** **

**UNITEDSTATESSECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON,D.C. 20549**

 

**FORM10-Q**

 
| **ý**** ****QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)  OF THE SECURITIES  EXCHANGE ACT OF 1934** |
|-------------------------------------------------------------------------------------------------------------------|
|                                                                                                              |
| **FOR THE QUARTER ENDED MARCH 31, 2006**                                                                          |
|                                                                                                              |
| **o****TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES  EXCHANGE ACT OF 1934**                |
|                                                                                                              |
| **COMMISSION FILE NUMBER: 814-00237**                                                                             |

 

**GLADSTONECAPITAL CORPORATION**

(Exact name of registrant as specified in its charter)

 

| **MARYLAND**                                                   | ** ** | **54-2040781**                       |
|----------------------------------------------------------------|------------|--------------------------------------|
| (State or other jurisdiction of incorporation or organization) |       | (I.R.S. Employer Identification No.) |

 

**1521WESTBRANCH DRIVE, SUITE 200MCLEAN, VIRGINIA 22102**(Address ofprincipal executive office)

** **

**(703) 287-5800**(Registrant’stelephone number, including area code)

 

Indicate by check mark whether the registrant (1) has filed allreports required to be filed by Section 13 or 15(d) of the Securities ExchangeAct of 1934 during the preceding 12 months and (2) has been subject to suchfiling requirements for the past 90 days. Yes ý No o.

 

Indicate by check mark whether the registrant is large acceleratedfiler, an accelerated filer, or a non-accelerated filer.  See definition of “accelerated filer andlarge accelerated filer” in Rule 12 b-2 of the Exchange Act. (Check One):

Large accelerated filer o Accelerated filer ý  Non-accelerated filer o.

 

Indicate by check mark whether the registrant is a shell company(as defined in Rule 12b-2 of the Exchange Act).

Yes o  No ý .

 

Indicate the number of shares outstanding of each of the issuer’sclasses of common stock, as of the latest practicable date.  The number of shares of the issuer’s CommonStock, $0.001 par value, outstanding as of May 1, 2006 was 11,308,510.

 

 

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**GLADSTONECAPITAL CORPORATION**

**TABLEOF CONTENTS**

 
| PART I.    | FINANCIAL INFORMATION                                                                                         |   |
|------------|---------------------------------------------------------------------------------------------------------------|--------|
|       |                                                                                                          |   |
| Item 1.    | Financial Statements (Unaudited)                                                                              |   |
|       |                                                                                                          |   |
|       | Consolidated  Statements of Assets and Liabilities as of March 31, 2006 and September 30,  2005               |   |
|       | Consolidated Schedules of  Investments as of March 31, 2006 and September 30, 2005                            |   |
|       | Consolidated  Statements of Operations for the three months ended March 31, 2006 and March  31, 2005          |   |
|       | Consolidated  Statements of Operations for the six months ended March 31, 2006 and March  31, 2005            |   |
|       | Consolidated  Statements of Changes in Net Assets for the six months ended March 31, 2006  and March 31, 2005 |   |
|       | Consolidated  Statements of Cash Flows for the six months ended March 31, 2006 and March  31, 2005            |   |
|       | Financial Highlights for  the three and six months ended March 31, 2006 and March 31, 2005                    |   |
|       | Notes to  Consolidated Financial Statements                                                                   |   |
|       |                                                                                                          |   |
| Item 2.    | Management’s  Discussion and Analysis of Financial Condition and Results of Operations                   |   |
|       |                                                                                                          |   |
|       | Overview                                                                                                      |   |
|       | Results  of Operations                                                                                        |   |
|       | Liquidity  and Capital Resources                                                                              |   |
|       |                                                                                                          |   |
| Item 3.    | Quantitative and  Qualitative Disclosure About Market Risk                                                    |   |
|       |                                                                                                          |   |
| Item 4.    | Controls and  Procedures                                                                                      |   |
|       |                                                                                                          |   |
| PART  II.  | OTHER  INFORMATION                                                                                            |   |
|       |                                                                                                          |   |
| Item  1.   | Legal  Proceedings                                                                                            |   |
|       |                                                                                                          |   |
| Item 1A.   | Risk  Factors                                                                                                 |   |
|       |                                                                                                          |   |
| Item 2.    | Unregistered  Sales of Equity Securities and Use of Proceeds                                                  |   |
|       |                                                                                                          |   |
| Item 3.    | Defaults  Upon Senior Securities                                                                              |   |
|       |                                                                                                          |   |
| Item 4.    | Submission  of Matters to a Vote of Security Holders                                                          |   |
|       |                                                                                                          |   |
| Item  5.   | Other  Information                                                                                            |   |
|       |                                                                                                          |   |
| Item 6.    | Exhibits                                                                                                      |   |
|       |                                                                                                          |   |
| SIGNATURES |                                                                                                          |

 

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**GLADSTONE CAPITAL CORPORATIONCONSOLIDATED STATEMENTS OF ASSETS AND LIABILITIES(Unaudited)**

 
| ** **                                                                                                                               | ** ** | **March 31,  2006** | ** **  | **September 30,  2005** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------------|------------|---------------------|-------------|-------------------------|------------|
| ASSETS                                                                                                                                   |       |                |        |                    |       |
| Investments at fair  value (Cost 3/31/2006:$206,033,242; 9/30/2005: $205,375,554)                                                        |       | $                   | 206,461,282 |                    | $          | 200,846,763 |   |
| Cash and cash  equivalents                                                                                                               |       | 311,090             |        | 503,776                 |       |
| Interest receivable –  investments in debt securities                                                                               |       | 1,063,698           |        | 1,406,212               |       |
| Interest receivable –  officers                                                                                                     |       | 13,015              |        | 27,067                  |       |
| Due from custodian                                                                                                                       |       | 9,251,975           |        | 2,624,074               |       |
| Due from Adviser                                                                                                                         |       | 320,621             |        | —                  |       |
| Deferred financing fees                                                                                                                  |       | 23,536              |        | 70,000                  |       |
| Prepaid assets                                                                                                                           |       | 145,036             |        | 177,848                 |       |
| Other assets                                                                                                                             |       | 135,066             |        | 137,354                 |       |
| TOTAL ASSETS                                                                                                                             |       | $                   | 217,725,319 |                    | $          | 205,793,094 |   |
|                                                                                                                                     |       |                |        |                    |       |
| LIABILITIES                                                                                                                              |       |                |        |                    |       |
| Accounts payable                                                                                                                         |       | $                   | 4,589       |                    | $          | 21,893 |   |
| Interest payable                                                                                                                         |       | 278,951             |        | 183,707                 |       |
| Fees due to Adviser                                                                                                                      |       | 230,182             |        | 391,322                 |       |
| Borrowings under lines  of credit                                                                                                        |       | 60,300,000          |        | 53,034,064              |       |
| Accrued expenses and  deferred liabilities                                                                                               |       | 249,286             |        | 350,665                 |       |
| Funds held in escrow                                                                                                                     |       | 200,800             |        | 200,760                 |       |
| Total Liabilities                                                                                                                        |       | 61,263,808          |        | 54,182,411              |       |
| Net Assets                                                                                                                               |       | $                   | 156,461,511 |                    | $          | 151,610,683 |   |
|                                                                                                                                     |       |                |        |                    |       |
| ANALYSIS OF NET ASSETS                                                                                                                   |       |                |        |                    |       |
| Common stock, $0.001 par value, 50,000,000 shares  authorized and 11,308,510 and 11,303,510 shares issued and outstanding,  respectively |       | $                   | 11,309      |                    | $          | 11,304 |   |
| Capital in excess of  par value                                                                                                          |       | 164,774,090         |        | 164,610,873             |       |
| Notes receivable –  employees                                                                                                       |       | (8,722,687          | )           | (8,745,781              | )          |
| Net unrealized  appreciation (depreciation) on investments                                                                               |       | 428,038             |        | (4,528,791              | )          |
| Unrealized depreciation  on derivative                                                                                                   |       | (229,981            | )           | (253,747                | )          |
| Realized (loss) gain on  sale of investments                                                                                             |       | (760,845            | )           | 42,250                  |       |
| Distributions less than  net investment income                                                                                           |       | 961,587             |        | 474,575                 |       |
| Total Net Assets                                                                                                                         |       | $                   | 156,461,511 |                    | $          | 151,610,683 |   |
| Net Assets Per Share                                                                                                                     |       | $                   | 13.84       |                    | $          | 13.41 |   |

 

*THEACCOMPANYING NOTES ARE AN INTEGRAL PART OF THESE CONSOLIDATED FINANCIALSTATEMENTS.*

 

