   |  | 6  |    |       |   | 14,645    |         |       |   | 13,790    |        
|                                      |                                      |                  | 9.00%10.99%  |           |   |  | 7  |    |       |   | 31,784    |         |       |   | 31,310    |        
|                                      |                                      |                  | 11.00%12.99% |           |   |  | 6  |    |       |   | 11,181    |         |       |   | 9,207     |        
|                                      |                                      |                  | 13.00%14.99% |           |   |  | 3  |    |       |   | 3,593     |         |       |   | 2,001     |        
|                                      |                                      | 15.00% and above |               |           | 2 |  |    |    | 4,319 |   |           |         | 4,319 |  
|                                     
|                                      | Total commercial mortgage loans      |                  |               |           |   |  |    | 40 |       |   | $         | 79,329  |       |   | $         | 74,816  | 
|                                     
|Real Estate Owned                     |                                      |                  |               |           |   |  |    |    |       |   | 16,093    |         |       |   | 14,283    |        
|                                     
|Equity Interests(Guarantees  $2,731) |                                      |                  |               |           |   |  |    |    |       |   | 5,742     |         |       |   | 4,571     |        
|                                     
|                                      | Total commercial real estate finance |                  |               |           |   |  |    |    |       |   | $         | 724,167 |       |   | $         | 714,000 | 
|                                     
|Total portfolio                       |                                      |                  |               |           |   |  |    |    |       | $ | 2,584,297 |         |       | $ | 2,399,564 |        
|                                     

|    |                                                                                                                                  
|--- | ---------------------------------------------------------------------------------------------------------------------------------
|(1) | Common stock, preferred stock, warrants, options,
    and equity interests are generally non-income producing and
    restricted.
|(2) | Public company.                                                                                                                  
|(3) | Non-U.S. company or principal place of
    business outside the U.S.                                                             
|(4) | 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 months ended
March 31, 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 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
accounting principles generally accepted in the United States of
America (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 March 31, 2004, and the results of
operations, changes in net assets, and cash flows for the three
months ended March 31, 2004 and 2003. The results of
operations for the three months ended March 31, 2004, are
not necessarily indicative of the operating results to be
expected for the full year.

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%

16



---



##### 



ALLIED CAPITAL CORPORATION AND
SUBSIDIARIES


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

Note 2. Summary of Significant Accounting
Policies, continued

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

17



---



##### 



ALLIED CAPITAL CORPORATION AND
SUBSIDIARIES


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

Note 2. Summary of Significant Accounting
Policies, continued

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 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 working capital needs. 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 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.

18



---



##### 



ALLIED CAPITAL CORPORATION AND
SUBSIDIARIES


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

Note 2. Summary of Significant Accounting
Policies, continued

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
|                                                                                                                                                 |             | Months Ended 
|                                                                                                                                                 |             | March 31,    
|                                                                                                                                                 |             |              
|                                                                                                                                                 |             | 2004          |        | 2003
|(in thousands, except per share amounts)                                                                                                         |             |               |        |     
|Net increase in net assets resulting from
    operations as reported                                                                             |             | $             | 20,308 |      |  | $ | 19,873 |     
|Less total stock-based employee compensation
    expense determined under fair value based method for all awards,
    net of related tax effects |             |               | (3,052 | )    |  |   | (3,742 | )   
|                                                                                                                                                 |             |               |        |      |  |   |        |     
|Pro forma net increase in net assets resulting
    from operations                                                                               |             |               | 17,256 |      |  |   | 16,131 |     
|Less preferred stock dividends                                                                                                                   |             |               | (45    | )    |  |   | (55    | )   
|                                                                                                                                                 |             |               |        |      |  |   |        |     
|Pro forma net income available to common
    shareholders                                                                                        |             | $             | 17,211 |      |  | $ | 16,076 |     
|                                                                                                                                                 |             |               |        |      |  |   |        |     
|Basic earnings per common share:                                                                                                                 |             |               |        |      |  |   |        |     
|                                                                                                                                                 | As reported |               | $      | 0.16 |  |   | $      | 0.18 | 
|                                                                                                                                                 | Pro forma   |               | $      | 0.13 |  |   | $      | 0.15 | 
|Diluted earnings per common share:                                                                                                               |             |               |        |      |  |   |        |     
|                                                                                                                                                 | As reported |               | $      | 0.15 |  |   | $      | 0.18 | 
|                                                                                                                                                 | Pro forma   |               | $      | 0.13 |  |   | $      | 0.15 | 

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 months ended March 31, 2004 and
2003:

|                                       |  |               |      |      |  |   |      |  
|-------------------------------------- |  | ------------- | ---- | ---- |  | - | ---- | -
|                                       |  |              
|                                       |  | For the Three
|                                       |  | Months Ended 
|                                       |  | March 31,    
|                                       |  |              
|                                       |  | 2004          |      | 2003
|                                       |  |               |      |     
|Risk-free interest rate                |  |               | 2.7  | %    |  |   | 2.8  | %
|Expected life                          |  |               | 5.0  |      |  |   | 5.0  |  
|Expected volatility                    |  |               | 37.0 | %    |  |   | 39.1 | %
|Dividend yield                         |  |               | 8.7  | %    |  |   | 8.9  | %
|Weighted average fair value per option |  | $             | 4.25 |      |  | $ | 3.23 |  



| |                                   
| | ----------------------------------
| | 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 $2.4 billion and
$2.6 billion at March 31, 2004, and December 31,
2003, respectively. At March 31, 2004, and
December 31, 2003, 80% 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 March 31, 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 |       | $    | 1,405,573 |           |  | $        | 1,182,600 |           |  |       | 14.4 | %        |  | $ | 1,406,052 |           |  | $ | 1,214,886 |           |  |  | 15.0 | %
|Equity interests          |       |      | 454,557   |           |  |          | 502,964   |           |  |       |      |          |  |   | 500,079   |           |  |   | 687,786   |           |  |  |      |  
|                          |       |      |           |           |  |          |           |           |  |       |      |          |  |   |           |           |  |   |           |           |  |  |      |  
|                          | Total |      | $         | 1,860,130 |  |          | $         | 1,685,564 |  |       |      |          |  |   | $         | 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 March 31, 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 structured as loans and debt
securities that carry a relatively high fixed rate of interest,
which may be combined with equity features, such as conversion
privileges, or warrants or options to purchase a portion of the
portfolio companys equity at a pre-determined strike
price, which is generally a nominal price for warrants or
options in a private company. Private finance investments are
generally issued by private companies and are generally illiquid
and subject to restrictions on resale or transferability.

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. At March 31, 2004, and
December 31, 2003, approximately 99% and 97%, respectively,
of the Companys loans and debt securities had fixed
interest rates.

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 investment at
March 31, 2004, was in Business Loan Express, LLC. 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.

At March 31, 2004, and December 31,
2003, the Company had an investment at value totaling
$337.4 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
March 31, 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.

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

22



---



##### 



ALLIED CAPITAL CORPORATION AND
SUBSIDIARIES


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

Note 3. Portfolio, continued

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 March 31, 2004, the Company has
considered the increase in fair value of its investment in BLX
due to BLXs tax attributes as an LLC and has also
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 $215.0 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 March 31, 2004, was $74.6 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 March 31, 2004. At March 31, 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 $1.3 million and
$1.0 million for the three months ended March 31, 2004
and 2003, respectively. BLX is headquartered in New York, NY.

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
$44.6 million in outstanding mezzanine debt. Total
consideration to the Company from the sale, 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. The Company
realized a gain of $149.0 million on the transaction. The
sale of Hillman is subject to certain post-closing working
capital and other adjustments.

Total interest and related portfolio income
earned from the Companys investments in BLX and Hillman
for the three months ended March 31, 2004 and 2003, was
$14.4 million and $15.3 million, respectively.

23



---



##### 



ALLIED CAPITAL CORPORATION AND
SUBSIDIARIES


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)



Note 3. Portfolio, continued


At March 31, 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 |       | $      | 19,312 |         |  | $      | 31,873 |        
|                                                                             | Companies 5% to 25% owned     |       |        | 15,152 |         |  |        | 2,777  |        
|                                                                             | Companies less than 5% owned  |       |        | 46,383 |         |  |        | 28,027 |        
|Not in workout  companies more
    than 50% owned                           |                               |       | 35,042 |        |         |  | 31,897 |       
|Not in workout  companies less
    than 50% owned                           |                               |       | 39,126 |        |         |  | 16,532 |       
|                                                                             |                               |       |        |        |         |  |        |       
|                                                                             |                               | Total |        | $      | 155,015 |  |        | $      | 111,106 | 
|                                                                             |                               |       |        |        |         |  |        |       

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

|                       |       |      |    |      |   |  |    |     |  
|---------------------- | ----- | ---- | -- | ---- | - |  | -- | --- | -
|                       |       | 2004 |    | 2003
|                       |       |      |    |     
|Industry               |       |      |    |      |   |  |    |    
|Consumer products      |       |      | 24 | %    |   |  | 30 | %  
|Business services      |       |      | 24 |      |   |  | 22 |    
|Financial services     |       |      | 20 |      |   |  | 19 |    
|Healthcare services    |       |      | 9  |      |   |  | 8  |    
|Industrial products    |       |      | 7  |      |   |  | 6  |    
|Retail                 |       |      | 5  |      |   |  | 4  |    
|Energy services        |       |      | 4  |      |   |  | 4  |    
|Telecommunications     |       |      | 2  |      |   |  | 2  |    
|Broadcasting and cable |       |      | 2  |      |   |  | 2  |    
|Other                  |       |      | 3  |      |   |  | 3  |    
|                       |       |      |    |      |   |  |    |    
|                       | Total |      |    | 100  | % |  |    | 100 | %
|                       |       |      |    |      |   |  |    |    
|Geographic Region      |       |      |    |      |   |  |    |    
|Mid-Atlantic           |       |      | 43 | %    |   |  | 40 | %  
|West                   |       |      | 21 |      |   |  | 16 |    
|Midwest                |       |      | 17 |      |   |  | 26 |    
|Southeast              |       |      | 14 |      |   |  | 13 |    
|Northeast              |       |      | 4  |      |   |  | 4  |    
|International          |       |      | 1  |      |   |  | 1  |    
|                       |       |      |    |      |   |  |    |    
|                       | Total |      |    | 100  | % |  |    | 100 | %
|                       |       |      |    |      |   |  |    |    

24



---



##### 



ALLIED CAPITAL CORPORATION AND
SUBSIDIARIES


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)



Note 3. Portfolio, continued




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

At March 31, 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                     |       | $    | 451,414 |         |  | $        | 448,872 |         |  |       | 13.7 | %        |  | $ | 399,106 |         |  | $ | 393,979 |         |  |  | 14.1 | %
|CDO bonds and preferred shares |       |      | 171,589 |         |  |          | 171,458 |         |  |       | 17.6 | %        |  |   | 186,824 |         |  |   | 186,557 |         |  |  | 16.7 | %
|Loans                          |       |      | 79,329  |         |  |          | 74,816  |         |  |       | 7.8  | %        |  |   | 87,427  |         |  |   | 83,639  |         |  |  | 8.6  | %
|Real estate owned              |       |      | 16,093  |         |  |          | 14,283  |         |  |       |      |          |  |   | 15,931  |         |  |   | 12,856  |         |  |  |      |  
|Equity interests               |       |      | 5,742   |         |  |          | 4,571   |         |  |       |      |          |  |   | 5,641   |         |  |   | 4,896   |         |  |  |      |  
|                               |       |      |         |         |  |          |         |         |  |       |      |          |  |   |         |         |  |   |         |         |  |  |      |  
|                               | Total |      | $       | 724,167 |  |          | $       | 714,000 |  |       |      |          |  |   | $       | 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 March 31, 2004, and December 31, 2003, CMBS bonds
consisted of the following:

|                        |  |      |           |      |  |   |           |  
|----------------------- |  | ---- | --------- | ---- |  | - | --------- | -
|                        |  | 2004 |           | 2003
|($ in thousands)        |  |      |           |     
|Face                    |  | $    | 1,121,794 |      |  | $ | 1,016,533 |  
|Original issue discount |  |      | (670,380  | )    |  |   | (617,427  | )
|                        |  |      |           |      |  |   |           |  
|Cost                    |  | $    | 451,414   |      |  | $ | 399,106   |  
|                        |  |      |           |      |  |   |           |  
|Value                   |  | $    | 448,872   |      |  | $ | 393,979   |  
|                        |  |      |           |      |  |   |           |  

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

|                 |       |      |         |               |  |             |         |               |  |       |      |             |   |   |         |         |  |   |        |         |  |  |      |       |  
|---------------- | ----- | ---- | ------- | ------------- |  | ----------- | ------- | ------------- |  | ----- | ---- | ----------- | - | - | ------- | ------- |  | - | ------ | ------- |  |  | ---- | ----- | -
|                 |       |      |         |              
|                 |       | 2004 |         | 2003         
|                 |       |      |         |              
|                 |       |      |         | Percentage of |  |             |         | Percentage of
|                 |       | Cost |         | Value         |  | Total Value |         | Cost          |  | Value |      | Total Value
|($ in thousands) |       |      |         |               |  |             |         |               |  |       |      |            
|BB+              |       | $    | 56,482  |               |  | $           | 61,202  |               |  |       | 13.6 | %           |   | $ | 49,477  |         |  | $ | 51,157 |         |  |  | 13.0 | %    
|BB               |       |      | 33,361  |               |  |             | 36,386  |               |  |       | 8.1  |             |   |   | 22,031  |         |  |   | 23,008 |         |  |  | 5.9  |      
|BB-              |       |      | 21,781  |               |  |             | 23,239  |               |  |       | 5.2  |             |   |   | 13,538  |         |  |   | 14,266 |         |  |  | 3.6  |      
|B+               |       |      | 60,556  |               |  |             | 60,552  |               |  |       | 13.5 |             |   |   | 54,464  |         |  |   | 54,246 |         |  |  | 13.8 |      
|B                |       |      | 47,719  |               |  |             | 48,677  |               |  |       | 10.8 |             |   |   | 38,416  |         |  |   | 38,362 |         |  |  | 9.7  |      
|B-               |       |      | 85,397  |               |  |             | 85,068  |               |  |       | 19.0 |             |   |   | 84,986  |         |  |   | 83,859 |         |  |  | 21.3 |      
|CCC+             |       |      | 19,320  |               |  |             | 15,404  |               |  |       | 3.4  |             |   |   | 15,935  |         |  |   | 15,494 |         |  |  | 3.9  |      
|CCC              |       |      | 17,869  |               |  |             | 14,620  |               |  |       | 3.3  |             |   |   | 13,323  |         |  |   | 11,413 |         |  |  | 2.9  |      
|CCC-             |       |      | 1,113   |               |  |             | 489     |               |  |       | 0.1  |             |   |   | 3,133   |         |  |   | 2,410  |         |  |  | 0.6  |      
|Unrated          |       |      | 107,816 |               |  |             | 103,235 |               |  |       | 23.0 |             |   |   | 103,803 |         |  |   | 99,764 |         |  |  | 25.3 |      
|                 |       |      |         |               |  |             |         |               |  |       |      |             |   |   |         |         |  |   |        |         |  |  |      |      
|                 | Total |      | $       | 451,414       |  |             | $       | 448,872       |  |       |      | 100.0       | % |   | $       | 399,106 |  |   | $      | 393,979 |  |  |      | 100.0 | %
|                 |       |      |         |               |  |             |         |               |  |       |      |             |   |   |         |         |  |   |        |         |  |  |      |      

25



---



##### 



ALLIED CAPITAL CORPORATION AND
SUBSIDIARIES


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)



Note 3. Portfolio, continued


The 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 March 31, 2004, the face value of the
CMBS bonds held by the Company were subordinate to 84% 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 significant discount from the face amount of the bonds.