2

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**GLADSTONE CAPITAL CORPORATIONCONSOLIDATED SCHEDULE OF INVESTMENTSAS OF MARCH 31, 2006(UNAUDITED)**

 
| **Company  (1)**                                     | ** ** | **Industry**                    | ** ** | **Investment (2)**                                | ** ** | **Cost**  | ** ** | **Fair Value** | ** ** |
|------------------------------------------------------|------------|---------------------------------|------------|---------------------------------------------------|------------|-----------|------------|----------------|------------|
|                                                 |       |                            |       |                                              |       |      |       |           |       |
| Advanced Homecare  Management, Inc.                  |       | Home health nursing  services   |       | Senior Subordinated  Term  Debt(5)(6)             |       | $         | 7,500,000  |           | $          | 7,500,000 |   |
|                                                 |       |                            |       | (13.7%, Due 12/2010)                              |       |      |       |           |       |
|                                                 |       |                            |       |                                              |       |      |       |           |       |
| Allied Extruders, LLC  P&O Packaging Acquisition |       | Polyethylene film  manufacturer |       | Senior Real Estate Term  Debt  (11.3%,Due 3/2011) |       | 1,000,000 |       | 1,000,000      |       |
| LLC                                                  |       |                            |       | Senior Term Debt (3)(5)                           |       | 8,000,000 |       | 8,030,000      |       |
|                                                 |       |                            |       | (11.3%,Due 3/2011)                                |       |      |       |           |       |
|                                                 |       |                            |       |                                              |       |      |       |           |       |
| Badanco Acquisition  Corp.                           |       | Manufacturing-luggage           |       | Senior Term Debt (5)                              |       | 5,880,019 |       | 5,894,719      |       |
|                                                 |       |                            |       | (10.3%, Due 2/2010)                               |       |      |       |           |       |
|                                                 |       |                            |       | Senior Term Debt (3)(5)                           |       | 8,650,000 |       | 8,693,250      |       |
|                                                 |       |                            |       | (13.3%, Due 2/2010)                               |       |      |       |           |       |
|                                                 |       |                            |       |                                              |       |      |       |           |       |
| Benetech, Inc.                                       |       | Dust management systems         |       | Senior Term Debt (5)                              |       | 2,437,500 |       | 2,461,875      |       |
|                                                 |       | for the coal and  electric      |       | (9.6%, Due 5/2009                                 |       |      |       |           |       |
|                                                 |       | utility industries              |       | Senior Term Debt (3)(5)                           |       | 3,128,125 |       | 3,175,047      |       |
|                                                 |       |                            |       | (12.6%, Due 5/2009)                               |       |      |       |           |       |
|                                                 |       |                            |       |                                              |       |      |       |           |       |
| Consolidated Bedding,  Inc.                          |       | Manufacturing-mattresses        |       | Senior Subordinated  Term   Debt (5)              |       | 2,495,370 |       | 2,375,472      |       |
|                                                 |       |                            |       | (13.8%, Due 3/2009)                               |       |      |       |           |       |
|                                                 |       |                            |       |                                              |       |      |       |           |       |
| Country Road                                         |       | Service-                        |       | Senior Subordinated  Term                         |       |      |       |           |       |
| Communications LLC                                   |       | telecommunications              |       | Debt (5)(6)                                       |       | 5,958,768 |       | 6,060,000      |       |
| Country Road  Management, Inc.                       |       |                            |       | (12.6%, Due 7/2013)                               |       |      |       |           |       |
|                                                 |       |                            |       |                                              |       |      |       |           |       |
| Defiance Stamping Company                            |       | Manufacturing-trucking          |       | Senior Term Debt (3)(5)                           |       | 6,325,000 |       | 6,317,094      |       |
|                                                 |       | parts                           |       | (12.6%, Due 4/2010)                               |       |      |       |           |       |
|                                                 |       |                            |       |                                              |       |      |       |           |       |
| Doe & Ingalls  Management                        |       | Distributor-specialty           |       | Senior Term Debt (5)                              |       | 5,100,000 |       | 5,112,750      |       |
| LLC                                                  |       | chemicals                       |       | (9.1%, Due 11/2010)                               |       |      |       |           |       |
| Doe & Ingalls of  North                          |       |                            |       | Senior Term Debt (3)(5)                           |       | 4,500,000 |       | 4,505,625      |       |
| Carolina Operating LLC                               |       |                            |       | (12.6%, Due 11/2010)                              |       |      |       |           |       |
| Doe & Ingalls of  Florida                        |       |                            |       |                                              |       |      |       |           |       |
| Operating LLC                                        |       |                            |       |                                              |       |      |       |           |       |
| Doe & Ingalls of  Virginia                       |       |                            |       |                                              |       |      |       |           |       |
| Operating LLC                                        |       |                            |       |                                              |       |      |       |           |       |
|                                                 |       |                            |       |                                              |       |      |       |           |       |
| Finn Corporation                                     |       | Manufacturing-landscape         |       | Common Stock Warrants                             |       | 37,000    |       | 730,178        |       |
|                                                 |       | equipment                       |       |                                              |       |      |       |           |       |
|                                                 |       |                            |       |                                              |       |      |       |           |       |
| Gammill, Inc.                                        |       | Designer and assembler  of      |       | Senior Term Debt (5)                              |       | 2,305,147 |       | 2,302,266      |       |
|                                                 |       | quilting machines and           |       | (9.5%, Due 12/2008)                               |       |      |       |           |       |
|                                                 |       | accessories                     |       | Senior Term Debt (3)(5)                           |       | 4,601,563 |       | 4,572,803      |       |
|                                                 |       |                            |       | (12.0%, Due 12/2008)                              |       |      |       |           |       |
|                                                 |       |                            |       |                                              |       |      |       |           |       |
| Global Materials                                     |       | Manufacturing-steel  wool       |       | Senior Term Debt (3)(5)                           |       | 5,400,000 |       | 5,373,000      |       |
| Technologies, Inc.                                   |       | products and metal  fibers      |       | (13.6%, Due 11/2009)                              |       |      |       |           |       |
|                                                 |       |                            |       |                                              |       |      |       |           |       |
| John Henry Holdings,  Inc.                           |       | Manufacturing-packaging         |       | Senior Subordinated  Term                         |       |      |       |           |       |
|                                                 |       | products                        |       | Debt(5)(6)                                        |       | 7,070,737 |       | 6,993,500      |       |
|                                                 |       |                            |       | (11.8%, Due 6/2011)                               |       |      |       |           |       |
|                                                      |            |                                 |            |                                                   |            |           |            |                |            |  |  |

 

3

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| **Company  (1)**                             | ** ** | **Industry**                                 | ** ** | **Investment (2)**                    | ** ** | **Cost**   | ** **      | **Fair Value** | ** ** |
|----------------------------------------------|------------|----------------------------------------------|------------|---------------------------------------|------------|------------|-----------------|----------------|------------|
|                                         |       |                                         |       |                                  |       |       |            |           |       |
| Mistras Holdings Corp.                       |       | Nondestructive testing                       |       | Senior Term Debt (3)(5)               |       | $          |  9,666,666 |           | $          |  9,437,083 |   |
|                                         |       | instruments, systems                         |       | (10.7%, Due 8/2008)                   |       |       |            |           |       |
|                                         |       | and services                                 |       | Senior Term Debt (3)(5)               |       | 5,333,334  |            | 5,200,001      |       |
|                                         |       |                                         |       | (12.5%, Due 8/2008)                   |       |       |            |           |       |
|                                         |       |                                         |       |                                  |       |       |            |           |       |
| Network Solutions LLC                        |       | Service-internet domain                      |       | Senior Term Debt (6)                  |       | 4,486,678  |            | 4,488,750      |       |
|                                         |       | registry and host                            |       | (10.0%,Due 1/2012)                    |       |       |            |           |       |
|                                         |       |                                         |       |                                  |       |       |            |           |       |
| Northern Contours                            |       | Manufacturing-veneer  and                    |       | Senior Subordinated  Term             |       |       |            |           |       |
| Northern Contours                            |       | laminate components                          |       | Debt (5)                              |       | 7,000,000  |            | 7,008,750      |       |
| of Kentucky, Inc.                            |       |                                         |       | (11.6%, Due 5/2010)                   |       |       |            |           |       |
| Norcon Holding LLC                           |       |                                         |       |                                  |       |       |            |           |       |
| Norcon Lewis LLC                             |       |                                         |       |                                  |       |       |            |           |       |
|                                         |       |                                         |       |                                  |       |       |            |           |       |
| Penn Engineering & Manufacturing Corp.   |       | Manufacturing-fractional  horsepower engines |       | Senior Subordinated  Term   Debt (6)  |       | 5,008,810  |            | 5,050,000      |       |
| PN Merger Sub Inc.                           |       |                                         |       | (10.9%, Due 5/2012)                   |       |       |            |           |       |
| PEM Holding Co.                              |       |                                         |       |                                  |       |       |            |           |       |
|                                         |       |                                         |       |                                  |       |       |            |           |       |
| Polar Corporation                            |       | Manufacturing-trailer  parts                 |       | Senior Subordinated  Term  Debt(5)(6) |       | 10,004,963 |            | 10,030,346     |       |
|                                         |       |                                         |       | (11.3%, Due 6/2010)                   |       |       |            |           |       |
|                                         |       |                                         |       |                                  |       |       |            |           |       |
| Puerto Rico Cable  Acquisition Company, Inc. |       | Service-telecommunications                   |       | Senior Subordinated  Term  Debt(5)(6) |       | 7,820,642  |            | 7,823,536      |       |
|                                         |       |                                         |       | (11.3%, Due 1/2012)                   |       |       |            |           |       |
|                                         |       |                                         |       |                                  |       |       |            |           |       |
| RCS Management Holding                       |       | Service-healthcare                           |       | Senior Term Debt (3)                  |       | 3,000,000  |            | 3,000,000      |       |
| Co.                                          |       | supplies                                     |       | (9.3%,Due 1/2011)                     |       |       |            |           |       |
|                                         |       |                                         |       | Senior Term Debt (4)                  |       | 3,000,000  |            | 3,000,000      |       |
|                                         |       |                                         |       | (11.8%,Due 1/2011)                    |       |       |            |           |       |
|                                         |       |                                         |       |                                  |       |       |            |           |       |
| Santana Plastics                             |       | Manufacturing-                               |       | Senior Term Debt (3)(5)               |       | 5,850,000  |            | 5,850,000      |       |
|                                         |       | polyethylene                                 |       | (12.7%, Due 11/2009)                  |       |       |            |           |       |
|                                         |       | bathroom partitions                          |       | Senior Term Debt (4)(5)               |       | 1,901,250  |            | 1,901,250      |       |
|                                         |       |                                         |       | (13.0%, Due 11/2009)                  |       |       |            |           |       |
|                                         |       |                                         |       |                                  |       |       |            |           |       |
| SCPH Holdings, Inc.                          |       | Manufacturing-underwater                     |       | Credit Facility (7)                   |       | —     |            | —         |       |
| Sea Con Phoenix, Inc.                        |       | and harsh environment                        |       | (9.3%, Due 2/2007)                    |       |       |            |           |       |
| Phoenix Optix, Inc.                          |       | components                                   |       | Senior Term Debt (5)                  |       | 2,975,000  |            | 2,978,719      |       |
|                                         |       |                                         |       | (9.8%, Due 2/2010)                    |       |       |            |           |       |
|                                         |       |                                         |       | Senior Term Debt (3)(5)               |       | 2,962,500  |            | 2,966,203      |       |
|                                         |       |                                         |       | (12.8%, Due 2/2010)                   |       |       |            |           |       |
|                                         |       |                                         |       |                                  |       |       |            |           |       |
| SCS Acquisition Corp.                        |       | Service-chemically  treated                  |       | Credit Facility (8)                   |       | —     |            | —         |       |
|                                         |       | equipment distribution                       |       | (8.6%, Due 12/2011)                   |       |       |            |           |       |
|                                         |       |                                         |       | Senior Term Debt (9)                  |       | 6,500,000  |            | 6,500,000      |       |
|                                         |       |                                         |       | (8.6%, Due 12/2011)                   |       |       |            |           |       |
|                                         |       |                                         |       | Senior Term Debt (3)(10)              |       | 6,606,250  |            | 6,606,250      |       |
|                                         |       |                                         |       | (10.6%, Due 12/2011)                  |       |       |            |           |       |
|                                              |            |                                              |            |                                       |            |            |                 |                |            |  |  |