At March 31, 2004, and December 31, 2003,
the Company held CMBS bonds in 43 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 March 31, 2004, and December 31,
2003:

|                                                                     |  |      |         |      |  |   |         |  
|-------------------------------------------------------------------- |  | ---- | ------- | ---- |  | - | ------- | -
|                                                                     |  | 2004 |         | 2003
|($ in millions)                                                      |  |      |         |     
|Approximate number of loans and REO
    properties(1)                |  |      | 6,100   |      |  |   | 5,600   |  
|Total outstanding principal balance                                  |  | $    | 42,269  |      |  | $ | 38,437  |  
|Loans over 30 days delinquent or classified as
    REO properties(2) |  |      | 1.3% (3 | )    |  |   | 1.5% (3 | )






|    |                                                                                                                                                                                                                                                                                                                                                                                                              
|--- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(1) | Includes approximately 28 and 22 REO properties
    obtained through the foreclosure of commercial mortgage loans at
    March 31, 2004, and December 31, 2003, respectively.                                                                                                                                                                                                                                
|   
|(2) | As a percentage of total outstanding principal
    balance.                                                                                                                                                                                                                                                                                                                                                  
|   
|(3) | At March 31, 2004, and December 31,
    2003, the Companys investments included bonds in the first
    loss, unrated bond class in 37 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 March 31, 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 March 31, 2004,
and December 31, 2003, were as follows:

|              |       |      |    |      |   |  |    |     |  
|------------- | ----- | ---- | -- | ---- | - |  | -- | --- | -
|              |       | 2004 |    | 2003
|              |       |      |    |     
|Property Type |       |      |    |      |   |  |    |    
|Retail        |       |      | 35 | %    |   |  | 35 | %  
|Office        |       |      | 28 |      |   |  | 24 |    
|Housing       |       |      | 22 |      |   |  | 25 |    
|Industrial    |       |      | 5  |      |   |  | 5  |    
|Hospitality   |       |      | 4  |      |   |  | 5  |    
|Other         |       |      | 6  |      |   |  | 6  |    
|              |       |      |    |      |   |  |    |    
|              | Total |      |    | 100  | % |  |    | 100 | %
|              |       |      |    |      |   |  |    |    

26



---



##### 



ALLIED CAPITAL CORPORATION AND
SUBSIDIARIES


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)



Note 3. Portfolio, continued


|                  |       |      |    |      |   |  |    |     |  
|----------------- | ----- | ---- | -- | ---- | - |  | -- | --- | -
|                  |       | 2004 |    | 2003
|                  |       |      |    |     
|Geographic Region |       |      |    |      |   |  |    |    
|West              |       |      | 31 | %    |   |  | 31 | %  
|Mid-Atlantic      |       |      | 26 |      |   |  | 27 |    
|Midwest           |       |      | 21 |      |   |  | 21 |    
|Southeast         |       |      | 18 |      |   |  | 17 |    
|Northeast         |       |      | 4  |      |   |  | 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 amount of losses and
the expected timing of recognition of such losses will be
updated, and the respective yield will be adjusted as necessary.
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 March 31, 2004, and December 31, 2003,
the unamortized discount related to the CMBS bond portfolio was
$670.4 million and $617.4 million, respectively, and
the Company had set aside $323.3 million and
$295.8 million, respectively, of this unamortized discount
to absorb potential future losses. The yields on the CMBS bonds
of 13.7% and 14.1%, respectively, assume that this amount that
has been set aside will not be amortized. At December 31,
2003, the Company had reduced the face amount and the original
issue discount on the CMBS bonds for specifically identified
losses of $52.6 million, 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 December 31, 2003.

At March 31, 2004, and December 31, 2003,
CMBS bonds with a value of $0.1 million and
$0.2 million, respectively, were not accruing interest.

Collateralized Debt Obligation Bonds and
Preferred Shares
(CDOs).At
March 31, 2004, the Company owned BB rated bonds in
one CDO totaling $0.9 million at value and preferred shares
in seven CDOs totaling $170.6 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 preferred shares of the CDOs in
which the Company has invested at March 31, 2004, 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

27



---



##### 



ALLIED CAPITAL CORPORATION AND
SUBSIDIARIES


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

Note 3. Portfolio, continued

right to the cash flow. Then, any 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
March 31, 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.

At March 31, 2004, and December 31,
2003, the underlying collateral for the Companys
investment in the seven outstanding CDO issuances, respectively,
had balances as follows:

|                                   |                  |      |         |         |  |   |         |         | 
|---------------------------------- | ---------------- | ---- | ------- | ------- |  | - | ------- | ------- | 
|                                   |                  | 2004 |         | 2003   
|($ in millions)                    |                  |      |         |        
|Investment grade REIT debt(1)      |                  | $    | 1,338.0 |         |  | $ | 1,338.0 |        
|Investment grade CMBS bonds(2)     |                  |      | 676.4   |         |  |   | 662.3   |        
|Non-investment grade CMBS bonds(3) |                  |      | 1,119.4 |         |  |   | 1,133.7 |        
|Other collateral                   |                  |      | 31.7    |         |  |   | 32.4    |        
|                                   |                  |      |         |         |  |   |         |        
|                                   | Total collateral |      | $       | 3,165.5 |  |   | $       | 3,166.4 | 
|                                   |                  |      |         |         |  |   |         |        



---

|    |                                                                               
|--- | ------------------------------------------------------------------------------
|(1) | Issued by 44 REITs for each of the respective
    periods presented.          
|(2) | Issued in 79 and 78 transactions, respectively,
    for the periods presented.
|(3) | Issued in 68 transactions for each of the
    respective periods presented.   

Included in the CMBS bond collateral for the CDOs
at March 31, 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.

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
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 March 31, 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 three
months ended March 31, 2004 and 2003, these fees totaled
$0.4 million and $0.2 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 March 31, 2004,
approximately 91% and 9% 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 March 31, 2004,
and December 31, 2003, loans with a value of

28



---



##### 



ALLIED CAPITAL CORPORATION AND
SUBSIDIARIES


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)



Note 3. Portfolio, continued


$12.0 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 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 March 31, 2004, and December 31, 2003, were
as follows:

|                  |       |      |    |      |   |  |    |     |  
|----------------- | ----- | ---- | -- | ---- | - |  | -- | --- | -
|                  |       | 2004 |    | 2003
|                  |       |      |    |     
|Property Type     |       |      |    |      |   |  |    |    
|Hospitality       |       |      | 45 | %    |   |  | 41 | %  
|Retail            |       |      | 23 |      |   |  | 21 |    
|Office            |       |      | 22 |      |   |  | 22 |    
|Housing           |       |      | 5  |      |   |  | 4  |    
|Healthcare        |       |      |   |      |   |  | 7  |    
|Other             |       |      | 5  |      |   |  | 5  |    
|                  |       |      |    |      |   |  |    |    
|                  | Total |      |    | 100  | % |  |    | 100 | %
|                  |       |      |    |      |   |  |    |    
|                 
|Geographic Region |       |      |    |      |   |  |    |    
|Midwest           |       |      | 31 | %    |   |  | 30 | %  
|Southeast         |       |      | 30 |      |   |  | 34 |    
|West              |       |      | 21 |      |   |  | 20 |    
|Mid-Atlantic      |       |      | 10 |      |   |  | 9  |    
|Northeast         |       |      | 8  |      |   |  | 7  |    
|                  |       |      |    |      |   |  |    |    
|                  | Total |      |    | 100  | % |  |    | 100 | %
|                  |       |      |    |      |   |  |    |    

29



---



##### 



ALLIED CAPITAL CORPORATION AND
SUBSIDIARIES


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

Note 4. Debt

At March 31, 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 long-term notes payable |                                    | $       | 869,220   |         |          | $ | 869,220  |         |        |   | 7.1      | %    |   | $       | 854,000   |         |  | $ | 854,000 |         |  |        | 7.2 | %   
|                              | SBA debentures                    |                                    |         | 94,800    |         |          |   | 87,500   |         |        |   | 8.1      | %    |   |         | 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 |         |           | 969,720 |          |   |          | 962,420 |        |   |          | 7.2  | % |         |           | 961,500 |  |   |         | 954,200 |  |        |     | 7.3  | %
|Revolving line of credit      |                                   |                                    | 532,500 |           |         |          |  |          |         |        |  | (2)      |      |   | 532,500 |           |         |  |  |         |         |  |   (2) |    
|                              |                                   |                                    |         |           |         |          |   |          |         |        |   |          |      |   |         |           |         |  |   |         |         |  |        |    
|                              | Total debt                        |                                    | $       | 1,502,220 |         |          | $ | 962,420  |         |        |   | 7.5      | %(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) | There were no amounts drawn on the revolving line
    of credit at March 31, 2004, and December 31, 2003,
    respectively, and the annual cost of commitment fees and other
    facility fees was $2.7 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.

Notes Payable and
Debentures

Unsecured Long-Term 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
March 31, 2004, the notes had remaining maturities of one
month to six years. Subsequent to March 31, 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 long-term 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 March 31,
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
quarter of 2004, the Company repaid $7.0 million of the SBA
debentures. At March 31, 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
March 31, 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.

30



---



##### 



ALLIED CAPITAL CORPORATION AND
SUBSIDIARIES


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)



Note 4. Debt, continued


Scheduled
Maturities.Scheduled future
maturities of notes payable and debentures at March 31,
2004, were as follows:

|           |       |                  |         |         | 
|---------- | ----- | ---------------- | ------- | ------- | 
|Year       |       | Amount Maturing 
|           |       |                 
|           |       | ($ in thousands)
|2004       |       | $                | 214,000 |        
|2005       |       |                  | 179,000 |        
|2006       |       |                  | 180,700 |        
|2007       |       |                  |        |        
|2008       |       |                  | 153,000 |        
|Thereafter |       |                  | 235,720 |        
|           |       |                  |         |        
|          
|           | Total |                  | $       | 962,420 | 
|           |       |                  |         |        



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

The committed amount under the unsecured
revolving credit facility is $532.5 million and may be
further expanded through new or additional commitments up to
$600 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 (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
$2.7 million at March 31, 2004, and December 31,
2003. The line of credit generally requires monthly payments of
interest, and all principal is due upon maturity.

There were no amounts outstanding on the
revolving line of credit for the three months ended
March 31, 2004, or at December 31, 2003. The average
debt outstanding on the revolving line of credit was
$97.1 million for the three months ended March 31,
2003. The maximum amount borrowed under this facility and the
weighted average stated interest rate for the three months ended
March 31, 2003, were $208.8 million and 2.7%,
respectively. As of March 31, 2004, the amount available
under the revolving line of credit was $488.4 million, net
of amounts committed for standby letters of credit of
$44.1 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 March 31,
2004, the Company was in compliance with these covenants.

31



---



##### 



ALLIED CAPITAL CORPORATION AND
SUBSIDIARIES


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

Note 5. Guarantees

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. As of March 31, 2004, and December 31,
2003, the Company had issued guarantees of debt, rental
obligations, lease obligations and severance obligations
aggregating $80.1 million and $83.4 million,
respectively, and had extended standby letters of credit
aggregating $44.1 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
$124.2 million and $128.9 million at March 31,
2004, and December 31, 2003, respectively. At
March 31, 2004, and December 31, 2003, no amounts had
been recorded as a liability for the Companys guarantees
or standby letters of credit.

As of March 31, 2004, the guarantees and
standby letters of credit expire as follows:

|                             |       |       |      |       |  |      |     |      |  |      |     |      |  |            |      |      |  |   |      |      |  |   |   |   |  |   |     |     | 
|---------------------------- | ----- | ----- | ---- | ----- |  | ---- | --- | ---- |  | ---- | --- | ---- |  | ---------- | ---- | ---- |  | - | ---- | ---- |  | - | - | - |  | - | --- | --- | 
|                             |       | Total |      | 2004  |  | 2005 |     | 2006 |  | 2007 |     | 2008 |  | After 2008
|(in millions)                |       |       |      |       |  |      |     |      |  |      |     |      |  |           
|Guarantees                   |       | $     | 80.1 |       |  | $    | 0.5 |      |  | $    | 0.9 |      |  | $          | 0.3  |      |  | $ | 74.8 |      |  | $ |  |   |  | $ | 3.6 |    
|Standby letters of credit(1) |       |       | 44.1 |       |  |      |    |      |  |      | 1.6 |      |  |            | 42.5 |      |  |   |     |      |  |   |  |   |  |   |    |    
|                             |       |       |      |       |  |      |     |      |  |      |     |      |  |            |      |      |  |   |      |      |  |   |   |   |  |   |     |    
|                             | Total |       | $    | 124.2 |  |      | $   | 0.5  |  |      | $   | 2.5  |  |            | $    | 42.8 |  |   | $    | 74.8 |  |   | $ |  |  |   | $   | 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.

Note 6. Preferred Stock

At March 31, 2004, and 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.