 

4

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| **Company  (1)**              | ** ** | **Industry**                                | ** ** | **Investment (2)**                    | ** ** | **Cost**   | ** **      | **Fair Value** | ** ** |
|-------------------------------|------------|---------------------------------------------|------------|---------------------------------------|------------|------------|-----------------|----------------|------------|
|                          |       |                                        |       |                                  |       |       |            |           |       |
| Survey Sampling               |       | Service-telecommunications                  |       | Senior Subordinated  Term  Debt(5)(6) |       | $          | 2,256,602       |           | $          |  2,269,688 |   |
|                          |       |                                        |       | (12.2%, Due 5/2012)                   |       |       |            |           |       |
|                          |       |                                        |       |                                  |       |       |            |           |       |
| Tech Lighting LLC             |       | Manufacturing-low  voltage lighting systems |       | Senior Subordinated  Term  Debt(5)(6) |       | 9,011,222  |            | 9,000,000      |       |
|                          |       |                                        |       | (11.5%, Due 10/2010)                  |       |       |            |           |       |
|                          |       |                                        |       |                                  |       |       |            |           |       |
| Thibaut Acquisition Co.       |       | Design and  disbtribution-                  |       | Credit Facility (11)                  |       | 575,000    |            | 574,281        |       |
|                          |       | wall coverings                              |       | (9.1%,Due 1/2011)                     |       |       |            |           |       |
|                          |       |                                        |       | Senior Term Debt                      |       | 3,500,000  |            | 3,500,000      |       |
|                          |       |                                        |       | (9.1%,Due 1/2011)                     |       |       |            |           |       |
|                          |       |                                        |       | Senior Term Debt (3)                  |       | 3,000,000  |            | 3,000,000      |       |
|                          |       |                                        |       | (11.6%,Due 1/2011)                    |       |       |            |           |       |
|                          |       |                                        |       |                                  |       |       |            |           |       |
| Visual Edge Technology,  Inc. |       | Service-office supplies                     |       | Senior Subordinated  Term             |       |       |            |           |       |
| Graphic Enterprises,  Inc.    |       | distribution                                |       | Debt (5)                              |       | 5,000,000  |            | 4,993,750      |       |
| Copeco, Inc.                  |       |                                        |       | (12.6%, Due 8/2011)                   |       |       |            |           |       |
|                          |       |                                        |       |                                  |       |       |            |           |       |
|                          |       |                                        |       |                                  |       |       |            |           |       |
| Westlake Hardware, Inc.       |       | Retail-hardware and                         |       | Senior Subordinated  Term             |       |       |            |           |       |
| WHI Holding Corp.             |       | variety                                     |       | Debt (5)                              |       | 15,000,000 |            | 15,000,000     |       |
|                          |       |                                        |       | (11.9%, Due 1/2011)                   |       |       |            |           |       |
|                          |       |                                        |       |                                  |       |       |            |           |       |
| Xspedius Communications       |       | Service-                                    |       | Senior Subordinated  Term             |       |       |            |           |       |
| LLC                           |       | telecommunications                          |       | Debt (5)                              |       | 5,185,096  |            | 5,185,096      |       |
|                          |       |                                        |       | (15.3%, Due 3/2010)                   |       |       |            |           |       |
|                          |       |                                        |       |                                  |       |       |            |           |       |
| **Total:**                    | ** ** | ** **                                  | ** ** | ** **                            | ** ** | **$**      | **206,033,242** | ** **     | **$**      | **206,461,282** | ** ** |
|                               |            |                                             |            |                                       |            |            |                 |                |            |  |  |  |  |

 

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(1) We do not “Control,” and are not an “Affiliate” of, any of ourportfolio companies, each as defined in the Investment Company Act of 1940, asamended (the “1940 Act”). In general, under the 1940 Act, we would “Control” aportfolio company if we owned 25% or more of its voting securities and would bean “Affiliate” of a portfolio company if we owned 5% or more of its votingsecurities.

(2) Percentage represents interest rates in effect at December 31,2005 and due date represents the contractual maturity date.

(3) Last Out Tranche of senior debt, meaning if the company isliquidated then the holder of the Last Out Tranche is paid after the seniordebt.

(4) Last Out Tranche of senior debt, meaning if the company isliquidated then the holder of the Last Out Tranche is paid after the seniordebt, however the debt is junior to another Last Out Tranche.

(5) Fair value was based on valuation prepared and provided byStandard & Poor’s Loan Evaluation Services.

(6) Marketable securities, such as syndicated loans, are valuedbased on the indicative bid price, as of March 31, 2005, from the respectiveoriginating syndication agent’s trading desk.

(7) Availability under the credit facility totals $500,000.  There were no borrowings outstanding at March31, 2006.

(8) Availability under the credit facility totals $2,500,000.  There were no borrowings outstanding at March31, 2006.

(9) Availability under the debt facility totals $7,500,000. Theoutstanding balance of the debt facility was $6,500,000 at March 31, 2006.

(10) Availability under the debt facility totals $7,500,000. Theoutstanding balance of the debt facility was $6,606,250 at March 31, 2006.

(11) Availability under the credit facility totals$1,000,000.  Borrowings of $575,000 wereoutstanding at March 31, 2006.

 

*THEACCOMPANYING NOTES ARE AN INTEGRAL PART OF THESE CONSOLIDATED FINANCIALSTATEMENTS.*

 

5

----

 

**GLADSTONECAPITAL CORPORATIONCONSOLIDATED SCHEDULE OF INVESTMENTSAS OF SEPTEMBER 30, 2005**

 
| **Company  (1)**                    | ** ** | **Industry**                       | ** ** | **Investment (2)**                   | ** ** | **Cost**   | ** ** | **Fair Value** | ** ** |
|-------------------------------------|------------|------------------------------------|------------|--------------------------------------|------------|------------|------------|----------------|------------|
|                                |       |                               |       |                                 |       |       |       |           |       |
| Advanced Homecare  Management, Inc. |       | Home health nursing  services      |       | Senior Subordinated  Term   Debt (6) |       | $          | 7,500,000  |           | $          | 7,500,000 |   |
|                                |       |                               |       | (12.6%, Due 12/2010)                 |       |       |       |           |       |
|                                |       |                               |       |                                 |       |       |       |           |       |
| Allied Extruders, Inc.              |       | Polyethylene film                  |       | Senior Term Debt (3)                 |       | 3,950,000  |       | 3,964,813      |       |
|                                |       | manufacturer                       |       | (12.3%, Due 7/2009)                  |       |       |       |           |       |
|                                |       |                               |       |                                 |       |       |       |           |       |
| ARI Holdings, Inc. (11)  (12)       |       | Manufacturing-auto  parts          |       | Senior Term Debt                     |       | 3,933,939  |       | 2,880,000      |       |
|                                |       |                               |       | (12.8%, Due 2/2008)                  |       |       |       |           |       |
|                                |       |                               |       |                                 |       |       |       |           |       |
| Badanco Acquisition  Corp.          |       | Manufacturing-luggage              |       | Senior Term Debt (6)                 |       | 6,615,019  |       | 6,615,019      |       |
|                                |       |                               |       | (9.2%, Due 2/2010)                   |       |       |       |           |       |
|                                |       |                               |       | Senior Term Debt (3)(6)              |       | 8,650,000  |       | 8,650,000      |       |
|                                |       |                               |       | (12.2%, Due 2/2010)                  |       |       |       |           |       |
|                                |       |                               |       |                                 |       |       |       |           |       |
| Benetech, Inc.                      |       | Dust management systems            |       | Senior Term Debt (6)                 |       | 2,762,500  |       | 2,783,219      |       |
|                                |       | for the coal and  electric         |       | (8.7%, Due 5/2009)                   |       |       |       |           |       |
|                                |       | utility industries                 |       | Senior Term Debt (3)(6)              |       | 3,209,375  |       | 3,249,492      |       |
|                                |       |                               |       | (11.7%, Due 5/2009)                  |       |       |       |           |       |
|                                |       |                               |       |                                 |       |       |       |           |       |
| Consolidated Bedding,  Inc.         |       | Manufacturing-mattresses           |       | Senior Subordinated  Term  Debt (6)  |       | 2,927,382  |       | 2,898,968      |       |
|                                |       |                               |       | (13.0%, Due 3/2009)                  |       |       |       |           |       |
|                                |       |                               |       |                                 |       |       |       |           |       |
| Country Road                        |       | Service-                           |       | Senior Subordinated  Term Debt       |       | 5,955,942  |       | 6,060,000      |       |
| Communications LLC                  |       | telecommunications                 |       | (11.6%, Due 7/2013)                  |       |       |       |           |       |
| Country Road  Management, Inc.      |       |                               |       |                                 |       |       |       |           |       |
|                                |       |                               |       |                                 |       |       |       |           |       |
| Coyne International                 |       | Industrial services                |       | Senior Term Debt  (3)(5)(6)          |       | 6,375,052  |       | 6,367,083      |       |
| Enterprises                         |       |                               |       | (13.0%, PIK 2%, Due  7/2007)         |       |       |       |           |       |
|                                |       |                               |       |                                 |       |       |       |           |       |
| Defiance Stamping                   |       | Manufacturing-trucking             |       | Senior Term Debt (3)                 |       | 6,325,000  |       | 6,332,906      |       |
| Company                             |       | parts                              |       | (11.7%, Due 4/2010)                  |       |       |       |           |       |
|                                |       |                               |       |                                 |       |       |       |           |       |
| Finn Corporation                    |       | Manufacturing-landscape  equipment |       | Senior Subordinated  Term   Debt (6) |       | 10,500,000 |       | 7,350,000      |       |
|                                |       |                               |       | (13.0%, Due 2/2006)                  |       |       |       |           |       |
|                                |       |                               |       | Common Stock Warrants                |       | 37,000     |       | 682,114        |       |
|                                |       |                               |       |                                 |       |       |       |           |       |
| Gammill, Inc.                       |       | Designer and assembler  of         |       | Senior Term Debt (6)                 |       | 3,771,427  |       | 3,771,427      |       |
|                                |       | quilting machines and              |       | (9.5%, Due 12/2008)                  |       |       |       |           |       |
|                                |       | accessories                        |       | Senior Term Debt (3)(6)              |       | 4,690,625  |       | 4,667,172      |       |
|                                |       |                               |       | (12.0%, Due 12/2008)                 |       |       |       |           |       |
|                                |       |                               |       |                                 |       |       |       |           |       |
| Global Materials                    |       | Manufacturing-steel  wool          |       | Senior Term Debt (3)(6)              |       | 5,500,000  |       | 5,486,250      |       |
| Technologies, Inc.                  |       | products and metal  fibers         |       | (13.0%, Due 11/2009)                 |       |       |       |           |       |
|                                |       |                               |       |                                 |       |       |       |           |       |
| Infor Global Solutions  Ltd.        |       | Enterprise application  solutions  |       | Senior Subordinated  Term   Debt (7) |       | 6,821,250  |       | 7,070,000      |       |
|                                |       |                               |       | (11.0%, Due 4/2012)                  |       |       |       |           |       |
|                                |       |                               |       |                                 |       |       |       |           |       |
| John Henry Holdings,  Inc.          |       | Manufacturing-packaging  products  |       | Senior Subordinated  Term   Debt(6)  |       | 7,067,923  |       | 7,064,500      |       |
|                                |       |                               |       | (11.0%, Due 6/2011)                  |       |       |       |           |       |
|                                     |            |                                    |            |                                      |            |            |            |                |            |  |  |

 

6

----

 
| **Company  (1)**                                         | ** ** | **Industry**                                | ** ** | **Investment (2)**                   | ** ** | **Cost**  | ** ** | **Fair Value** | ** ** |
|----------------------------------------------------------|------------|---------------------------------------------|------------|--------------------------------------|------------|-----------|------------|----------------|------------|
|                                                     |       |                                        |       |                                 |       |      |       |           |       |
| Marcal Paper Mills,  Inc. (12)                           |       | Manufacturing-paper products                |       | Senior Subordinated  Term   Debt (6) |       | $         | 6,275,000  |           | $          | 6,149,500 |   |
|                                                     |       |                                        |       | (13.0%, Due 12/2006)                 |       |      |       |           |       |
|                                                     |       |                                        |       | First Mortgage Loan (5)              |       | 9,277,877 |       | 9,277,877      |       |
|                                                     |       |                                        |       | (16%, PIK 1%, Due  12/2006)          |       |      |       |           |       |
|                                                     |       |                                        |       |                                 |       |      |       |           |       |
| Mistras Holdings Corp.                                   |       | Nondestructive testing                      |       | Senior Term Debt (3)(6)              |       | 9,666,666 |       | 9,461,249      |       |
|                                                     |       | instruments, systems                        |       | (10.5%, Due 8/2008)                  |       |      |       |           |       |
|                                                     |       | and services                                |       | Senior Term Debt (3)(6)              |       | 4,833,334 |       | 4,724,584      |       |
|                                                     |       |                                        |       | (12.5%, Due 8/2008)                  |       |      |       |           |       |
|                                                     |       |                                        |       | Senior Term Debt (3)(6)              |       | 1,000,000 |       | 982,500        |       |
|                                                     |       |                                        |       | (13.5%, Due 8/2008)                  |       |      |       |           |       |
|                                                     |       |                                        |       |                                 |       |      |       |           |       |
| Northern Contours                                        |       | Manufacturing-veneer  and                   |       | Senior Subordinated  Term            |       |      |       |           |       |
| Northern Contours                                        |       |                                        |       | Debt (8)                             |       | 7,000,000 |       | 7,000,000      |       |
| of Kentucky, Inc.                                        |       | laminate components                         |       | (10.7%, Due 5/2010)                  |       |      |       |           |       |
| Norcon Holding LLC                                       |       |                                        |       |                                 |       |      |       |           |       |
| Norcon Lewis LLC                                         |       |                                        |       |                                 |       |      |       |           |       |
|                                                     |       |                                        |       |                                 |       |      |       |           |       |
| Penn Engineering &                                   |       | Manufacturing-fractional                    |       | Senior Subordinated  Term            |       | 5,009,524 |       | 5,050,000      |       |
| Manufacturing Corp.                                      |       |                                        |       | Debt (8)                             |       |      |       |           |       |
| PN Merger Sub Inc.                                       |       | horsepower engines                          |       | (10.0%, Due 5/2012)                  |       |      |       |           |       |
| PEM Holding Co.                                          |       |                                        |       |                                 |       |      |       |           |       |
|                                                     |       |                                        |       |                                 |       |      |       |           |       |
| Polar Corporation                                        |       | Manufacturing-trailer  parts                |       | Senior Subordinated  Term   Debt (6) |       | 8,609,566 |       | 8,627,500      |       |
|                                                     |       |                                        |       | (10.3%, Due 6/2010)                  |       |      |       |           |       |
|                                                     |       |                                        |       |                                 |       |      |       |           |       |
| Puerto Rico Cable                                        |       | Service-                                    |       | Senior Subordinated  Term Debt       |       | 5,050,182 |       | 5,075,000      |       |
| Acquisition Company,  Inc.                               |       | telecommunications                          |       | (10.3%, Due 1/2012)                  |       |      |       |           |       |
|                                                     |       |                                        |       |                                 |       |      |       |           |       |
| Regency Gas Services  LLC                                |       | Midstream gas gathering  and processing     |       | Senior Subordinated  Term   Debt (7) |       | 5,029,188 |       | 5,037,500      |       |
|                                                     |       |                                        |       | (9.9%, Due 12/2010)                  |       |      |       |           |       |
|                                                     |       |                                        |       |                                 |       |      |       |           |       |
| Santana Plastics                                         |       | Manufacturing-                              |       | Senior Term Debt (3)(6)              |       | 6,000,000 |       | 6,007,500      |       |
|                                                     |       | polyethylene bathroom                       |       | (11.7%, Due 11/2009)                 |       |      |       |           |       |
|                                                     |       | partitions                                  |       | Senior Term Debt (4)(6)              |       | 1,950,000 |       | 1,952,438      |       |
|                                                     |       |                                        |       | (13.0%, Due 11/2009)                 |       |      |       |           |       |
|                                                     |       |                                        |       |                                 |       |      |       |           |       |
| SCPH Holdings, Inc.                                      |       | Manufacturing-underwater                    |       | Credit Facility (9)                  |       | —    |       | —         |       |
| Sea Con Phoenix, Inc.                                    |       | and harsh environment                       |       | (8.0%, Due 3/2006)                   |       |      |       |           |       |
| Phoenix Optix, Inc.                                      |       | components                                  |       | Senior Term Debt (3)(6)              |       | 3,237,500 |       | 3,241,547      |       |
|                                                     |       |                                        |       | (8.7%, Due 2/2010)                   |       |      |       |           |       |
|                                                     |       |                                        |       | Senior Term Debt (6)                 |       | 3,000,000 |       | 3,003,750      |       |
|                                                     |       |                                        |       | (12.0%, Due 2/2010)                  |       |      |       |           |       |
|                                                     |       |                                        |       |                                 |       |      |       |           |       |
| Survey Sampling                                          |       | Service-telecommunications                  |       | Senior Subordinated  Term   Debt (6) |       | 4,514,105 |       | 4,539,375      |       |
|                                                     |       |                                        |       | (11.0%, Due 5/2012)                  |       |      |       |           |       |
|                                                     |       |                                        |       |                                 |       |      |       |           |       |
| Tech Lighting LLC                                        |       | Manufacturing-low  voltage lighting systems |       | Senior Subordinated  Term   Debt (6) |       | 9,012,452 |       | 9,067,500      |       |
|                                                     |       |                                        |       | (10.4%, Due 10/2010)                 |       |      |       |           |       |
|                                                     |       |                                        |       |                                 |       |      |       |           |       |
| Visual Edge Technology,  Inc.  Graphic Enterprises, Inc. |       | Service-office supplies  distribution       |       | Senior Subordinated  Term   Debt     |       | 5,000,000 |       | 5,000,000      |       |
| Copeco, Inc.                                             |       |                                        |       | (11.7%, Due 8/2011)                  |       |      |       |           |       |
|                                                          |            |                                             |            |                                      |            |           |            |                |            |  |  |