In accordance with SFAS No. 150,
Accounting for Certain Financial Instruments with
Characteristics of Both Liabilities and Equity, (SFAS
No. 150) the Company has classified the 10,000 shares of
$100 par value, 4% redeemable cumulative preferred securities in
other liabilities on the accompanying consolidated balance
sheet. Accordingly, the Company has also recorded the associated
dividends as interest expense on the accompanying consolidated
statement of operations beginning with the quarter ended
September 30, 2003. The effect of this change in accounting
principle was not material to the financial results or the
results of operations of the Company. Also, in accordance with
SFAS No. 150, no previously reported amounts have been
reclassified.

32



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##### 



ALLIED CAPITAL CORPORATION AND
SUBSIDIARIES


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

Note 7. Shareholders
Equity

Sales of common stock for the three months ended
March 31, 2004 and 2003, were as follows:

|                                        |              |                      |   |      |  |   |        |        | 
|--------------------------------------- | ------------ | -------------------- | - | ---- |  | - | ------ | ------ | 
|                                        |              |                     
|                                        |              | For the Three Months
|                                        |              | Ended March 31,     
|                                        |              |                     
|                                        |              | 2004                 |   | 2003
|                                        |              |                     
|(in thousands)                          |              |                     
|Number of common shares                 |              |                      |  |      |  |   | 4,250  |       
|Gross proceeds                          |              | $                    |  |      |  | $ | 85,880 |       
|Less costs, including underwriting fees |              |                      |  |      |  |   | (3,518 | )     
|                                        |              |                      |   |      |  |   |        |       
|                                        | Net proceeds |                      | $ |     |  |   | $      | 82,362 | 
|                                        |              |                      |   |      |  |   |        |       

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.

Dividend reinvestment plan activity for the three
months ended March 31, 2004 and 2003, was as follows:

|                                         |  |                      |       |      |  |   |       | 
|---------------------------------------- |  | -------------------- | ----- | ---- |  | - | ----- | 
|                                         |  |                     
|                                         |  | For the Three Months
|                                         |  | Ended March 31,     
|                                         |  |                     
|                                         |  | 2004                 |       | 2003
|(in thousands, except per share amounts) |  |                      |       |     
|Shares issued                            |  |                      | 50    |      |  |   | 84    | 
|Average price per share                  |  | $                    | 29.65 |      |  | $ | 20.13 | 

Note 8. Earnings Per Common
Share

Earnings per common share for the three months
ended March 31, 2004 and 2003, were as follows:

|                                                         |  |                      |         |      |  |   |         |  
|-------------------------------------------------------- |  | -------------------- | ------- | ---- |  | - | ------- | -
|                                                         |  |                     
|                                                         |  | For the Three Months
|                                                         |  | Ended March 31,     
|                                                         |  |                     
|                                                         |  | 2004                 |         | 2003
|(in thousands, except per share amounts)                 |  |                      |         |     
|Net increase in net assets resulting from
    operations |  | $                    | 20,308  |      |  | $ | 19,873  |  
|Less preferred stock dividends                           |  |                      | (45     | )    |  |   | (55     | )
|                                                         |  |                      |         |      |  |   |         |  
|Income available to common shareholders                  |  | $                    | 20,263  |      |  | $ | 19,818  |  
|                                                         |  |                      |         |      |  |   |         |  
|Weighted average common shares
    outstanding  basic   |  |                      | 128,314 |      |  |   | 109,458 |  
|Dilutive options outstanding to officers                 |  |                      | 3,654   |      |  |   | 640     |  
|                                                         |  |                      |         |      |  |   |         |  
|Weighted average common shares
    outstanding  diluted |  |                      | 131,968 |      |  |   | 110,098 |  
|                                                         |  |                      |         |      |  |   |         |  
|Basic earnings per common share                          |  | $                    | 0.16    |      |  | $ | 0.18    |  
|                                                         |  |                      |         |      |  |   |         |  
|Diluted earnings per common share                        |  | $                    | 0.15    |      |  | $ | 0.18    |  
|                                                         |  |                      |         |      |  |   |         |  

33



---



##### 



ALLIED CAPITAL CORPORATION AND
SUBSIDIARIES


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

Note 9. Individual Performance
Award

In the first quarter of 2004, the Company
established the Individual Performance Award (IPA)
as a long-term compensation program for its senior officers. In
conjunction with the program, the Company has approved a
non-qualified deferred compensation plan
(DCP II), which will be administered through a
trust. The administrator of the DCP II will be the
Compensation Committee of the Companys Board of Directors
(DCP II Administrator) and the DCP II
trust will be 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, subject to shareholder approval, to
then require the trustee to use the cash exclusively to purchase
shares of the Companys common stock in the open market.

For the three months ended March 31, 2004,
the Company accrued $3.5 million in IPA expense.
Contribution of these amounts into the DCP II trust is
pending shareholder approval to invest the IPA contributions in
the Companys common stock.

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.

There are 26.0 million shares authorized
under the Option Plan. At March 31, 2004, and
December 31, 2003, the number of shares available to be
granted under the Option Plan was 2.1 million and
8.8 million, respectively. On March 11, 2004, options
for 6.8 million shares were granted to employees under the
Option Plan at an exercise price of $28.98 per share.

Options were outstanding for 21.0 million and
14.9 million shares with a weighted average exercise price
of $23.39 and $20.68 per share at March 31, 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 quarter of 2004 and for the first quarter of 2003.
These dividends totaled $73.4 million and
$63.0 million for the three months ended March 31,
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.

34



---



##### 



ALLIED CAPITAL CORPORATION AND
SUBSIDIARIES


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)



Note 11. Dividends and Distributions,
continued


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

Note 12. Supplemental Disclosure of Cash
Flow Information

For the three months ended March 31, 2004
and 2003, the Company paid $6.1 million and
$6.2 million, respectively, for interest. For the three
months ended March 31, 2004 and 2003, the Companys
non-cash financing activities totaled $1.5 million and
$1.7 million, respectively, related to the issuance of
common stock in lieu of cash distributions.

Non-cash operating activities for the three
months ended March 31, 2004 and 2003, include notes or
other securities received as consideration from the sale of
investments of $48.3 million and $3.9 million,
respectively, which increased the portfolio. The notes received
for the three months ended March 31, 2004, include a note
received for $47.5 million in conjunction with the sale of
Hillman (see Note 3). Non-cash operating activities for the
three months ended March 31, 2003, also included the
receipt of commercial mortgage loans in satisfaction of private
finance loans and debt securities of $9.1 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 at value, including accrued interest payable on the
obligations, as of March 31, 2004, and December 31,
2003, consisted of the following:

|                                               |       |      |        |         |  |   |        |        | 
|---------------------------------------------- | ----- | ---- | ------ | ------- |  | - | ------ | ------ | 
|($ in thousands)                               |       |      |        |        
|Description of Issue                           |       | 2004 |        | 2003   
|                                               |       |      |        |        
|5-year Treasury securities, due November 2007  |       | $    | 7,363  |         |  | $ | 7,185  |       
|5-year Treasury securities, due February 2008  |       |      |       |         |  |   | 5,977  |       
|5-year Treasury securities, due March 2009     |       |      | 3,001  |         |  |   |       |       
|10-year Treasury securities, due November 2012 |       |      | 9,781  |         |  |   | 9,357  |       
|10-year Treasury securities, due February 2013 |       |      | 22,972 |         |  |   | 32,226 |       
|10-year Treasury securities, due May 2013      |       |      | 5,500  |         |  |   | 5,281  |       
|10-year Treasury securities, due August 2013   |       |      | 21,816 |         |  |   | 23,666 |       
|10-year Treasury securities, due November 2013 |       |      | 35,829 |         |  |   | 14,833 |       
|10-year Treasury securities, due February 2014 |       |      | 5,475  |         |  |   |       |       
|                                               |       |      |        |         |  |   |        |       
|                                               | Total |      | $      | 111,737 |  |   | $      | 98,525 | 
|                                               |       |      |        |         |  |   |        |       

As of March 31, 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

35



---



##### 



ALLIED CAPITAL CORPORATION AND
SUBSIDIARIES


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

Note 13. Hedging Activities,
continued

securities, resulting in unrealized depreciation
on the obligations of $2.6 million. As of December 31,
2003, the total obligations to replenish borrowed Treasury
securities had decreased since the 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 $108.7 million and
$98.5 million at March 31, 2004, and December 31,
2003, respectively. Under the terms of the transactions, the
Company had provided additional cash collateral of
$3.0 million and $18 thousand at March 31, 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 March 31, 2004, the repurchase agreements
were due on April 7, 2004, and had a weighted average
interest rate of 0.7%. The weighted average interest rate on the
repurchase agreements as of December 31, 2003, was 0.3%.

Note 14. Financial Highlights

|                                                               |                                                               |                    |       |                |   |      |       |       |   |   |       |       |  
|-------------------------------------------------------------- | ------------------------------------------------------------- | ------------------ | ----- | -------------- | - | ---- | ----- | ----- | - | - | ----- | ----- | -
|                                                               |                                                               |                    |       |               
|                                                               |                                                               | At and for the     |       |               
|                                                               |                                                               | Three Months Ended |       | At and for the
|                                                               |                                                               | March 31,          |       | 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                                         |                    |       | 0.34           |   |      |       | 0.39  |   |   |       | 1.65  |  
|                                                               | Net realized gains(3)                                         |                    |       | 1.12           |   |      |       | 0.44  |   |   |       | 0.63  |  
|                                                               | Net change in unrealized appreciation or
    depreciation (3) |                    |       | (1.31          | ) |      |       | (0.65 | ) |   |       | (0.66 | )
|                                                               |                                                               |                    |       |                |   |      |       |       |   |   |       |      
|Net increase in net assets resulting from
    operations       |                                                               |                    | 0.15  |                |   |      | 0.18  |       |   |   | 1.62  |      
|                                                               |                                                               |                    |       |                |   |      |       |       |   |   |       |      
|Net decrease in net assets from shareholder
    distributions  |                                                               |                    | (0.57 | )              |   |      | (0.57 | )     |   |   | (2.28 | )    
|Net increase in net assets from capital share
    transactions |                                                               |                    | 0.08  |                |   |      | 0.22  |       |   |   | 1.38  |      
|                                                               |                                                               |                    |       |                |   |      |       |       |   |   |       |      
|Net asset value, end of period                                 |                                                               | $                  | 14.60 |                |   | $    | 14.05 |       |   | $ | 14.94 |      
|                                                               |                                                               |                    |       |                |   |      |       |       |   |   |       |      
|Market value, end of period                                    |                                                               | $                  | 30.29 |                |   | $    | 19.98 |       |   | $ | 27.88 |      
|Total return(4)                                                |                                                               |                    | 11    | %              |   |      | (6    | )%    |   |   | 41    | %    

36



---



##### 



ALLIED CAPITAL CORPORATION AND
SUBSIDIARIES


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)



Note 14. Financial Highlights,
continued


|                                                                                          |  |                    |           |                |  |      |           |   |  |   |           |  
|----------------------------------------------------------------------------------------- |  | ------------------ | --------- | -------------- |  | ---- | --------- | - |  | - | --------- | -
|                                                                                          |  |                    |           |               
|                                                                                          |  | At and for the     |           |               
|                                                                                          |  | Three Months Ended |           | At and for the
|                                                                                          |  | March 31,          |           | Year Ended    
|                                                                                          |  |                    |           | December 31,  
|                                                                                          |  | 2004(1)            |           | 2003           |  | 2003
|                                                                                          |  |                    |           |                |  |     
|Ratios and Supplemental Data($ and shares in thousands,
    except per
    share amounts) |  |                    |           |                |  |      |           |   |  |   |           |  
|Ending net assets                                                                         |  | $                  | 1,879,970 |                |  | $    | 1,588,293 |   |  | $ | 1,914,577 |  
|Common shares outstanding at end of period                                                |  |                    | 128,761   |                |  |      | 113,056   |   |  |   | 128,118   |  
|Diluted weighted average common shares outstanding                                        |  |                    | 131,968   |                |  |      | 110,098   |   |  |   | 118,351   |  
|Employee and administrative expenses/average net
    assets (5)                           |  |                    | 0.96      | %              |  |      | 0.80      | % |  |   | 3.50      | %
|Total expenses/average net assets                                                         |  |                    | 1.97      | %              |  |      | 1.94      | % |  |   | 8.06      | %
|Net investment income/average net assets                                                  |  |                    | 2.35      | %              |  |      | 2.72      | % |  |   | 11.51     | %
|Net increase in net assets resulting from
    operations/ average net assets              |  |                    | 1.07      | %              |  |      | 1.27      | % |  |   | 11.33     | %
|Portfolio turnover rate                                                                   |  |                    | 6.83      | %              |  |      | 11.06     | % |  |   | 31.12     | %
|Average debt outstanding                                                                  |  | $                  | 952,986   |                |  | $    | 891,325   |   |  | $ | 943,507   |  
|Average debt per share(2)                                                                 |  | $                  | 7.22      |                |  | $    | 8.10      |   |  | $ | 7.97      |  



---

|    |                                                                                                                                                                                                      
|--- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(1) | The results for the three months ended
    March 31, 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, quarterly comparisons may not be
    meaningful.
|(4) | Total return assumes the reinvestment of all
    dividends paid for the periods presented.                                                                                                           
|(5) | Employee expenses for the three months ended
    March 31, 2004, include the accrual of the new individual
    performance award totaling $3.5 million.                                              

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.

37



---



##### 



Independent Accountants Review
Report

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
March 31, 2004, and the related consolidated statements of
operations, changes in net assets and cash flows and the
financial highlights (included in Note 14) for the three-month
periods ended March 31, 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 established by the American Institute of Certified
Public Accountants. 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 auditing standards generally
accepted in the United States of America, 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 accounting principles
generally accepted in the United States of America.

We have previously audited, in accordance with
auditing standards generally accepted in the United States of
America, 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.

April 26, 2004


38



---



##### 





|         |                                                                                          
|-------- | -----------------------------------------------------------------------------------------
|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 accounting principles generally
accepted in the United States of America 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 accounting principles generally accepted in the
United States of America.

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.