 

7

----

 
| **Company  (1)**              | ** ** | **Industry**               | ** ** | **Investment (2)**                   | ** ** | **Cost**  | ** **      | **Fair Value** | ** ** |
|-------------------------------|------------|----------------------------|------------|--------------------------------------|------------|-----------|-----------------|----------------|------------|
|                          |       |                       |       |                                 |       |      |            |           |       |
| Woven Electronics Corporation |       | Custom electrical cable    |       | Senior Term Debt (4)(6)(10)          |       | $         | 8,344,999       |           | $          | 8,776,435 |   |
|                          |       | assemblies                 |       | (11.5%, Due 3/2009)                  |       |      |            |           |       |
|                          |       |                       |       |                                 |       |      |            |           |       |
| Xspedius Communications  LLC  |       | Service-telecommunications |       | Senior Subordinated  Term   Debt (6) |       | 5,972,727 |            | 4,479,545      |       |
|                          |       |                       |       | (14.3%, Due 3/2010)                  |       |      |            |           |       |
|                          |       |                       |       |                                 |       |      |            |           |       |
| **Total:**                    | ** ** | ** **                 | ** ** | ** **                           | ** ** | **$**     | **205,375,554** | ** **     | **$**      | **200,846,763** | ** ** |

 

----

(1) We do not “Control,” and are not an “Affiliate” of, any of ourportfolio companies, each as defined in the Investment Company Act of 1940, asamended (the “1940 Act”). In general, under the 1940 Act, we would “Control” aportfolio company if we owned 25% or more of its voting securities and would bean “Affiliate” of a portfolio company if we owned 5% or more of its votingsecurities.

(2) Percentage represents interest rates in effect at September30, 2005 and due date represents the contractual maturity date.

(3) Last Out Tranche of senior debt, meaning if the company isliquidated then the holder of the Last Out Tranche is paid after the seniordebt.

(4) Last Out Tranche of senior debt, meaning if the company isliquidated then the holder of the Last Out Tranche is paid after the seniordebt, however the debt is junior to another Last Out Tranche.

(5) Has some paid in kind (PIK) interest.  Refer to Note 2 “Summary of SignificantAccounting Policies” of the Company’s Form 10-K for the fiscal year endedSeptember 30, 2005.

(6) Fair value was based on valuation prepared and provided byStandard & Poor’s Loan Evaluation Services.

(7) Marketable securities, such as syndicated loans, are valuedbased on the indicative bid price, as of September 30, 2005, from therespective originating syndication agent’s trading desk.

(8) Investment was valued at cost due to recent acquisition.

(9) Availability under the credit facility totals $500,000.  There were no borrowings outstanding atSeptember 30, 2005.

(10) Includes a success fee with a $347,986 fair value and no costbasis.

(11) Non-income producing at September 30, 2005.

(12) Subsequent to September 30, 2005, the entire investment inthe portfolio company was sold at the fair value reflected herein.

 

*THEACCOMPANYING NOTES ARE AN INTEGRAL PART OF THESE CONSOLIDATED FINANCIALSTATEMENTS.*

 

8

----

 

**GLADSTONE CAPITAL CORPORATIONCONSOLIDATED STATEMENTS OF OPERATIONS(UNAUDITED)**

 
| ** **                                                              | ** ** | **Three Months Ended March 31,** | ** ** |
|-------------------------------------------------------------------------|------------|----------------------------------|------------|
| ** **                                                              | ** ** | **2006**                         | ** ** | **2005** | ** ** |
| INVESTMENT INCOME                                                       |       |                             |       |   |   |
| Interest income – investments                                      |       | $                                | 6,875,264  |   | $ | 5,198,180 |   |
| Interest income – cash and cash equivalents                        |       | 4,624                            |       | 5,130 |   |
| Interest income – notes receivable from employees                  |       | 107,033                          |       | 113,599 |   |
| Prepayment fees and other income                                        |       | 13,779                           |       | 569,620 |   |
| Total investment income                                                 |       | 7,000,700                        |       | 5,886,529 |   |
|                                                                    |       |                             |       |   |   |
| EXPENSES                                                                |       |                             |       |   |   |
| Loan servicing (Refer to Note 12)                                       |       | 734,644                          |       | 585,542 |   |
| Management fee (Refer to Notes 12 and 15)                               |       | 352,379                          |       | 390,007 |   |
| Professional fees                                                       |       | 110,887                          |       | 156,383 |   |
| Amortization of deferred financing fees                                 |       | 32,286                           |       | 91,912 |   |
| Interest expense                                                        |       | 948,166                          |       | 439,521 |   |
| Stockholder related costs                                               |       | 115,864                          |       | 104,541 |   |
| Directors fees                                                          |       | 30,212                           |       | 24,000 |   |
| Insurance expense                                                       |       | 50,590                           |       | 43,890 |   |
| Stock option compensation                                               |       | 34,065                           |       | — |   |
| General and administrative exepnses                                     |       | 60,791                           |       | 69,475 |   |
| Expenses before credit from Gladstone Management                        |       | 2,469,884                        |       | 1,905,271 |   |
| Credit to management  fee for fees collected by Gladstone Management    |       |                             |       |   |   |
| (Refer to Note 15)                                                      |       | (673,000                         | )          | (450,000 | ) |
| Total expenses net of credit to management fee                          |       | 1,796,884                        |       | 1,455,271 |   |
|                                                                    |       |                             |       |   |   |
| NET INVESTMENT INCOME  BEFORE INCOME TAXES                              |       | 5,203,816                        |       | 4,431,258 |   |
| Income tax expense                                                      |       | —                           |       | — |   |
| NET INVESTMENT INCOME                                                   |       | 5,203,816                        |       | 4,431,258 |   |
|                                                                    |       |                             |       |   |   |
| REALIZED AND UNREALIZED  GAIN (LOSS) ON INVESTMENTS:                    |       |                             |       |   |   |
| Realized gain on sale of investments                                    |       | 377,500                          |       | 20,000 |   |
| Unrealized appreciation on derivative                                   |       | 24,658                           |       | 15,848 |   |
| Net unrealized depreciation on investments                              |       | (15,593                          | )          | (191,728 | ) |
| Net gain (loss) on investments                                          |       | 386,565                          |       | (155,880 | ) |
|                                                                    |       |                             |       |   |   |
| NET INCREASE IN NET  ASSETS RESULTING FROM OPERATIONS                   |       | $                                | 5,590,381  |   | $ | 4,275,378 |   |
|                                                                    |       |                             |       |   |   |
| NET INCREASE IN NET ASSETS RESULTING FROM OPERATIONS  PER COMMON SHARE: |       |                             |       |   |   |
| Basic                                                                   |       | $                                | 0.49       |   | $ | 0.38 |   |
| Diluted                                                                 |       | $                                | 0.48       |   | $ | 0.37 |   |
|                                                                    |       |                             |       |   |   |
| WEIGHTED AVERAGE SHARES  OF COMMON STOCK OUTSTANDING:                   |       |                             |       |   |   |
| Basic                                                                   |       | 11,308,510                       |       | 11,288,833 |   |
| Diluted                                                                 |       | 11,536,360                       |       | 11,620,603 |   |

 

*THEACCOMPANYING NOTES ARE AN INTEGRAL PART OF THESE CONSOLIDATED FINANCIALSTATEMENTS.*

 

9

----

 

**GLADSTONE CAPITAL CORPORATIONCONSOLIDATED STATEMENTS OF OPERATIONS(UNAUDITED)**

 
| ** **                                                              | ** ** | **Six Months Ended March 31** | ** ** |
|-------------------------------------------------------------------------|------------|-------------------------------|------------|
| ** **                                                              | ** ** | **2006**                      | ** ** | **2005** | ** ** |
| INVESTMENT INCOME                                                       |       |                          |       |   |   |
| Interest income – investments                                      |       | $                             | 12,722,371 |   | $ | 10,905,523 |   |
| Interest income – cash and cash equivalents                        |       | 13,536                        |       | 21,470 |   |
| Interest income – notes receivable from employees                  |       | 214,126                       |       | 228,317 |   |
| Prepayment fees and other income                                        |       | 80,986                        |       | 809,620 |   |
| Total investment income                                                 |       | 13,031,019                    |       | 11,964,930 |   |
|                                                                    |       |                          |       |   |   |
| EXPENSES                                                                |       |                          |       |   |   |
| Loan servicing (Refer to Note 12)                                       |       | 1,450,059                     |       | 1,116,494 |   |
| Management fee (Refer to Notes 12 and 15)                               |       | 621,080                       |       | 717,309 |   |
| Professional fees                                                       |       | 233,353                       |       | 395,105 |   |
| Amortization of deferred financing fees                                 |       | 58,536                        |       | 183,824 |   |
| Interest expense                                                        |       | 1,600,244                     |       | 611,251 |   |
| Stockholder related costs                                               |       | 244,799                       |       | 176,310 |   |
| Directors fees                                                          |       | 54,212                        |       | 51,000 |   |
| Insurance expense                                                       |       | 101,367                       |       | 90,162 |   |
| Stock option compensation                                               |       | 77,322                        |       | — |   |
| General and administrative exepnses                                     |       | 116,580                       |       | 112,635 |   |
| Expenses before credit from Gladstone Management                        |       | 4,557,552                     |       | 3,454,090 |   |
| Credit to management fee for fees collected by  Gladstone Management    |       |                          |       |   |   |
| (Refer to Note 15)                                                      |       | (1,223,000                    | )          | (736,500 | ) |
| Total expenses net of credit to management fee                          |       | 3,334,552                     |       | 2,717,590 |   |
|                                                                    |       |                          |       |   |   |
| NET INVESTMENT INCOME  BEFORE INCOME TAXES                              |       | 9,696,467                     |       | 9,247,340 |   |
| Income tax expense                                                      |       | 50,237                        |       | 138,678 |   |
| NET INVESTMENT INCOME                                                   |       | 9,646,230                     |       | 9,108,662 |   |
|                                                                    |       |                          |       |   |   |
| REALIZED AND UNREALIZED  GAIN (LOSS) ON INVESTMENTS:                    |       |                          |       |   |   |
| Net realized (loss) gain on sale of investments                         |       | (803,095                      | )          | 29,750 |   |
| Unrealized appreciation (depreciation) on derivative                    |       | 23,766                        |       | (8,963 | ) |
| Net unrealized appreciation on investments                              |       | 4,956,829                     |       | 90,877 |   |
| Net gain on investments                                                 |       | 4,177,500                     |       | 111,664 |   |
|                                                                    |       |                          |       |   |   |
| NET INCREASE IN NET  ASSETS RESULTING FROM OPERATIONS                   |       | $                             | 13,823,730 |   | $ | 9,220,326 |   |
|                                                                    |       |                          |       |   |   |
| NET INCREASE IN NET ASSETS RESULTING FROM OPERATIONS  PER COMMON SHARE: |       |                          |       |   |   |
| Basic                                                                   |       | $                             | 1.22       |   | $ | 0.82 |   |
| Diluted                                                                 |       | $                             | 1.20       |   | $ | 0.79 |   |
|                                                                    |       |                          |       |   |   |
| WEIGHTED AVERAGE SHARES  OF COMMON STOCK OUTSTANDING:                   |       |                          |       |   |   |
| Basic                                                                   |       | 11,307,510                    |       | 11,283,671 |   |
| Diluted                                                                 |       | 11,555,479                    |       | 11,614,219 |   |
|                                                                    |       |                          |       |   |   |

 

*THEACCOMPANYING NOTES ARE AN INTEGRAL PART OF THESE CONSOLIDATED FINANCIALSTATEMENTS.*

 

10

----

 

**GLADSTONE CAPITAL CORPORATIONCONSOLIDATED STATEMENTS OF CHANGES IN NET ASSETS(UNAUDITED)**

 
| ** **                                              | ** ** | **Six Months Ended March 31,** | ** **  |
|---------------------------------------------------------|------------|--------------------------------|-------------|
| ** **                                              | ** ** | **2006**                       | ** **  | **2005** | ** ** |
| *Operations:*                                           | * *   | * *                       | * *    | * * | * * |
| Net investment income                                   |       | $                              | 9,646,230   |   | $ | 9,108,662 |   |
| Net realized (loss) gain on sale of investments         |       | (803,095                       | )           | 29,750 |   |
| Unrealized appreciation (depreciation) on  derivatives  |       | 23,766                         |        | (8,963 | ) |
| Net unrealized appreciation on investments              |       | 4,956,829                      |        | 90,877 |   |
| Net increase in net assets from operations              |       | 13,823,730                     |        | 9,220,326 |   |
|                                                    |       |                           |        |   |   |
| *Capital transactions:*                                 | * *   | * *                       | * *    | * * | * * |
| Distributions to stockholders                           |       | (9,159,218                     | )           | (8,125,327 | ) |
| Stock option compensation                               |       | 77,322                         |        | — |   |
| Issuance of common stock under stock option plan        |       | 85,900                         |        | 157,500 |   |
| Repayment of principal on employee notes                |       | 23,094                         |        | 773,389 |   |
| Shelf offering costs                                    |       | —                         |        | (111,233 | ) |
| Decrease in net assets from capital share  transactions |       | (8,972,902                     | )           | (7,305,671 | ) |
|                                                    |       |                           |        |   |   |
| Total increase in net  assets                           |       | 4,850,828                      |        | 1,914,655 |   |
| Net assets at beginning  of year                        |       | 151,610,683                    |        | 152,226,655 |   |
| Net assets at end of  period                            |       | $                              | 156,461,511 |   | $ | 154,141,310 |   |

 

*THEACCOMPANYING NOTES ARE AN INTEGRAL PART OF THESE CONSOLIDATED FINANCIALSTATEMENTS.*

 

11

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**GLADSTONE CAPITAL CORPORATIONCONSOLIDATED STATEMENTS OF CASH FLOWS(UNAUDITED)**

 
| ** **                                                          | ** ** | **Six Months Ended March 31,** | ** ** |
|---------------------------------------------------------------------|------------|--------------------------------|------------|
| ** **                                                          | ** ** | **2006**                       | ** ** | **2005** | ** ** |
| **CASH FLOWS FROM OPERATING  ACTIVITIES**                           | ** ** | ** **                     | ** ** | ** ** | ** ** |
| ** **                                                          | ** ** | ** **                     | ** ** | ** ** | ** ** |
| Net increase in net assets resulting from operations                |       | $                              | 13,823,730 |   | $ | 9,220,326 |   |
| Adjustments to reconcile net increase in net assets  resulting from |       |                           |       |   |   |
| operations to net cash provided by (used in)  operating activities: |       |                           |       |   |   |
| Net amortization of premiums and discounts                          |       | (121,151                       | )          | (8,267 | ) |
| Amortization of deferred financing fees                             |       | 58,536                         |       | 183,824 |   |
| Stock compensation                                                  |       | 77,322                         |       | — |   |
| Realized loss on investments                                        |       | 1,180,595                      |       | — |   |
| Unrealized (appreciation) depreciation on derivative                |       | (23,766                        | )          | 8,963 |   |
| Change in net unrealized appreciation                               |       | (4,956,829                     | )          | (90,877 | ) |
| Decrease (increase) in interest receivable                          |       | 356,566                        |       | (272,193 | ) |
| Increase in funds due from custodian                                |       | (6,627,901                     | )          | (13,268,958 | ) |
| Decrease in prepaid assets                                          |       | 32,812                         |       | 36,136 |   |
| (Increase) decrease in due from affiliate                           |       | (320,621                       | )          | 109,639 |   |
| Decrease in other assets                                            |       | 26,054                         |       | 4,038 |   |
| (Decrease) increase in accounts payable                             |       | (17,304                        | )          | 141 |   |
| Increase in interest payable                                        |       | 95,244                         |       | 49,810 |   |
| Decrease in accrued expenses and deferred  liabilities              |       | (101,379                       | )          | (608,523 | ) |
| (Decrease) increase in fees due to affiliate                        |       | (161,140                       | )          | 53,732 |   |
| Increase in funds held in escrow                                    |       | 40                             |       | — |   |
| Increase in investment balance due to payment in  kind interest     |       | (74,701                        | )          | (275,483 | ) |
| Net cash provided by (used in) operating activities                 |       | 3,246,107                      |       | (4,857,692 | ) |
|                                                                |       |                           |       |   |   |
| **CASH FLOWS FROM INVESTING  ACTIVITIES:**                          | ** ** | ** **                     | ** ** | ** ** | ** ** |
| ** **                                                          | ** ** | ** **                     | ** ** | ** ** | ** ** |
| Purchase of investments                                             |       | (65,159,566                    | )          | (91,463,375 | ) |
| Principal repayments on investments                                 |       | 63,517,133                     |       | 59,835,625 |   |
| Repayment of repurchase agreements                                  |       | —                         |       | (21,345,997 | ) |
| Receipt of principal on notes receivable - employees                |       | 23,094                         |       | 773,389 |   |
| Net cash used in investing activities                               |       | (1,619,339                     | )          | (52,200,358 | ) |
|                                                                |       |                           |       |   |   |
| **CASH FLOWS FROM FINANCING  ACTIVITIES:**                          | ** ** | ** **                     | ** ** | ** ** | ** ** |
| ** **                                                          | ** ** | ** **                     | ** ** | ** ** | ** ** |
| Borrowings from the lines of credit                                 |       | 69,780,000                     |       | 100,400,000 |   |
| Repayments on the lines of credit                                   |       | (62,514,064                    | )          | (82,043,547 | ) |
| Distributions paid                                                  |       | (9,159,218                     | )          | (8,125,327 | ) |
| Exercise of employee stock options                                  |       | 85,900                         |       | 157,500 |   |
| Deferred financing fees                                             |       | (12,072                        | )          | — |   |
| Shelf offering costs                                                |       | —                         |       | (111,233 | ) |
| Net cash (used in) provided by financing activities                 |       | (1,819,454                     | )          | 10,277,393 |   |
|                                                                |       |                           |       |   |   |
| **NET DECREASE IN CASH AND CASH  EQUIVALENTS (1)**                  |       | (192,686                       | )          | (46,780,657 | ) |
| **CASH AND CASH EQUIVALENTS,  BEGINNING OF PERIOD**                 |       | 503,776                        |       | 65,954,840 |   |
| **CASH AND CASH EQUIVALENTS, END  OF PERIOD**                       |       | $                              | 311,090    |   | $ | 19,174,183 |   |
|                                                                |       |                           |       |   |   |
| **CASH PAID DURING PERIOD FOR  INTEREST**                           |       | $                              | 1,505,000  |   | $ | 417,143 |   |
| **CASH PAID DURING PERIOD FOR  INCOME TAXES**                       |       | $                              | —     |   | $ | 138,678 |   |

 

----

(1) Cash and cash equivalents consist of demand deposits andhighly liquid investments with original maturities of three months or less whenpurchased.