39



---



##### 



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

|                               |  |      |    |      |  |  |    |  
|------------------------------ |  | ---- | -- | ---- |  |  | -- | -
|                               |  | 2004 |    | 2003
|                               |  |      |    |     
|Private finance                |  |      | 70 | %    |  |  | 74 | %
|Commercial real estate finance |  |      | 30 | %    |  |  | 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.

40



---



##### 



PORTFOLIO AND INVESTMENT ACTIVITY

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

|                                                                    |  |                    |         |                |  |      |         |   |  |   |         |  
|------------------------------------------------------------------- |  | ------------------ | ------- | -------------- |  | ---- | ------- | - |  | - | ------- | -
|                                                                    |  |                    |         |               
|                                                                    |  | At and for the     |         |               
|                                                                    |  | Three Months Ended |         | At and for the
|                                                                    |  | March 31,          |         | Year Ended    
|                                                                    |  |                    |         | December 31,  
|                                                                    |  | 2004               |         | 2003           |  | 2003
|($ in millions)                                                     |  |                    |         |                |  |     
|                                                                    |  |                    |         |               
|                                                                    |  | (unaudited)        |         |               
|Portfolio at value                                                  |  | $                  | 2,399.6 |                |  | $    | 2,376.9 |   |  | $ | 2,584.6 |  
|Investments funded(1)                                               |  | $                  | 217.8   |                |  | $    | 269.0   |   |  | $ | 931.5   |  
|Change in accrued or reinvested interest and
    dividends          |  | $                  | 13.1    |                |  | $    | 11.1    |   |  | $ | 45.0    |  
|Principal collections related to investment
    repayments or sales |  | $                  | 237.1   |                |  | $    | 320.1   |   |  | $ | 784.0   |  
|Yield(2)                                                            |  |                    | 14.3    | %              |  |      | 14.0    | % |  |   | 14.7    | %




|    |                                                                                                                                                                                                                                                                                                                                                                                                                     
|--- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(1) | Investments funded for the three months ended
    March 31, 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 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.

Private Finance

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

|                                                                    |                           |                    |         |                |  |      |         |         |  |   |         |         | 
|------------------------------------------------------------------- | ------------------------- | ------------------ | ------- | -------------- |  | ---- | ------- | ------- |  | - | ------- | ------- | 
|                                                                    |                           |                    |         |               
|                                                                    |                           | At and for the     |         |               
|                                                                    |                           | Three Months Ended |         | At and for the
|                                                                    |                           | March 31,          |         | Year Ended    
|                                                                    |                           |                    |         | December 31,  
|                                                                    |                           | 2004               |         | 2003           |  | 2003
|($ in millions)                                                     |                           |                    |         |                |  |     
|                                                                    |                           |                    |         |               
|                                                                    |                           | (unaudited)        |         |               
|Portfolio at value:                                                 |                           |                    |         |                |  |      |         |         |  |   |         |        
|                                                                    | Loans and debt securities |                    | $       | 1,182.6        |  |      | $       | 1,148.3 |  |   | $       | 1,214.9 | 
|                                                                    | Equity interests          |                    |         | 503.0          |  |      |         | 593.8   |  |   |         | 687.8   | 
|                                                                    |                           |                    |         |                |  |      |         |         |  |   |         |        
|Total portfolio                                                     |                           | $                  | 1,685.6 |                |  | $    | 1,742.1 |         |  | $ | 1,902.7 |        
|                                                                    |                           |                    |         |                |  |      |         |         |  |   |         |        
|Investments funded(1)                                               |                           | $                  | 157.7   |                |  | $    | 110.1   |         |  | $ | 498.0   |        
|Change in accrued or reinvested interest and
    dividends          |                           | $                  | 11.1    |                |  | $    | 11.3    |         |  | $ | 41.8    |        
|Principal collections related to investment
    repayments or sales |                           | $                  | 204.8   |                |  | $    | 75.1    |         |  | $ | 314.3   |        
|Yield(2)                                                            |                           |                    | 14.4    | %              |  |      | 14.0    | %       |  |   | 15.0    | %      






|    |                                                                                                                                                                                                                                                                                                                                                                                                            
|--- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(1) | Investments funded for the three months ended
    March 31, 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.

41



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##### 



Investments funded for the three months ended
March 31, 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 Three Months Ended March 31,
    2004(1) |                               |            |   |           |       |       |   |      |      |  |   |      
|                                                 | Companies more than 25% owned |            | $ | 16.1      |       |       | $ | 1.4  |      |  | $ | 17.5  |      
|                                                 | Companies 5% to 25% owned     |            |   | 10.8      |       |       |   | 15.4 |      |  |   | 26.2  |      
|                                                 | Companies less than 5% owned  |            |   | 108.9     |       |       |   | 5.1  |      |  |   | 114.0 |      
|                                                 |                               |            |   |           |       |       |   |      |      |  |   |      
|                                                 |                               | Total      |   | $         | 135.8 |       |   | $    | 21.9 |  |   | $     | 157.7 | 
|                                                 |                               |            |   |           |       |       |   |      |      |  |   |      
|For the Three Months Ended March 31,
    2003(1) |                               |            |   |           |       |       |   |      |      |  |   |      
|                                                 | Companies more than 25% owned |            | $ | 33.2      |       |       | $ | 25.0 |      |  | $ | 58.2  |      
|                                                 | Companies 5% to 25% owned     |            |   | 7.9       |       |       |   | 1.0  |      |  |   | 8.9   |      
|                                                 | Companies less than 5% owned  |            |   | 41.2      |       |       |   | 1.8  |      |  |   | 43.0  |      
|                                                 |                               |            |   |           |       |       |   |      |      |  |   |      
|                                                 |                               | Total      |   | $         | 82.3  |       |   | $    | 27.8 |  |   | $     | 110.1 | 
|                                                 |                               |            |   |           |       |       |   |      |      |  |   |      
|For the Year Ended December 31,
    2003(1)      |                               |            |   |           |       |       |   |      |      |  |   |      
|                                                 | 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 | 
|                                                 |                               |            |   |           |       |       |   |      |      |  |   |      




|    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
|--- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(1) | The private finance portfolio is presented in
    three categories  companies more than 25% owned,
    which represent portfolio companies where we directly or
    indirectly own more than 25% of the outstanding voting
    securities of such portfolio company and, therefore, are deemed
    controlled by us under the Investment Company Act of 1940, or
    the 1940 Act; companies owned 5% to 25%, which represent
    portfolio companies where we directly or indirectly own 5% to
    25% of the outstanding voting securities of such portfolio
    company or where we hold one or more seats on the portfolio
    companys board of directors and, therefore, are deemed to
    be an affiliated person under the 1940 Act; and companies less
    than 5% owned, which represent portfolio companies where we
    directly or indirectly own less than 5% of the outstanding
    voting securities of such portfolio company and where we have no
    other affiliations with such portfolio company.

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.

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, 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. We realized a gain of
$149.0 million on the transaction. The sale of Hillman is
subject to certain post-closing working capital and other
adjustments.

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.

42



---



##### 



At March 31, 2004, we had outstanding
investment commitments to private finance portfolio companies
totaling $458.4 million. In addition, we had commitments to
private finance portfolio companies in the form of standby
letters of credit and guarantees totaling $121.5 million.

Significant outstanding investment commitments at
March 31, 2004, included the following:



| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         
| | - | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | Approximately $133 million in the form of
    subordinated debt and equity to recapitalize and acquire a
    majority interest in Advantage Sales & Marketing, Inc.,
    a leading sales and marketing agency providing outsourced sales,
    merchandising, and marketing services to the consumer packaged
    goods industry. The closing of this transaction is subject to
    customary closing conditions, including regulatory and
    shareholder approvals and certain other adjustments, and is
    anticipated to close near the end of the second quarter of 2004.                                                                                                                                                                                                                                                                          
|
| |  | $93.6 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, $41.8 million to purchase preferred equity
    securities in Callidus future CDO or CLO transactions, and
    $1.8 million for working capital needs. At March 31,
    2004, we had an investment in Callidus totaling
    $5.5 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.
|
| |   | During the first quarter of 2004, Callidus
    obtained a secured warehouse credit facility for up to
    $300 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 $30 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.                                                                                                                                                                                                                                                                                                                                                           
|
| |  | Approximately $91 million in debt and equity
    financing to acquire Mercury Air Centers, Inc. (Mercury), a
    provider of fixed base operations at airports throughout the
    United States. This transaction closed on April 12, 2004,
    and we funded approximately $81 million, including closing
    costs. The purchase of Mercury is subject to post-closing
    adjustments. In addition to the amounts funded at closing, we
    have committed to fund $10 million in senior subordinated
    debt for future working capital and construction commitments. In
    connection with the transaction, Mercury Air Group, Inc. repaid
    its $24.0 million subordinated debt obligation to us.                                                                                                                                             

Our most significant investment at March 31,
2004, was in Business Loan Express, LLC (BLX), which was
acquired in 2000.

Business Loan Express,
LLC.At
March 31, 2004, our investment in BLX totaled
$259.6 million at cost and $337.4 million at value, or
11.2% of our total assets, which includes unrealized
appreciation of $77.8 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.

43



---



##### 



Summary financial data for BLX at and for the six
months ended March 31, 2004, and at and for its fiscal year
ended September 30, 2003, is presented below. Summary
financial data has been provided by BLX and is unaudited.

|                                    |                                                                    |                           |                         |                |       |       |   |         |       |       |  
|----------------------------------- | ------------------------------------------------------------------ | ------------------------- | ----------------------- | -------------- | ----- | ----- | - | ------- | ----- | ----- | -
|                                    |                                                                    |                           |                         | At and for the
|                                    |                                                                    |                           |                         | Fiscal Year   
|                                    |                                                                    | At and for the            |                         | Ended         
|                                    |                                                                    | Six Months Ended          |                         | September 30, 
|                                    |                                                                    | March 31, 2004(1)         |                         | 2003          
|($ in millions)                     |                                                                    |                           |                         |               
|Operating Data                      |                                                                    |                           |                         |                |       |       |   |        
|                                    | Total revenue                                                      |                           | $                       | 60.6           |       |       | $ | 108.3   |      
|                                    | Net income(2)                                                      |                           | $                       | 9.7            |       |       | $ | 4.7     |      
|                                    | Earnings before interest, taxes and management
    fees (EBITM)(2) |                           | $                       | 26.4           |       |       | $ | 37.5    |      
|Balance Sheet Data                  |                                                                    |                           |                         |                |       |       |   |        
|                                    | Total assets                                                       |                           | $                       | 382.8          |       |       | $ | 353.0   |      
|                                    | Total debt                                                         |                           | $                       | 190.1          |       |       | $ | 178.5   |      
|                                    | Total owners equity                                               |                           | $                       | 144.0          |       |       | $ | 136.1   |      
|Other Data                          |                                                                    |                           |                         |                |       |       |   |        
|                                    | Loan originations                                                  |                           |                         |                |       |       |   |         |      
|                                    |                                                                    | 7(a) originations         |                         | $              | 179.6 |       |   | $       | 502.4 |      
|                                    |                                                                    | Conventional originations |                         |                | 127.8 |       |   |         | 151.6 |      
|                                    |                                                                    | B&I originations          |                         |                | 11.4  |       |   |         | 31.8  |      
|                                    |                                                                    |                           |                         |                |       |       |   |        
|                                    |                                                                    |                           | Total loan originations |                | $     | 318.8 |   |         | $     | 685.8 |  
|                                    |                                                                    |                           |                         |                |       |       |   |        
|                                   
|                                    | Serviced loan portfolio                                            |                           | $                       | 2,407.4        |       |       | $ | 2,227.4 |      
|                                    | Number of loans                                                    |                           |                         | 3,384          |       |       |   | 3,136   |      
|                                    | Loan delinquencies(3)                                              |                           |                         | 8.4            | %     |       |   | 8.3     | %    
|Serviced Loan Portfolio by Industry |                                                                    |                           |                         |                |       |       |   |        
|                                    | Hotels                                                             |                           |                         | 23             | %     |       |   | 24      | %    
|                                    | Gas stations/convenience stores                                    |                           |                         | 19             |       |       |   | 19      |      
|                                    | Professional and retail services                                   |                           |                         | 12             |       |       |   | 12      |      
|                                    | Restaurants                                                        |                           |                         | 9              |       |       |   | 9       |      
|                                    | Manufacturing and industrial                                       |                           |                         | 9              |       |       |   | 9       |      
|                                    | Car wash/auto repair services                                      |                           |                         | 7              |       |       |   | 7       |      
|                                    | Child care and health care services                                |                           |                         | 6              |       |       |   | 6       |      
|                                    | Recreation                                                         |                           |                         | 4              |       |       |   | 5       |      
|                                    | Shrimp/fishing vessels                                             |                           |                         | 4              |       |       |   | 5       |      
|                                    | Other                                                              |                           |                         | 7              |       |       |   | 4       |      
|                                    |                                                                    |                           |                         |                |       |       |   |        
|                                    |                                                                    |                           | Total                   |                |       | 100   | % |         |       | 100   | %
|                                    |                                                                    |                           |                         |                |       |       |   |        



---

|    |                                                                                                                                                                                 | 
|--- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- | 
|(1) | The results of operations for the six months
    ended March 31, 2004, are not necessarily indicative of the
    operating results to be expected for the full fiscal
    year. | 



|    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           | 
|--- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- | 
|(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 8.3% at March 31, 2004. SBA 7(a) loans
    greater than one year old at March 31, 2004, had a
    delinquency rate of 10.3%. 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. For these reasons, BLX focuses on
    collateral protection for each loan in addition to the cash flow
    of the small business and receives personal guarantees from the
    principal owners of the small business. | 

44



---



##### 





|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     | 
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- | 
|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 77% of
    BLXs revenue of $60.6 million for the six months
    ended March 31, 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 six
months ended March 31, 2004, totaled $318.8 million.
Proceeds from loan sales during the six months ended
March 31, 2004, totaled approximately $311.9 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. 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s loan originations were
$130.5 million for the quarter ended March 31, 2004, as
compared to $188.3 million for the quarter ended
December 31, 2003. During the quarter ended March 31, 2004,
the SBA 7(a) guaranteed loan program imposed certain lending
constraints, including imposing a maximum loan size cap of
$750,000. On April 5, 2004, certain amendments to the
SBA 7(a) program were signed into law. The amended program
removed the $750,000 loan cap and the program now provides for a
maximum SBA 7(a) guaranteed loan of $2 million with a
maximum loan guarantee of $1.5 million.