 

*THEACCOMPANYING NOTES ARE AN INTEGRAL PART OF THESE CONSOLIDATED FINANCIALSTATEMENTS.*

 

12

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**GLADSTONE CAPITAL CORPORATIONFINANCIAL HIGHLIGHTS(UNAUDITED)**

 
| ** **                                                       | ** ** | **Three Months Ended March 31,** | ** **  |
|------------------------------------------------------------------|------------|----------------------------------|-------------|
| ** **                                                       | ** ** | **2006**                         | ** **  | **2005** | ** ** |
| Per Share Data (1)                                               |       |                             |        |   |   |
| Net asset value at beginning of period                           |       | $                                | 13.74       |   | $ | 13.58 |   |
| *Income from investment operations:*                             | * *   | * *                         | * *    | * * | * * |
| Net investment income (2)                                        |       | 0.46                             |        | 0.39 |   |
| Realized (loss) gain on sale of investments (2)                  |       | 0.03                             |        | — |   |
| Net unrealized gain (loss) on investments (2)                    |       | —                           |        | (0.02 | ) |
| Net unrealized gain on derivatives (2)                           |       | —                           |        | — |   |
| Total from investment operations                                 |       | 0.49                             |        | 0.37 |   |
| Less distributions:                                              |       |                             |        |   |   |
| Distributions from net investment income                         |       | (0.41                            | )           | (0.36 | ) |
| Total distributions                                              |       | (0.41                            | )           | (0.36 | ) |
| Issuance of common stock under stock option plan                 |       | —                           |        | 0.01 |   |
| Repayment of principal on notes receivable                       |       | —                           |        | 0.06 |   |
| Dilutive effect of share issuance                                |       | —                           |        | (0.02 | ) |
| Effect of antidilution (3)                                       |       | 0.02                             |        | — |   |
| Net asset value at end of period                                 |       | $                                | 13.84       |   | $ | 13.64 |   |
|                                                             |       |                             |        |   |   |
| Per share market value at beginning of period                    |       | $                                | 21.38       |   | $ | 23.70 |   |
| Per share market value at end of period                          |       | 21.55                            |        | 21.22 |   |
| Total return (4)(5)                                              |       | 2.78                             | %           | -9.07 | % |
| Shares outstanding at end of period                              |       | 11,308,510                       |        | 11,298,510 |   |
|                                                             |       |                             |        |   |   |
| Ratios/Supplemental Data                                         |       |                             |        |   |   |
| Net assets at end of period                                      |       | $                                | 156,461,511 |   | $ | 154,141,310 |   |
| Average net assets                                               |       | $                                | 154,397,504 |   | $ | 152,288,314 |   |
| Ratio of expenses to average net assets-annualized  (6)          |       | 6.40                             | %           | 5.00 | % |
| Ratio of net expenses to average net  assets-annualized (7)      |       | 4.66                             | %           | 3.82 | % |
| Ratio of net investment income to average net  assets-annualized |       | 13.48                            | %           | 11.64 | % |
|                                                                  |            |                                  |             |  |  |  |  |  |  |

 

----

(1)     Basicper share data.

(2)     Basedon weighted average basic per share data.

(3)     Thisrepresents the antidilutive impact of other components in changes in net assetsand the different share amounts used in calculating per share data as a resultof calculating certain per share data based upon the weighted average basicshares outstanding during the period and certain per share data based on theshares outstanding as of a period end.

(4)     Totalreturn equals the increase of the ending market value over the beginning marketvalue plus monthly dividends divided by the monthly beginning market value,assuming monthly dividend reinvestment.

(5)     Amountswere not annualized.

(6)     Ratioof expenses to average net assets is computed using expenses before credit fromGladstone Management and including income tax expense.

(7)     Ratioof net expenses to average net assets is computed using total expenses net ofcredits to management fee and including income tax expense.

 

*THEACCOMPANYING NOTES ARE AN INTEGRAL PART OF THESE CONSOLIDATED FINANCIALSTATEMENTS.*

 

13

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**GLADSTONECAPITAL CORPORATION**

**FINANCIALHIGHLIGHTS**

**(UNAUDITED)**

 
| ** **                                                       | ** ** | **Six Months Ended March 31,** | ** **  |
|------------------------------------------------------------------|------------|--------------------------------|-------------|
| ** **                                                       | ** ** | **2006**                       | ** **  | **2005** | ** ** |
| Per Share Data (1)                                               |       |                           |        |   |   |
| Net asset value at beginning of period                           |       | $                              | 13.41       |   | $ | 13.50 |   |
| *Income from investment operations:*                             | * *   | * *                       | * *    | * * | * * |
| Net investment income (2)                                        |       | 0.85                           |        | 0.81 |   |
| Realized (loss) gain on sale of investments (2)                  |       | (0.07                          | )           | — |   |
| Net unrealized gain on investments (2)                           |       | 0.44                           |        | 0.01 |   |
| Net unrealized gain (loss) on derivatives (2)                    |       | —                         |        | — |   |
| Total from investment operations                                 |       | 1.22                           |        | 0.82 |   |
| Less distributions:                                              |       |                           |        |   |   |
| Distributions from net investment income                         |       | (0.81                          | )           | (0.72 | ) |
| Total distributions                                              |       | (0.81                          | )           | (0.72 | ) |
| Issuance of common stock under stock option plan                 |       | 0.01                           |        | 0.01 |   |
| Repayment of principal on notes receivable                       |       | —                         |        | 0.07 |   |
| Dilutive effect of share issuance                                |       | —                         |        | (0.03 | ) |
| Offering costs                                                   |       | —                         |        | (0.01 | ) |
| Effect of antidilution (3)                                       |       | 0.01                           |        | — |   |
| Net asset value at end of period                                 |       | $                              | 13.84       |   | $ | 13.64 |   |
|                                                             |       |                           |        |   |   |
| Per share market value at beginning of period                    |       | $                              | 22.55       |   | $ | 22.71 |   |
| Per share market value at end of period                          |       | 21.55                          |        | 21.22 |   |
| Total return (4)(5)                                              |       | -0.75                          | %           | -3.66 | % |
| Shares outstanding at end of period                              |       | 11,308,510                     |        | 11,298,510 |   |
|                                                             |       |                           |        |   |   |
| Ratios/Supplemental Data                                         |       |                           |        |   |   |
| Net assets at end of period                                      |       | $                              | 156,461,511 |   | $ | 154,141,310 |   |
| Average net assets                                               |       | $                              | 152,679,547 |   | $ | 151,859,115 |   |
| Ratio of expenses to average net assets-annualized  (6)          |       | 6.04                           | %           | 4.73 | % |
| Ratio of net expenses to average net  assets-annualized (7)      |       | 4.43                           | %           | 3.76 | % |
| Ratio of net investment income to average net  assets-annualized |       | 12.64                          | %           | 12.00 | % |

 

----

(1)     Basicper share data.

(2)     Basedon weighted average basic per share data.

(3)     Thisrepresents the antidilutive impact of other components in changes in net assetsand the different share amounts used in calculating per share data as a resultof calculating certain per share data based upon the weighted average basicshares outstanding during the period and certain per share data based on theshares outstanding as of a period end.

(4)     Totalreturn equals the increase of the ending market value over the beginning marketvalue plus monthly dividends divided by the monthly beginning market value,assuming monthly dividend reinvestment.

(5)     Amountswere not annualized.

(6)     Ratioof expenses to average net assets is computed using expenses before credit fromGladstone Management and including income tax expense.

(7)     Ratioof net expenses to average net assets is computed using total expenses net ofcredits to management fee and including income tax expense.

 

*THEACCOMPANYING NOTES ARE AN INTEGRAL PART OF THESE CONSOLIDATED FINANCIALSTATEMENTS.*

 

14

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**GLADSTONECAPITAL CORPORATION**

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

**March31, 2006**

**(UNAUDITED)**

 

NOTE 1.  ORGANIZATION

 

Gladstone CapitalCorporation (the “Company”) was incorporated under the General Corporation Lawsof the State of Maryland on May 30, 2001 as a closed-end investmentcompany.  The Company has elected to betreated as a business development company, or BDC, under the Investment CompanyAct of 1940, as amended (the “1940 Act”). In addition, the Company has elected to be treated for tax purposes as aregulated investment company, or RIC, under the Internal Revenue Code of 1986,as amended (the “Code”).  The Company’sinvestment objectives are to achieve a high level of current income byinvesting in debt and equity securities of established private businesses.

 

Gladstone Capital Advisers,Inc. is a wholly-owned subsidiary of the Company.  The financial statements of this subsidiaryare consolidated with those of the Company.

 

Gladstone Business LoanLLC, a wholly-owned subsidiary of the Company, was established for the purposeof owning the Company’s portfolio of loan investments.  The financial statements of this subsidiaryare consolidated with those of the Company.

 

The Company is externallymanaged by Gladstone Management Corporation (“Gladstone Management” or the “Adviser”),an unconsolidated affiliate of the Company.