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 six
months ended March 31, 2004, were approximately
$14.3 million in total. Cash premiums received from
guaranteed loan sales during the fiscal year ended
September 30, 2003, were approximately $31.3 million
in total. 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 4.8% 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,

45



---



##### 



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 six
months ended March 31, 2004, BLX received cash payments
from the Residual Interest of approximately $27.4 million.
For the fiscal year ended September 30, 2003, BLX received
cash payments from the Residual Interest of approximately
$49.3 million.


At March 31, 2004, BLXs Residual
Interest totaled $195.0 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
$812.7 million over time, with approximately
$67.4 million, $58.8 million, $57.1 million, and
$55.5 million (or $238.8 million in the aggregate)
scheduled to be received in the next four years ending on
March 31, 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 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 three months ended March 31, 2004
and 2003, BLX paid dividends to us in cash or in kind on the
Class A interests totaling $3.0 million and
$1.8 million, respectively. In addition, for the three
months ended March 31, 2004 and 2003, BLX paid dividends to
us on the Class B interests totaling $2.0 million and
$1.0 million, respectively, and this dividend was paid to
us through the issuance of additional Class B equity
interests.

At March 31, 2004, BLX had a three-year
$215.0 million revolving credit facility that matures in
January 2007. Subsequent to March 31, 2004, the commitments
under the revolving credit facility have been increased to
$260.0 million. 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. The principal amount
outstanding on the revolving credit facility at March 31,
2004, was $148.9 million and the amount guaranteed by us
was $74.6 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
March 31, 2004. At March 31, 2004, we had also
provided four standby letters of credit totaling
$35.6 million in connection with four term securitization
transactions completed by BLX.

46



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##### 



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 months ended March 31,
2004 and 2003, and at and for the year ended December 31,
2003, were as follows:

|                                                                    |                                |                              |       |                |  |              |  |          |  |       |       |          |  |  |  |       |  |   |       |       |  |  |  |       | 
|------------------------------------------------------------------- | ------------------------------ | ---------------------------- | ----- | -------------- |  | ------------ |  | -------- |  | ----- | ----- | -------- |  |  |  | ----- |  | - | ----- | ----- |  |  |  | ----- | 
|                                                                    |                                |                              |       |                |  |             
|                                                                    |                                | At and for the               |       |               
|                                                                    |                                | Three Months Ended March 31, |       | At and for    
|                                                                    |                                |                              |       | the Year Ended
|                                                                    |                                |                              |       |                |  | December 31,
|                                                                    |                                | 2004                         |       | 2003           |  | 2003        
|                                                                    |                                |                              |       |                |  |             
|                                                                    |                                |                              |       |               
|                                                                    |                                | (unaudited)                  |       |               
|                                                                    |                                | Value                        |       | Yield(1)       |  | Value        |  | Yield(1) |  | Value |       | Yield(1)
|($ in millions)                                                     |                                |                              |       |                |  |              |  |          |  |       |       |         
|Portfolio at value:                                                 |                                |                              |       |                |  |              |  |          |  |       |       |          |  |  |  |       |  |   |       |       |  |  |  |      
|                                                                    | CMBS bonds                     |                              | $     | 448.9          |  |              |  | 13.7%    |  |       | $     | 326.5    |  |  |  | 15.5% |  |   | $     | 394.0 |  |  |  | 14.1% | 
|                                                                    | CDO bonds and preferred shares |                              |       | 171.4          |  |              |  | 17.6%    |  |       |       | 172.0    |  |  |  | 16.4% |  |   |       | 186.6 |  |  |  | 16.7% | 
|                                                                    | Commercial mortgage loans      |                              |       | 74.8           |  |              |  | 7.8%     |  |       |       | 63.7     |  |  |  | 7.0%  |  |   |       | 83.6  |  |  |  | 8.6%  | 
|                                                                    | Residual interest              |                              |       |               |  |              |  |         |  |       |       | 69.0     |  |  |  | 9.4%  |  |   |       |      |  |  |  |      | 
|                                                                    | Real estate owned              |                              |       | 14.3           |  |              |  |          |  |       |       | 3.6      |  |  |  |       |  |   |       | 12.8  |  |  |  |       | 
|                                                                    | Equity interests               |                              |       | 4.6            |  |              |  |          |  |       |       |         |  |  |  |       |  |   |       | 4.9   |  |  |  |       | 
|                                                                    |                                |                              |       |                |  |              |  |          |  |       |       |          |  |  |  |       |  |   |       |       |  |  |  |      
|Total portfolio                                                     |                                | $                            | 714.0 |                |  |              |  |          |  | $     | 634.8 |          |  |  |  |       |  | $ | 681.9 |       |  |  |  |      
|                                                                    |                                |                              |       |                |  |              |  |          |  |       |       |          |  |  |  |       |  |   |       |       |  |  |  |      
|Investments funded                                                  |                                | $                            | 60.1  |                |  |              |  |          |  | $     | 158.9 |          |  |  |  |       |  | $ | 433.5 |       |  |  |  |      
|Change in accrued or reinvested interest                            |                                | $                            | 2.0   |                |  |              |  |          |  | $     | (0.2  | )        |  |  |  |       |  | $ | 3.2   |       |  |  |  |      
|Principal collections related to investment
    repayments or sales |                                | $                            | 32.3  |                |  |              |  |          |  | $     | 245.0 |          |  |  |  |       |  | $ | 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 three months ended March 31, 2004 and 2003, and for
the year ended December 31, 2003, was as follows:

|                                              |       |        |       |          |  |        |        |        |   |   |       |       | 
|--------------------------------------------- | ----- | ------ | ----- | -------- |  | ------ | ------ | ------ | - | - | ----- | ----- | 
|                                              |       | Face   |       |          |  | Amount
|                                              |       | Amount |       | Discount |  | Funded
|($ in millions)                               |       |        |       |          |  |       
|For the Three Months Ended March 31,
    2004 |       |        |       |          |  |        |        |        |   |   |       |      
|CMBS bonds                                    |       | $      | 114.3 |          |  | $      | (54.9  | )      |   | $ | 59.4  |      
|Commercial mortgage loans                     |       |        | 0.6   |          |  |        |       |        |   |   | 0.6   |      
|Equity interests                              |       |        | 0.1   |          |  |        |       |        |   |   | 0.1   |      
|                                              |       |        |       |          |  |        |        |        |   |   |       |      
|                                              | Total |        | $     | 115.0    |  |        | $      | (54.9  | ) |   | $     | 60.1  | 
|                                              |       |        |       |          |  |        |        |        |   |   |       |      
|For the Three Months Ended March 31,
    2003 |       |        |       |          |  |        |        |        |   |   |       |      
|CMBS bonds                                    |       | $      | 90.4  |          |  | $      | (49.6  | )      |   | $ | 40.8  |      
|CDO preferred shares                          |       |        | 118.4 |          |  |        | (0.3   | )      |   |   | 118.1 |      
|                                              |       |        |       |          |  |        |        |        |   |   |       |      
|                                              | Total |        | $     | 208.8    |  |        | $      | (49.9  | ) |   | $     | 158.9 | 
|                                              |       |        |       |          |  |        |        |        |   |   |       |      
|For the Year Ended December 31,
    2003      |       |        |       |          |  |        |        |        |   |   |       |      
|CMBS bonds                                    |       | $      | 508.5 |          |  | $      | (225.9 | )      |   | $ | 282.6 |      
|CDO bonds and preferred shares                |       |        | 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 | 
|                                              |       |        |       |          |  |        |        |        |   |   |       |      

47



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##### 



At March 31, 2004, we had outstanding
funding commitments related to commercial mortgage loans and
equity interests of $4.3 million and commitments in the
form of standby letters of credit and guarantees related to
equity interests of $2.7 million.

CMBS Bonds.During the three months ended
March 31, 2004, we invested $48.9 million in four CMBS
bond issuances, including $8.7 million of investments in
BB+, BB and BB- rated bonds in two CMBS issuances where the
below BB- rated bonds were purchased by other parties. In
addition, we acquired CMBS bonds rated BB+ through CCC with a
face amount of $14.3 million for a total purchase price of
$10.5 million. During the three months ended March 31,
2003, we invested $40.8 million in two CMBS bond issuances.
During the year ended December 31, 2003, we invested
$282.6 million in 18 CMBS bond issuances, including
$73.4 million of investments in BB+, BB and BB- rated bonds
in eight CMBS issuances where the below BB- rated bonds were
purchased by other parties.

The underlying pools of mortgage loans that are
collateral for our investments in new CMBS bond issuances for
the three months ended March 31, 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 Three Months Ended |         |            |  |                   
|                               |  | March 31,                  |         |            |  |                   
|                               |  |                            |         |           
|                               |  |                            |         |            |  | For the Year Ended
|                               |  | 2004                       |         | 2003       |  | December 31, 2003 
|                               |  |                            |         |            |  |                   
|Loan to Value Ranges           |  | Amount                     |         | Percentage |  | Amount             |     | Percentage |  | Amount |         | Percentage
|($ in millions)                |  |                            |         |            |  |                    |     |            |  |        |         |           
|Less than 60%                  |  | $                          | 1,309.0 |            |  |                    | 26  | %          |  | $      | 1,217.0 |            |  |  | 41  | % |  | $ | 4,114.3  |   |  |  | 22  | %
|60-65%                         |  |                            | 465.1   |            |  |                    | 9   |            |  |        | 400.0   |            |  |  | 13  |   |  |   | 1,582.8  |   |  |  | 9   |  
|65-70%                         |  |                            | 447.0   |            |  |                    | 9   |            |  |        | 237.7   |            |  |  | 8   |   |  |   | 1,768.0  |   |  |  | 10  |  
|70-75%                         |  |                            | 966.6   |            |  |                    | 20  |            |  |        | 323.4   |            |  |  | 11  |   |  |   | 4,024.3  |   |  |  | 22  |  
|75-80%                         |  |                            | 1,527.2 |            |  |                    | 31  |            |  |        | 795.1   |            |  |  | 27  |   |  |   | 6,560.5  |   |  |  | 36  |  
|Greater than 80%               |  |                            | 254.1   |            |  |                    | 5   |            |  |        | 9.5     |            |  |  |    |   |  |   | 138.6    |   |  |  | 1   |  
|                               |  |                            |         |            |  |                    |     |            |  |        |         |            |  |  |     |   |  |   |          |   |  |  |     |  
|Total                          |  | $                          | 4,969.0 |            |  |                    | 100 | %          |  | $      | 2,982.7 |            |  |  | 100 | % |  | $ | 18,188.5 |   |  |  | 100 | %
|                               |  |                            |         |            |  |                    |     |            |  |        |         |            |  |  |     |   |  |   |          |   |  |  |     |  
|Weighted average loan to value |  |                            | 66.5    | %          |  |                    |     |            |  |        | 63.4    | %          |  |  |     |   |  |   | 68.5     | % |  |  |     |  

48



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##### 



|                                             |  |                            |         |            |  |                    |     |            |  |        |         |            |  |  |     |   |  |   |          |  |  |  |     |  
|-------------------------------------------- |  | -------------------------- | ------- | ---------- |  | ------------------ | --- | ---------- |  | ------ | ------- | ---------- |  |  | --- | - |  | - | -------- |  |  |  | --- | -
|                                             |  |                            |         |            |  |                   
|                                             |  | For the Three Months Ended |         |            |  |                   
|                                             |  | March 31,                  |         |            |  |                   
|                                             |  |                            |         |           
|                                             |  |                            |         |            |  | 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                            |  | $                          | 832.1   |            |  |                    | 17  | %          |  | $      | 1,323.4 |            |  |  | 45  | % |  | $ | 4,208.7  |  |  |  | 23  | %
|1.76-2.00                                    |  |                            | 276.6   |            |  |                    | 6   |            |  |        | 368.7   |            |  |  | 12  |   |  |   | 2,094.6  |  |  |  | 12  |  
|1.51-1.75                                    |  |                            | 607.8   |            |  |                    | 12  |            |  |        | 515.8   |            |  |  | 17  |   |  |   | 3,132.8  |  |  |  | 17  |  
|1.26-1.50                                    |  |                            | 2,434.9 |            |  |                    | 49  |            |  |        | 741.5   |            |  |  | 25  |   |  |   | 7,362.9  |  |  |  | 40  |  
|Less than 1.25                               |  |                            | 817.6   |            |  |                    | 16  |            |  |        | 33.3    |            |  |  | 1   |   |  |   | 1,389.5  |  |  |  | 8   |  
|                                             |  |                            |         |            |  |                    |     |            |  |        |         |            |  |  |     |   |  |   |          |  |  |  |     |  
|Total                                        |  | $                          | 4,969.0 |            |  |                    | 100 | %          |  | $      | 2,982.7 |            |  |  | 100 | % |  | $ | 18,188.5 |  |  |  | 100 | %
|                                             |  |                            |         |            |  |                    |     |            |  |        |         |            |  |  |     |   |  |   |          |  |  |  |     |  
|Weighted average debt service coverage ratio |  |                            | 1.61    |            |  |                    |     |            |  |        | 1.91    |            |  |  |     |   |  |   | 1.73     |  |  |  |     |  

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 three months ended March 31, 2004
and 2003, and for the year ended December 31, 2003, were as
follows:

|                                                              |  |               |     |              |  |      |       |   |  |   |       |  
|------------------------------------------------------------- |  | ------------- | --- | ------------ |  | ---- | ----- | - |  | - | ----- | -
|                                                              |  |               |     |             
|                                                              |  | For the Three |     |             
|                                                              |  | Months Ended  |     | For the Year
|                                                              |  | March 31,     |     | Ended       
|                                                              |  |               |     | December 31,
|                                                              |  | 2004          |     | 2003         |  | 2003
|($ in millions)                                               |  |               |     |              |  |     
|Cost basis                                                    |  | $             | 6.3 |              |  | $    | 244.1 |   |  | $ | 412.3 |  
|Gross sales proceeds(1)                                       |  | $             | 6.4 |              |  | $    | 275.1 |   |  | $ | 446.8 |  
|Net realized gains (net of related hedge gains or
    losses) |  | $             | 0.1 |              |  | $    | 24.6  |   |  | $ | 31.6  |  
|Weighted average yield                                        |  |               | 7.7 | %            |  |      | 11.9  | % |  |   | 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 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 resulting in
reduced cash flows, our most subordinate tranche will bear this
loss first. At March 31, 2004, the face value of the CMBS
bonds we held were subordinate to 84% 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 three months ended
March 31, 2004

49



---



##### 



and 2003, and for the year ended
December 31, 2003, the average discount for the CMBS bonds
in which we invested was 48%, 55% and 44%, respectively.


At March 31, 2004, the unamortized discount
related to the CMBS bond portfolio was $670.4 million, of
which $323.3 million has been set aside to absorb potential
future losses. The yield on the CMBS bonds of 13.7% 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 March 31, 2004, the CMBS bond portfolio had a
fair value of $448.9 million, which included net unrealized
depreciation on the CMBS bonds of $2.5 million.

The yield on our CMBS bond portfolio at
March 31, 2004 and 2003, and December 31, 2003, was
13.7%, 15.5% and 14.1%, respectively. The yield on the CMBS bond
portfolio at any point in time will vary depending on the
concentration of lower yielding BB+, BB, and BB- rated CMBS
bonds held in the portfolio. The BB+, BB, and BB- rated CMBS
bonds totaled $120.8 million, $78.9 million and
$88.4 million at value and had a yield of 7.8%, 8.4%, and
8.2% at March 31, 2004 and 2003, and December 31,
2003, respectively.

At March 31, 2004, and December 31,
2003, we held CMBS bonds in 43 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
March 31, 2004, and December 31, 2003:

|                                                                      |  |      |          |      |  |  |          | 
|--------------------------------------------------------------------- |  | ---- | -------- | ---- |  |  | -------- | 
|                                                                      |  | 2004 |          | 2003
|($ in million)                                                        |  |      |          |     
|Approximate number of loans and REO
    properties(1)                 |  |      | 6,100    |      |  |  | 5,600    | 
|Total outstanding principal balance                                   |  | $    | 42,269   |      |  |  | $38,437  | 
|Loans over 30 days delinquent or classified
    as REO properties (2) |  |      | 1.3% (3) |      |  |  | 1.5% (3) | 



---

|    |                                                                                                                                                                                                                                                                                                                                                                                                    
|--- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(1) | Includes approximately 28 and 22 REO properties
    obtained through the foreclosure of commercial mortgage loans at
    March 31, 2004, and December 31, 2003, respectively.                                                                                                                                                                                                                      
|(2) | As a percentage of total outstanding principal
    balance.                                                                                                                                                                                                                                                                                                                                        
|(3) | At March 31, 2004, and December 31,
    2003, our investments included bonds in the first loss, unrated
    bond class in 37 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 March 31, 2004, and
    December 31, 2003, respectively.

At March 31, 2004, and December 31,
2003, the age of our bonds with a rating class of B+ and lower
was as follows:

|                         |       |       |       |            |  |       |      |            |   |   |       |       |  |  |      |       |  
|------------------------ | ----- | ----- | ----- | ---------- |  | ----- | ---- | ---------- | - | - | ----- | ----- |  |  | ---- | ----- | -
|                         |       |       |       |           
|                         |       | 2004  |       | 2003      
|                         |       |       |       |           
|                         |       | Value |       | Percentage |  | Value |      | Percentage
|($ in millions)          |       |       |       |            |  |       |      |           
|Less than one year old   |       | $     | 93.9  |            |  |       | 28.6 | %          |   | $ | 83.9  |       |  |  | 27.5 | %    
|One to two years old     |       |       | 50.8  |            |  |       | 15.5 |            |   |   | 41.0  |       |  |  | 13.4 |      
|Two to three years old   |       |       | 39.9  |            |  |       | 12.2 |            |   |   | 43.8  |       |  |  | 14.3 |      
|Three years old or older |       |       | 143.5 |            |  |       | 43.7 |            |   |   | 136.9 |       |  |  | 44.8 |      
|                         |       |       |       |            |  |       |      |            |   |   |       |       |  |  |      |      
|                         | Total |       | $     | 328.1      |  |       |      | 100.0      | % |   | $     | 305.6 |  |  |      | 100.0 | %
|                         |       |       |       |            |  |       |      |            |   |   |       |       |  |  |      |      

Collateralized Debt Obligation Bonds and
Preferred Shares.During the three
months ended March 31, 2004, we did not invest in any
collateralized debt obligations (CDO). During the three months
ended March 31, 2003, and the year ended December 31,
2003, we invested in the BBB rated

50



---



##### 



bonds, BB rated bonds and preferred shares of one
and three CDOs, respectively. The CDOs are generally secured by
investment grade unsecured debt issued by various real estate
investment trusts, or REITs, and investment and non-investment
grade CMBS bonds.


During the three months ended March 31,
2004, and the year ended December 31, 2003, we sold CDO
bonds with a cost basis of $16.3 million and
$13.9 million, for a net realized gain of $0.1 million
and a net realized loss of $0.1 million, net of the related
hedge gain and loss, respectively. The yield on the CDO bonds
sold was 7.6% for both periods presented. There were no sales
during the three months ended March 31, 2003.

The BB rated bonds and the preferred shares of
the seven 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 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 March 31, 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 March 31, 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 March 31, 2004 and 2003, and December 31,
2003, was 17.6%, 16.4% 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 March 31, 2004, and December 31,
2003, the underlying collateral for our investments in the seven
outstanding CDO issuances had balances as follows:

|                                   |                  |      |         |         |  |   |         |         | 
|---------------------------------- | ---------------- | ---- | ------- | ------- |  | - | ------- | ------- | 
|                                   |                  | 2004 |         | 2003   
|($ in millions)                    |                  |      |         |        
|Investment grade REIT debt(1)      |                  | $    | 1,338.0 |         |  | $ | 1,338.0 |        
|Investment grade CMBS bonds(2)     |                  |      | 676.4   |         |  |   | 662.3   |        
|Non-investment grade CMBS bonds(3) |                  |      | 1,119.4 |         |  |   | 1,133.7 |        
|Other collateral                   |                  |      | 31.7    |         |  |   | 32.4    |        
|                                   |                  |      |         |         |  |   |         |        
|                                   | Total collateral |      | $       | 3,165.5 |  |   | $       | 3,166.4 | 
|                                   |                  |      |         |         |  |   |         |        



---

|    |                                                                               
|--- | ------------------------------------------------------------------------------
|(1) | Issued by 44 REITs for each of the respective
    periods presented.          
|(2) | Issued in 79 and 78 transactions, respectively,
    for the periods presented.
|(3) | Issued in 68 transactions for each of the
    respective 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.

51



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

|                |  |                   |         |                      |  |           |       |                 |  |   |         |  |  |  |       |  
|--------------- |  | ----------------- | ------- | -------------------- |  | --------- | ----- | --------------- |  | - | ------- |  |  |  | ----- | -
|                |  |                   |         |                     
|                |  | At March 31, 2004 |         | At December 31, 2003
|                |  |                   |         |                     
|                |  | Portfolio         |         | Percentage of        |  | Portfolio |       | Percentage of  
|Grade           |  | at Value          |         | Total Portfolio      |  | at Value  |       | Total Portfolio
|                |  |                   |         |                      |  |           |       |                
|($ in millions) |  |                   |         |                      |  |           |       |                
|1               |  | $                 | 687.0   |                      |  |           | 28.6  | %               |  | $ | 985.1   |  |  |  | 38.1  | %
|2               |  |                   | 1,467.9 |                      |  |           | 61.2  |                 |  |   | 1,271.4 |  |  |  | 49.2  |  
|3               |  |                   | 112.9   |                      |  |           | 4.7   |                 |  |   | 212.4   |  |  |  | 8.2   |  
|4               |  |                   | 62.2    |                      |  |           | 2.6   |                 |  |   | 34.7    |  |  |  | 1.4   |  
|5               |  |                   | 69.6    |                      |  |           | 2.9   |                 |  |   | 81.0    |  |  |  | 3.1   |  
|                |  |                   |         |                      |  |           |       |                 |  |   |         |  |  |  |       |  
|                |  | $                 | 2,399.6 |                      |  |           | 100.0 | %               |  | $ | 2,584.6 |  |  |  | 100.0 | %
|                |  |                   |         |                      |  |           |       |                 |  |   |         |  |  |  |       |  

The total portfolio at value at March 31,
2004, was $185.0 million lower than the total portfolio at
value at December 31, 2003, 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 new subordinated debt in Hillman in
conjunction with the sale and this new debt was included in
Grade 2 assets at March 31, 2004. The net cash
proceeds to us from the sale of Hillman of $196.8 million
were included in cash and cash equivalents at March 31,
2004, pending being reinvested into the portfolio. 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 March 31, 2004, will
necessarily result in a realized gain or loss.

Total Grade 4 and 5 assets were
$131.8 million and $115.7 million, or 5.5% and 4.5% of
the total portfolio at value at March 31, 2004, and
December 31, 2003, respectively. Total Grade 3, 4 and 5
assets declined to $244.7 million at March 31, 2004,
from $328.1 million at December 31, 2003. Included in
Grade 4 and 5 assets at March 31, 2004, and
December 31, 2003, were assets totaling $28.2 million
and $26.8 million, respectively, that are secured by
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 Grades 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
Grades 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.Loans and debt securities
on non-accrual status for which we have doubt about interest
collection and are in workout status are classified as
Grade 4 or 5 assets. In addition, from time to time we may
not accrue interest on loans and debt securities to companies
that are more than 50% owned by us depending on such
companys working capital needs. In these situations we may
choose to defer current debt service.

52



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At March 31, 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) |                               | $    | 91.0 |       |  | $ | 69.4 |      
|Not in workout  companies more
    than 50% owned                              |                               |      | 35.0 |       |  |   | 31.9 |      
|Not in workout  companies less
    than 50% owned(2)                           |                               |      | 41.1 |       |  |   | 16.7 |      
|                                                                                |                               |      |      |       |  |   |      |      
|                                                                                | Total                         |      | $    | 167.1 |  |   | $    | 118.0 | 
|                                                                                |                               |      |      |       |  |   |      |      
|                                                                                | Percentage of total portfolio |      |      | 7.0%  |  |   |      | 4.6%  | 



---

|    |                                                                                                                                                                                                                                                                       
|--- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(1) | Workout loans and debt securities exclude equity
    securities that are included in the total Grade 4 and 5
    assets above. Includes commercial real estate loans of
    $10.2 million and $6.8 million at March 31, 2004,
    and December 31, 2003, respectively.
|   
|(2) | Includes commercial real estate loans of
    $1.8 million at March 31, 2004.                                                                                                                                                                                          

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

|                               |                           |                               |      |      |       |   |      |      |       | 
|------------------------------ | ------------------------- | ----------------------------- | ---- | ---- | ----- | - | ---- | ---- | ----- | 
|                               |                           | 2004                          |      | 2003
|                               |                           |                               |      |     
|($ in millions)                |                           |                               |      |     
|Private finance                |                           | $                             | 88.3 |      |       | $ | 85.6 |     
|Commercial real estate finance |                           |                               |      |      |       |   |      |     
|                               | CMBS bonds                |                               |      | 53.6 |       |   |      | 40.3 |      
|                               | Commercial mortgage loans |                               |      | 4.9  |       |   |      | 3.7  |      
|                               |                           |                               |      |      |       |   |      |     
|                               |                           | Total                         |      | $    | 146.8 |   |      | $    | 129.6 | 
|                               |                           |                               |      |      |       |   |      |     
|                               |                           | Percentage of total portfolio |      |      | 6.1%  |   |      |      | 5.0%  | 

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

53



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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 $111.7 million and $98.5 million at
March 31, 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 $111.7 million and
$98.5 million at March 31, 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.

54



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##### 



RESULTS OF OPERATIONS

Comparison of Three Months Ended
March 31, 2004 and 2003

The following table summarizes the Companys
operating results for the three months ended March 31, 2004
and 2003.

|                                                         |                                                           |                                             |         |          |         |            |         |         |         |   |        |          |        |   |     |     |    |  
|-------------------------------------------------------- | --------------------------------------------------------- | ------------------------------------------- | ------- | -------- | ------- | ---------- | ------- | ------- | ------- | - | ------ | -------- | ------ | - | --- | --- | -- | -
|                                                         |                                                           |                                             |         |          |         |           
|                                                         |                                                           | For the Three                               |         |          |         |           
|                                                         |                                                           | Months Ended                                |         |          |         |           
|                                                         |                                                           | March 31,                                   |         |          |         |           
|                                                         |                                                           |                                             |         |          |         | Percentage
|                                                         |                                                           | 2004                                        |         | 2003     |         | Change     |         | Change 
|($ in thousands, except per share amounts)               |                                                           |                                             |         |          |         |            |         |        
|                                                         |                                                           |                                             |         |          |         |           
|                                                         |                                                           | (unaudited)                                 |         |          |         |           
|Interest and Related Portfolio Income                    |                                                           |                                             |         |          |         |            |         |         |         |   |        |          |        |   |     |    
|                                                         | Interest and dividends                                    |                                             | $       | 73,539   |         |            | $       | 65,521  |         |   | $      | 8,018    |        |   |     | 12  | % 
|                                                         | Loan prepayment premiums                                  |                                             |         | 950      |         |            |         | 1,121   |         |   |        | (171     | )      |   |     | (15 | )%
|                                                         | Fees and other income                                     |                                             |         | 7,276    |         |            |         | 6,488   |         |   |        | 788      |        |   |     | 12  | % 
|                                                         |                                                           |                                             |         |          |         |            |         |         |         |   |        |          |        |   |     |    
|                                                         |                                                           | Total interest and related portfolio income |         |          | 81,765  |            |         |         | 73,130  |   |        |          | 8,635  |   |     |     | 12 | %
|                                                         |                                                           |                                             |         |          |         |            |         |         |         |   |        |          |        |   |     |    
|Expenses                                                 |                                                           |                                             |         |          |         |            |         |         |         |   |        |          |        |   |     |    
|                                                         | Interest                                                  |                                             |         | 19,113   |         |            |         | 17,922  |         |   |        | 1,191    |        |   |     | 7   | % 
|                                                         | Employee                                                  |                                             |         | 8,862    |         |            |         | 8,121   |         |   |        | 741      |        |   |     | 9   | % 
|                                                         | Individual performance award                              |                                             |         | 3,493    |         |            |         |        |         |   |        | 3,493    |        |   |     | 100 | % 
|                                                         | Administrative                                            |                                             |         | 5,827    |         |            |         | 4,417   |         |   |        | 1,410    |        |   |     | 32  | % 
|                                                         |                                                           |                                             |         |          |         |            |         |         |         |   |        |          |        |   |     |    
|                                                         |                                                           | Total operating expenses                    |         |          | 37,295  |            |         |         | 30,460  |   |        |          | 6,835  |   |     |     | 22 | %
|                                                         |                                                           |                                             |         |          |         |            |         |         |         |   |        |          |        |   |     |    
|Net investment income before income taxes                |                                                           |                                             | 44,470  |          |         |            | 42,670  |         |         |   | 1,800  |          |        |   | 4   | %  
|Income tax expense (benefit)                             |                                                           |                                             | (75     | )        |         |            |        |         |         |   | (75    | )        |        |   | **  |    
|                                                         |                                                           |                                             |         |          |         |            |         |         |         |   |        |          |        |   |     |    
|Net investment income                                    |                                                           |                                             | 44,545  |          |         |            | 42,670  |         |         |   | 1,875  |          |        |   | 4   | %  
|                                                         |                                                           |                                             |         |          |         |            |         |         |         |   |        |          |        |   |     |    
|Net Realized and Unrealized Gains (Losses)               |                                                           |                                             |         |          |         |            |         |         |         |   |        |          |        |   |     |    
|                                                         | Net realized gains (losses)                               |                                             |         | 147,850  |         |            |         | 48,339  |         |   |        | 99,511   |        |   |     | *   |   
|                                                         | Net change in unrealized appreciation or
    depreciation |                                             |         | (172,087 | )       |            |         | (71,136 | )       |   |        | (100,951 | )      |   |     | *   |   
|                                                         |                                                           |                                             |         |          |         |            |         |         |         |   |        |          |        |   |     |    
|                                                         |                                                           | Total net gains (losses)                    |         |          | (24,237 | )          |         |         | (22,797 | ) |        |          | (1,440 | ) |     |     | *  |  
|                                                         |                                                           |                                             |         |          |         |            |         |         |         |   |        |          |        |   |     |    
|Net income                                               |                                                           | $                                           | 20,308  |          |         | $          | 19,873  |         |         | $ | 435    |          |        |   | 2   | %  
|                                                         |                                                           |                                             |         |          |         |            |         |         |         |   |        |          |        |   |     |    
|Diluted earnings per common share                        |                                                           | $                                           | 0.15    |          |         | $          | 0.18    |         |         | $ | (0.03  | )        |        |   | (17 | )% 
|                                                         |                                                           |                                             |         |          |         |            |         |         |         |   |        |          |        |   |     |    
|Weighted average common shares
    outstanding  diluted |                                                           |                                             | 131,968 |          |         |            | 110,098 |         |         |   | 21,870 |          |        |   | 20  | %  




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

Total 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 March 31, 2004 and 2003, was composed of the
following:

|                |                              |      |      |      |  |   |      |      | 
|--------------- | ---------------------------- | ---- | ---- | ---- |  | - | ---- | ---- | 
|                |                              | 2004 |      | 2003
|($ in millions) |                              |      |      |     
|Interest        |                              | $    | 69.9 |      |  | $ | 62.4 |     
|Dividends       |                              |      | 3.6  |      |  |   | 3.1  |     
|                |                              |      |      |      |  |   |      |     
|                | Total interest and dividends |      | $    | 73.5 |  |   | $    | 65.5 | 
|                |                              |      |      |      |  |   |      |     

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. The weighted average yield varies from period to period
based on the current stated interest rate earned on interest-

55



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##### 



bearing investments and the amount of loans and
debt securities for which interest is not accruing. Certain
loans were placed on non-accrual during the first quarter of
2004, which reduced interest income by $2.7 million for the
three months ended March 31, 2004. The interest-bearing
investments in the portfolio at value and the weighted average
yield on the interest-bearing investments in the portfolio at
March 31, 2004 and 2003, were as follows:


|                           |  |      |         |      |  |   |         |  
|-------------------------- |  | ---- | ------- | ---- |  | - | ------- | -
|                           |  | 2004 |         | 2003
|($ in millions)            |  |      |         |     
|Interest-bearing portfolio |  | $    | 1,892.0 |      |  | $ | 1,779.5 |  
|Portfolio yield            |  |      | 14.3    | %    |  |   | 14.0    | %

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 March 31,
2004 and 2003, includes $2.0 million and $1.0 million,
respectively, of dividends from BLX on the Class B equity
interests held by us. These dividends were paid through the
issuance of additional Class B equity interests.

Loan prepayment premiums were $1.0 million
and $1.1 million for the three months ended March 31,
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 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
March 31, 2004 and 2003, included fees relating to the
following:

|                                                                                                   |                             |      |     |      |  |   |     |     | 
|-------------------------------------------------------------------------------------------------- | --------------------------- | ---- | --- | ---- |  | - | --- | --- | 
|                                                                                                   |                             | 2004 |     | 2003
|($ in millions)                                                                                    |                             |      |     |     
|Structuring and diligence                                                                          |                             | $    | 1.8 |      |  | $ | 0.3 |    
|Transaction and other services provided to
    portfolio companies                                 |                             |      | 0.8 |      |  |   | 0.3 |    
|Management services provided to portfolio
    companies, other advisory services and guaranty fees |                             |      | 4.4 |      |  |   | 5.7 |    
|Other income                                                                                       |                             |      | 0.3 |      |  |   | 0.2 |    
|                                                                                                   |                             |      |     |      |  |   |     |    
|                                                                                                   | Total fees and other income |      | $   | 7.3  |  |   | $   | 6.5 | 
|                                                                                                   |                             |      |     |      |  |   |     |    

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.

BLX was our most significant investment at
March 31, 2004, and represented 11.2% of our total assets.
BLX and Hillman were our most significant portfolio investments
at March 31, 2003, and together represented 18.9% of our
total assets at March 31, 2003. As discussed above, we sold

56



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Hillman on March 31, 2004. Total interest
and related portfolio income earned from these investments for
the three months ended March 31, 2004 and 2003, were
$14.4 million and $15.3 million, respectively.


As part of the Hillman sale transaction, we were
repaid our existing $44.6 million in outstanding mezzanine debt
and received $47.5 million in new subordinated debt in
conjunction with the transaction. After the sale date, we will
no longer receive a management fee from Hillman. We estimate
that this sale transaction will result in a net reduction to
interest and related portfolio income for 2004 of
approximately $2.4 million.

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
March 31, 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 interest cost, including
fees and closing costs, at and for the three months ended
March 31, 2004 and 2003, were as follows:

|                         |  |                |       |      |  |   |       | 
|------------------------ |  | -------------- | ----- | ---- |  | - | ----- | 
|                         |  |               
|                         |  | At and for the
|                         |  | Three Months  
|                         |  | Ended         
|                         |  | March 31,     
|                         |  |               
|                         |  | 2004           |       | 2003
|($ in millions)          |  |                |       |     
|Total Outstanding Debt   |  | $              | 962.4 |      |  | $ | 856.0 | 
|Average Outstanding Debt |  | $              | 953.0 |      |  | $ | 891.3 | 
|Weighted Average Cost    |  |                | 7.5%  |      |  |   | 7.6%  | 

In addition to interest on indebtedness, interest
expense includes interest on our obligations to replenish
borrowed Treasury securities related to our hedging activities
of $0.9 million and $1.4 million for the three months
ended March 31, 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 133 and 110 at
March 31, 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 March 31, 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 compensation
program for our senior officers. In conjunction with the
program, the Board has approved a non-qualified deferred
compensation plan (DCP II), which will be administered
through a trust.

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 of the
Board of Directors has designed the DCP II, subject to
shareholder approval, to then require the trustee to use the
cash exclusively to purchase shares of our common stock in the
open market. Although no new shares will be issued as part of
the plan, DCP II is considered an equity compensation
plan under the New York Stock Exchange rules. As a result
of the requirement to invest in our common stock, the
DCP II is being submitted to stockholders for approval at
our Annual Meeting of Stockholders that will be held on
May 12, 2004.

57



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Amounts credited to participants under the
DCP II will be immediately vested once deposited by us into
the trust. A participants account shall become
distributable only after his or her termination of employment,
or in the event of a change of control of the Company. The
Compensation Committee of the Board of Directors may also
determine other distributable events and the timing of such
distributions.

For the three months ended March 31, 2004,
we accrued $3.5 million in IPA expense, or $0.026 per
share. Contribution of these amounts into the DCP II trust
is pending shareholder approval to invest the IPA contributions
to the trust in our common stock. Because the IPA is deferred
compensation, the cost of this award will not be a current
expense for purposes of computing our taxable income. The
expense will be deferred for tax purposes until distributions
from the trust occur in the future.

We have a stock option plan to provide officers
and non-officer directors with additional incentives. At
March 31, 2004, there were 26.0 million shares
authorized under the option plan, of which there were
2.1 million shares available to be granted. Subject to
approval by shareholders, we plan to increase the number of
shares authorized under the option plan and available for future
grant by 9.0 million shares.

Administrative expenses include legal and
accounting 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 $5.8 million for the
three months ended March 31, 2004, a $1.4 million
increase over administrative expenses of $4.4 million for
the three months ended March 31, 2003. The increase in
administrative expenses was primarily due to portfolio-related
legal and diligence costs ($0.6 million) and increased
costs associated with corporate liability insurance
($0.3 million), outside consultants ($0.3 million) and
office leases ($0.2 million).

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 March 31, 2004 and 2003, were as
follows:

|                   |  |              |       |      |  |   |      |  
|------------------ |  | ------------ | ----- | ---- |  | - | ---- | -
|                   |  |             
|                   |  | For the     
|                   |  | Three Months
|                   |  | Ended       
|                   |  | March 31,   
|                   |  |             
|                   |  | 2004         |       | 2003
|($ in millions)    |  |              |       |     
|Realized gains     |  | $            | 156.0 |      |  | $ | 48.5 |  
|Realized losses    |  |              | (8.1  | )    |  |   | (0.2 | )
|                   |  |              |       |      |  |   |      |  
|Net realized gains |  | $            | 147.9 |      |  | $ | 48.3 |  
|                   |  |              |       |      |  |   |      |  

Realized gains and losses for the three months
ended March 31, 2004 and 2003, resulted from various
private finance and commercial real estate finance transactions.

Realized gains for the three months ended
March 31, 2004, primarily resulted from transactions
involving two private finance portfolio companies 
The Hillman Companies, Inc. ($149.0 million) and
CBA-Mezzanine Capital Finance, LLC ($3.9 million).

Realized gains for the three months ended
March 31, 2003, primarily resulted from transactions
involving five private finance portfolio companies 
Morton Grove Pharmaceuticals, Inc. ($8.4 million), CyberRep
($8.3 million), Blue Rhino Corporation ($3.9 million),
GC-Sun

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Holdings, II, LP ($2.0 million), and
Kirklands, Inc. ($1.2 million). In addition, gains
were also realized from the sale of CMBS bonds
($24.6 million, net of a realized loss of $6.4 million
from hedges related to the CMBS bonds sold).


For the three months ended March 31, 2004
and 2003, we reversed previously recorded unrealized
appreciation totaling $142.8 million and
$43.0 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
March 31, 2004, primarily resulted from transactions
involving two private finance portfolio companies 
Logic Bay Corporation ($5.7 million) and Sure-Tel, Inc.
($2.3 million).

For the three months ended March 31, 2004
and 2003, we reversed previously recorded unrealized
depreciation totaling $7.7 million and $0.2 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 March 31, 2004,
portfolio investments recorded at fair value were approximately
80% 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
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,

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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 accounting principles
generally accepted in the United States of America 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 accounting principles generally
accepted in the United States of America. 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 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

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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.

For the quarter ended March 31, 2004, we received
valuation assistance from S&P Corporate Value Consulting
(S&P CVC) in determining the fair value of 22 private
finance portfolio companies. In addition, we continued to
receive valuation assistance from JMP Securities, LLC (JMP) for
our investment in Business Loan Express, LLC, as discussed
below. In total we received valuation assistance from S&P
CVC and JMP for 40% of the value of the private finance
portfolio at March 31, 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.

For the portfolio, net change in unrealized
appreciation or depreciation for the three months ended
March 31, 2004 and 2003, consisted of the following:

|                                                                                            |  |         |        |         |  |   |       |  
|------------------------------------------------------------------------------------------- |  | ------- | ------ | ------- |  | - | ----- | -
|                                                                                            |  | 2004(1) |        | 2003(1)
|($ in millions)                                                                             |  |         |        |        
|Net unrealized appreciation or depreciation                                                 |  | $       | (37.0  | )       |  | $ | (28.3 | )
|Reversal of previously recorded unrealized
    appreciation associated with realized gains  |  |         | (142.8 | )       |  |   | (43.0 | )
|Reversal of previously recorded unrealized
    depreciation associated with realized losses |  |         | 7.7    |         |  |   | 0.2   |  
|                                                                                            |  |         |        |         |  |   |       |  
|Net change in unrealized appreciation or
    depreciation                                   |  | $       | (172.1 | )       |  | $ | (71.1 | )
|                                                                                            |  |         |        |         |  |   |       |  






|    |                                                                                                                                                                               
|--- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(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 March 31, 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 March 31, 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.

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

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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 March 31, 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
December 31, 2003.


Our investment in BLX at March 31, 2004, was
valued at $337.4 million. This fair value was within the
range of values determined by the four valuation analyses.
Unrealized appreciation on our investment was $77.8 million
at March 31, 2004, a decrease in unrealized appreciation of
$9.3 million for the three months ended March 31,
2004. The SBA 7(a) Guaranteed Loan Program operated under
certain limitations during the quarter ended March 31,
2004, and as such, BLXs loan originations were lower than
expected. The reduction in loan origination volume reduced our
estimate of trailing pro-forma net income and excess working
capital in the valuation analysis, resulting in the unrealized
depreciation for the quarter.

The value of our investment in BLXs
Class B and Class C equity interests was
$247.0 million at March 31, 2004. The value of our
Class B and Class C equity interests are at an implied
trailing price to pro-forma earnings ratio of approximately
12.5 times and on an implied forward projected price to
pro-forma earnings ratio of approximately 9.1 times. The
value of BLXs Class B and Class C equity
interests is at an implied multiple of investor cost basis of
approximately 1.5 times.

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 132.0 million and
110.1 million for the three months ended March 31,
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 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.

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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
three months ended March 31, 2004 and 2003, was as follows:

|                                          |                                                                        |      |       |       |  |   |       |       | 
|----------------------------------------- | ---------------------------------------------------------------------- | ---- | ----- | ----- |  | - | ----- | ----- | 
|($ in millions)                           |                                                                        | 2004 |       | 2003 
|                                          |                                                                        |      |       |      
|Net cash provided by operating activities |                                                                        | $    | 207.9 |       |  | $ | 120.3 |      
|Add: portfolio investments funded         |                                                                        |      | 170.3 |       |  |   | 269.0 |      
|                                          |                                                                        |      |       |       |  |   |       |      
|                                          | Total cash provided by operating activities
    before new investments |      | $     | 378.2 |  |   | $     | 389.3 | 
|                                          |                                                                        |      |       |       |  |   |       |      

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 three
months ended March 31, 2004 and 2003, were
$73.4 million and $63.0 million, respectively, or
$0.57 per common share for both quarters. 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 second quarter
of 2004, the Board of Directors has declared a dividend of
$0.57 per common share payable on June 30, 2004.

Dividends are paid based on our 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.

Because of the level of cash flow provided in
2003 and the first quarter of 2004, we ended the quarter with
$375.3 million in cash and cash equivalents. We invest
otherwise uninvested cash in U.S. government- or agency-issued
or guaranteed securities that are backed by the full faith and
credit of the United States, or in high quality, short-term
repurchase agreements fully collateralized by such securities.

At March 31, 2004, we had significant
outstanding commitments to fund investments totaling
$462.7 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.

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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.

At March 31, 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               |  | $    | 3,010.5 |      |  | $ | 3,019.9 |  
|Total debt outstanding     |  | $    | 962.4   |      |  | $ | 954.2   |  
|Total shareholders equity |  | $    | 1,880.0 |      |  | $ | 1,914.6 |  
|Debt to equity ratio       |  |      | 0.51    |      |  |   | 0.50    |  
|Asset coverage ratio(1)    |  |      | 314     | %    |  |   | 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 at the
low end of the target debt to equity ratio range. We have been
in a period of economic uncertainty, and we believe that it is
prudent to operate with a larger equity capital base and less
leverage. We did not sell equity during the three months ended
March 31, 2004. For the three months ended March 31,
2003, and the year ended December 31, 2003, we sold equity
of $82.4 million and $422.9 million, respectively. In
addition, we raised $18.5 million, $3.0 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 three months ended March 31, 2004 and 2003,
and the year ended December 31, 2003.

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 $488.4 million on March 31, 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.

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At March 31, 2004, we had outstanding debt
as follows:

|                              |                                   |                                    |       |             |         |          |   |       |       |  |   |     |     |      
|----------------------------- | --------------------------------- | ---------------------------------- | ----- | ----------- | ------- | -------- | - | ----- | ----- |  | - | --- | --- | -----
|                              |                                   |                                    |       |             |         | Annual  
|                              |                                   | Facility                           |       | Amount      |         | Interest
|                              |                                   | Amount                             |       | Outstanding |         | Cost(1) 
|($ in millions)               |                                   |                                    |       |             |         |         
|Notes payable and debentures: |                                   |                                    |       |             |         |          |   |       |       |  |   |    
|                              | Unsecured long-term notes payable |                                    | $     | 869.2       |         |          | $ | 869.2 |       |  |   | 7.1 | %  
|                              | SBA debentures                    |                                    |       | 94.8        |         |          |   | 87.5  |       |  |   | 8.1 | %  
|                              | OPIC loan                         |                                    |       | 5.7         |         |          |   | 5.7   |       |  |   | 6.6 | %  
|                              |                                   |                                    |       |             |         |          |   |       |       |  |   |    
|                              |                                   | Total notes payable and debentures |       |             | 969.7   |          |   |       | 962.4 |  |   |     | 7.2 | %    
|Revolving line of credit      |                                   |                                    | 532.5 |             |         |          |  |       |       |  |  | (2)
|                              |                                   |                                    |       |             |         |          |   |       |       |  |   |    
|                              |                                   | Total debt                         |       | $           | 1,502.2 |          |   | $     | 962.4 |  |   |     | 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) | There were no amounts drawn on the revolving line
    of credit at March 31, 2004. As of March 31, 2004,
    $488.4 million remained unused and available, net of
    amounts committed for standby letters of credit of
    $44.1 million issued under the line of credit facility. 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 outstanding on the facility as
    of the balance sheet date. The annual cost of commitment fees
    and other facility fees on the revolving line of credit is
    currently $2.7 million.

Unsecured Long-Term 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 long-term 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 long-term notes payable that matured on May 1, 2004,
with excess cash.

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 quarter
of 2004, we repaid $7.0 million 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 March 31, 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 $532.5 million.
The committed amount may be further expanded through new or
additional commitments up to $600 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.

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As of March 31, 2004, $488.4 million
remained unused and available, net of amounts committed for
standby letters of credit of $44.1 million issued under the
line of credit facility. There were no amounts outstanding on
the revolving line of credit at March 31, 2004.

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 March 31, 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 March 31, 2004.

|                              |                                      |                               |      |                      |       |       |     |       |       |      |     |       |       |      |     |       |       |  |     |   |     |  |     |       |       |  |      |       |       | 
|----------------------------- | ------------------------------------ | ----------------------------- | ---- | -------------------- | ----- | ----- | --- | ----- | ----- | ---- | --- | ----- | ----- | ---- | --- | ----- | ----- |  | --- | - | --- |  | --- | ----- | ----- |  | ---- | ----- | ----- | 
|                              |                                      |                               |      |                     
|                              |                                      |                               |      | Payments Due By Year
|                              |                                      |                               |      |                     
|                              |                                      |                               |      |                      |       | After
|                              |                                      | Total                         |      | 2004                 |       | 2005  |     | 2006  |       | 2007 |     | 2008  |       | 2008
|($ in millions)               |                                      |                               |      |                      |       |       |     |       |       |      |     |       |       |     
|Notes payable and debentures: |                                      |                               |      |                      |       |       |     |       |       |      |     |       |       |      |     |       |       |  |     |   |     |  |     |       |       |  |      |      
|                              | Unsecured long-term notes payable(1) |                               | $    | 869.2                |       |       | $   | 214.0 |       |      | $   | 165.0 |       |      | $   | 175.0 |       |  | $   |  |     |  | $   | 153.0 |       |  | $    | 162.2 |      
|                              | SBA debentures                       |                               |      | 87.5                 |       |       |     |      |       |      |     | 14.0  |       |      |     |      |       |  |     |  |     |  |     |      |       |  |      | 73.5  |      
|                              | OPIC loan                            |                               |      | 5.7                  |       |       |     |      |       |      |     |      |       |      |     | 5.7   |       |  |     |  |     |  |     |      |       |  |      |      |      
|Revolving line of credit(2)   |                                      |                               |     |                      |       |       |    |       |       |      |    |       |       |      |    |       |       |  |    |   |     |  |    |       |       |  |     |      
|Operating leases              |                                      |                               | 34.0 |                      |       |       | 2.5 |       |       |      | 4.2 |       |       |      | 4.2 |       |       |  | 4.1 |   |     |  | 4.1 |       |       |  | 14.9 |      
|                              |                                      |                               |      |                      |       |       |     |       |       |      |     |       |       |      |     |       |       |  |     |   |     |  |     |       |       |  |      |      
|                              |                                      | Total contractual obligations |      | $                    | 996.4 |       |     | $     | 216.5 |      |     | $     | 183.2 |      |     | $     | 184.9 |  |     | $ | 4.1 |  |     | $     | 157.1 |  |      | $     | 250.6 | 
|                              |                                      |                               |      |                      |       |       |     |       |       |      |     |       |       |      |     |       |       |  |     |   |     |  |     |       |       |  |      |      



---

|    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
|--- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(1) | During April 2004, we repaid $112.0 million of
    unsecured long-term notes payable that matured on May 1, 2004,
    with excess cash.                                                                                                                                                                                                                                                                                                                                                                                                         
|   
|(2) | 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
    March 31, 2004, there were no amounts drawn under the
    facility and $488.4 million remained unused and available,
    net of amounts committed for standby letters of credit of
    $44.1 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 March 31, 2004.

|                             |                   |       |      |                                          |  |       |     |      |  |      |     |      |  |      |      |      |  |   |      |      |  |   |   |   |  |   |     |     | 
|---------------------------- | ----------------- | ----- | ---- | ---------------------------------------- |  | ----- | --- | ---- |  | ---- | --- | ---- |  | ---- | ---- | ---- |  | - | ---- | ---- |  | - | - | - |  | - | --- | --- | 
|                             |                   |       |      |                                         
|                             |                   |       |      | Amount of Commitment Expiration Per Year
|                             |                   |       |      |                                         
|                             |                   |       |      |                                          |  | After
|                             |                   | Total |      | 2004                                     |  | 2005  |     | 2006 |  | 2007 |     | 2008 |  | 2008
|($ in millions)              |                   |       |      |                                          |  |       |     |      |  |      |     |      |  |     
|Guarantees                   |                   | $     | 80.1 |                                          |  | $     | 0.5 |      |  | $    | 0.9 |      |  | $    | 0.3  |      |  | $ | 74.8 |      |  | $ |  |   |  | $ | 3.6 |    
|Standby letters of credit(1) |                   |       | 44.1 |                                          |  |       |    |      |  |      | 1.6 |      |  |      | 42.5 |      |  |   |     |      |  |   |  |   |  |   |    |    
|                             |                   |       |      |                                          |  |       |     |      |  |      |     |      |  |      |      |      |  |   |      |      |  |   |   |   |  |   |     |    
|                             | Total commitments |       | $    | 124.2                                    |  |       | $   | 0.5  |  |      | $   | 2.5  |  |      | $    | 42.8 |  |   | $    | 74.8 |  |   | $ |  |  |   | $   | 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.

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

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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 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 are 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 working
capital needs. 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.

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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
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 March 31, 2004,
portfolio investments recorded at fair value were approximately
80% 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
March 31, 2004, the investment totaled $337.4 million
at value, or 11.2% 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 $215.0 million revolving credit
facility. The amount we have guaranteed at March 31, 2004,
was $74.6 million. This guaranty can only be called in the
event of a default by BLX. At March 31, 2004, we had also
provided four standby letters of credit totaling
$35.6 million in connection with four term securitization
transactions completed by BLX.

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

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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
March 31, 2004, our asset coverage for senior indebtedness
was 314%.

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 March 31, 2004, we had
$962.4 million of outstanding indebtedness bearing a
weighted average annual interest cost of 7.5%. In order for us
to cover these annual interest payments on indebtedness, we must
achieve annual returns on our assets of at least 2.4%.

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 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

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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 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 accounting principles generally accepted in the
United States of America 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

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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.

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.                                                                                                                                                                             

73



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##### 



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 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 March 31, 2004, that have
materially affected, or are reasonably likely to materially
affect, the Companys internal control over financial
reporting.

74



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##### 



PART II. OTHER INFORMATION

Item 1.     Legal
Proceedings

We are party to certain lawsuits in the normal
course of our business. While the outcome of these legal
proceedings cannot at this time be predicted with certainty, we
do not expect that these proceedings will have a material effect
upon our financial condition or results of operations.

Item 2.  Changes in
Securities, Use of Proceeds and Issuer Purchases of Equity
Securities

During the three months ended March 31,
2004, we issued a total of 50,060 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 $1.5 million.

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.

75



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##### 



Item 6.  Exhibits and
Reports on Form 8-K

(a) List of 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).                                                                                                                                                                                                                                                                                                                                                                              
|        | 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).                                                                                                                                                                                                                                                                                                                                                                                                                                             
|        | 10.3    |             |  | 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).                                                                                                                                                                                                                                                                                                                                                                                             

76



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##### 



|        |          |             |  |                                                                                                                                                                                                                                                                                                                                                                 
|------- | -------- | ----------- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|Exhibit |          |            
|Number  |          | Description
|        |          |            
|        | 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 A of Allied Capitals definitive
    proxy statement for Allied Capitals 2002 Annual Meeting of
    Stockholders filed on April 3, 2002).                                                                                                                                                 
|        | 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).                                                                                                                       
|        | 10.20(b) |             |  | Amendment to Allied Capital Corporation 401(k)
    Plan, dated December 15, 2003. (Incorporated by
    reference to Exhibit 10.20(b) filed with Allied
    Capitals Form 10-K for the year ended
    December 31, 2003).                                                                                                                                       
|        | 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).                                                                                                                                      

77



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##### 



|        |        |             |  |                                                                                                                                                                                                                                          
|------- | ------ | ----------- |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|Exhibit |        |            
|Number  |        | Description
|        |        |            
|        | 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.                                                                                                                                                                                              
|        | 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
    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.

(b) Reports on Form 8-K

On February 18, 2004, we filed and furnished
a Form 8-K pursuant to Items 5 and 12, respectively,
reporting the issuance of a press release announcing our
financial results for the quarter and year ended
December 31, 2003, and the issuance of a press release
announcing that a definitive agreement had been signed to sell
The Hillman Companies, Inc. to an affiliate of Code
Hennessy & Simmons LLC, a Chicago-based private equity
firm.

On April 26, 2004, we furnished a
Form 8-K pursuant to Item 12 reporting the issuance of
a press release announcing that we had declared a dividend for
the second quarter of 2004.

On April 28, 2004, we furnished a
Form 8-K pursuant to Item 12 reporting the issuance of
a press release announcing our financial results for the quarter
ended March 31, 2004.

78



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##### 



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: May 7, 2004 |  | /s/ WILLIAM L. WALTON
    ---------------------------------------------------
    William L. Walton
    Chairman and Chief Executive Officer
|                  
|                   |  | /s/ PENNI F. ROLL
    ---------------------------------------------------
    Penni F. Roll
    Chief Financial Officer                     

79



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##### 



EXHIBIT INDEX

|        |        |             |  |                                                                                                                                    
|------- | ------ | ----------- |  | -----------------------------------------------------------------------------------------------------------------------------------
|Exhibit |        |            
|Number  |        | Description
|        |        |            
|        | 10.38* |             |  | Note Agreement, dated as of March 25, 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.                       
|        | 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.