 

NOTE 2.  UNAUDITED INTERIM FINANCIAL STATEMENTS

 

Interim financialstatements of the Company are prepared in accordance with accounting principlesgenerally accepted in the United States of America (“GAAP”) for interimfinancial information and pursuant to the requirements for reporting on Form 10-Qand Article 10 of Regulation S-X. Accordingly, certain disclosures accompanying annual financialstatements prepared in accordance with GAAP are omitted.  In the opinion of management, alladjustments, consisting solely of normal recurring accruals, necessary for thefair statement of financial statements for the interim periods have beenincluded.  The current period’s resultsof operations are not necessarily indicative of results that ultimately may beachieved for the year.  The interimfinancial statements and notes thereto should be read in conjunction with thefinancial statements and notes thereto included in the Company’s Form 10-K forthe fiscal year ended September 30, 2005, as filed with the Securities andExchange Commission.

 

Certain amounts in theprior year’s financial statements have been reclassified to conform to thecurrent year presentation with no effect to net increase in net assetsresulting from operations.

 

NOTE 3.  RECENT ACCOUNTING PRONOUNCEMENTS

 

In October 2005, theFinancial Accounting Standards Board (“FASB”) released FASB Staff PositionNo. FAS 123(R)-2 (“FSP FAS 123(R)-2”), “*PracticalAccommodation to the Application of Grant Date as Defined in FASB StatementNo. 123(R).”* FSP FAS 123(R)-2 provides guidance on the applicationof grant date as defined in Statement of Financial Accounting Standards (“SFAS”)No. 123(R)*.* The FASBaddresses the notion of “mutual understanding,” specifically that a mutualunderstanding shall be presumed to exist at the date the award is approved inaccordance with the relevant corporate governance requirements if, the award isa unilateral grant and therefore the recipient does not have the ability tonegotiate the terms and conditions of the award with the employer and, the keyterms and conditions of the award are expected to be communicated to anindividual recipient within a relatively short time period for the date ofapproval. The Company applied FSP FAS 123(R)-2 in conjunction with the adoptionof SFAS No. 123(R) on October 1, 2005.

 

15

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NOTE 4.  COMMON STOCKTRANSACTIONS

 

As of March 31, 2005 and March 31, 2006, 50,000,000 shares of $0.001par value common stock were authorized and 11,298,510 and 11,308,510 shareswere outstanding, respectively.

 

Transactions in common stock were as follows:

 
| ** **                                       | ** ** | **Common Stock** | ** ** |
|--------------------------------------------------|------------|-----------------------|------------|
| ** **                                       | ** ** | **Shares**            | ** ** | **Amount** | ** ** |
| Balance at September 30, 2004                    |       | 11,278,510            |       | $ | 11,279 |   |
| Issuance of Common Stock Under Stock Option Plan |       | 20,000                |       | 20 |   |
| Balance at March 31, 2005                        |       | 11,298,510            |       | $ | 11,299 |   |
|                                             |       |                  |       |   |   |
| Balance at September 30, 2005                    |       | 11,303,510            |       | $ | 11,304 |   |
| Issuance of Common Stock Under Stock Option Plan |       | 5,000                 |       | 5 |   |
| Balance at March 31, 2006                        |       | 11,308,510            |       | $ | 11,309 |   |

 

NOTE 5. STOCK OPTIONS

 

In December 2004,the FASB issued SFAS No. 123 (revised 2004) (“SFAS No. 123(R)”) *Share-based Payment*. SFAS No. 123(R)replaces SFAS No. 123, *Accounting forStock-Based Compensation*and supersedes Accounting Principles Board(“APB”) Opinion No. 25, *Accounting forStock Issued to Employees*(“APB No. 25”)*.*SFAS No. 123(R)is effective for awards that are granted, modified, or settled in cash forannual periods beginning after June 15, 2005.  The Company adopted SFASNo. 123(R) on October 1, 2005 using the modified prospectiveapproach. Under the modified prospective approach, stock-based compensationexpense will be recorded for the unvested portion of previously issued awardsthat remain outstanding at October 1, 2005 using the same estimate of thegrant date fair value and the same attribution method used to determine the proforma disclosure under SFAS No. 123. SFAS No. 123(R) also requiresthat all share-based payments to employees after October 1, 2005,including employee stock options, be recognized in the financial statements asstock-based compensation expense based on the fair value on the date ofgrant.  Accordingly, prior period amountshave not been restated.

 

In connection withthe externalization of the Company’s management, all of its officers andemployees became direct employees of Gladstone Management Corporation as ofOctober 1, 2004, the start of fiscal year 2005. However, these individuals continue to be eligible to receive stockoptions under the 2001 Plan (as defined below). Effective October 1, 2004, the Company accounted for any options grantedto employees of Gladstone Management Corporation, who qualify as leasedemployees of the Company under FIN 44, *“Accounting for CertainTransactions Involving Stock Compensation, an Interpretation of APB Opinion No.25.*”

 

Prior to October 1,2005, the Company accounted for stock-based awards in accordance with APB No.25. For the three and six months ended March 31, 2006, the Companyrecorded stock option compensation expense for the cost of stock options issuedunder the Amended and Restated 2001 Equity Incentive Plan (the “2001 Plan”) of$34,065 and $77,322, respectively. The Company’s expensing of stock optionsdecreased both basic and diluted net increase to net assets resulting fromoperations per share by $0.003 and $0.01 for the three and six months endedMarch 31, 2006, respectively. Additionally, SFAS No. 123(R) states that any potential taxbenefits associated with incentive stock options should be recognized only atthe time of settlement if those options settle through a disqualifying disposition.Thus, the related stock-based compensation expense must be treated as apermanent difference until that time which in turn, results in an increase tothe Company’s effective tax rate.  TheCompany does not record tax benefits associated with the expensing of stockoptions since the Company intends to qualify as a RIC under Subchapter M of theCode and as such the Company is not subject to federal income tax on theportion of its taxable income and gains distributed to stockholders, provided thatat least 90% of the taxable income is distributed.

 

Under the provisions ofAPB No. 25, the Company was not required to recognize compensation expensefor the cost of stock options issued under the Company’s 2001 Plan. Thefollowing table illustrates the effect on net increase to net assets resultingfrom operations and net increase to net assets resulting from operations pershare for the three and six months ended March 31, 2005 as if the Companyhad applied the fair value recognition provisions of SFAS No. 123, asamended by SFAS No. 148, *Accounting forStock-Based Compensation-Transition and Disclosure:*

 

16

----

 

 
| ** **                                                                                                  | ** ** | **Three Months  Ended  March 31,  2005** | ** ** | **Six Months  Ended  March 31,  2005** | ** ** |
|-------------------------------------------------------------------------------------------------------------|------------|----------------------------------------------------|------------|--------------------------------------------------|------------|
| Net increase in net assets resulting from operations  as reported:                                          |       | $                                                  | 4,275,378  |                                             | $          | 9,220,326 |   |
|                                                                                                        |       |                                               |       |                                             |       |
| Deduct: Total stock-based compensation expense  determined using the fair value based method for all awards |       | (76,222                                            | )          | (148,577                                         | )          |
|                                                                                                        |       |                                               |       |                                             |       |
| Pro forma net increase in net assets resulting from  operations per share                                   |       | $                                                  | 4,199,156  |                                             | $          | 9,071,749 |   |
|                                                                                                        |       |                                               |       |                                             |       |
| As reported - basic                                                                                         |       | $                                                  | 0.38       |                                             | $          | 0.82 |   |
| As reported - diluted                                                                                       |       | $                                                  | 0.37       |                                             | $          | 0.79 |   |
|                                                                                                        |       |                                               |       |                                             |       |
| Pro forma-basic                                                                                             |       | $                                                  | 0.37       |                                             | $          | 0.80 |   |
| Pro forma-diluted                                                                                           |       | $                                                  | 0.36       |                                             | $          | 0.78 |   |

 

The fair value of each option grant is estimated onthe date of grant using the Black-Scholes option pricing model, whichincorporates a risk free interest rate, an expected life, an expectedvolatility factor, and an expected dividend yield.

 

The following is a summary of the status of theCompany’s 2001 Plan from September 30, 2005 through March 31, 2006:

 

| ** **                                                                        | ** ** | **Shares** | ** ** | **Weighted Average  Exercise Price** | ** ** |
|-----------------------------------------------------------------------------------|------------|------------|------------|------------------------------------------------|------------|
|                                                                              |       |       |       |                                           |       |
| Options outstanding at October 1, 2005                                            |       | 1,307,998  |       | $                                              | 17.81      |   |
| Granted                                                                           |       | 2,500      |       | $                                              | 21.17      |   |
| Expired                                                                           |       | —     |       | $                                              | —     |   |
| Exercised                                                                         |       | (5,000     | )          | $                                              | 17.18      |   |
| Forfeited                                                                         |       | (5,000     | )          | $                                              | 22.55      |   |
| Options outstanding at March 31, 2006, of which  1,300,498 shares are exercisable |       | 1,300,498  |       | $                                              | 17.80      |   |

 

The following is a detailed summary of the stockoptions outstanding at March 31, 2006:

 

| **Range of  Exercise Prices** | ** ** | **Stock  Options  Outstanding** | ** ** | **Weighted  Average  Remaining  Contractual  Life (Years)** | ** ** | **Weighted  Average  Exercise  Price** | ** ** |
|-----------------------------------------|------------|---------------------------------|------------|------------------------------------------------------------------|------------|----------------------------------------|------------|
|                                    |       |                            |       |                                                             |       |                                   |       |
| $15.00 - $21.94                         |       | 971,498                         |       | 5.99                                                             |       | $                                      | 16.07      |   |
| $22.21 - $24.39                         |       | 329,000                         |       | 8.14                                                             |       | $                                      | 22.90      |   |
| Total                                   |       | 1,300,498                       |       | 6.53                                                             |       | $                                      | 17.80      |   |

 

17

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On December 2, 2005, the Company held a specialmeeting of stockholders in which the stockholders voted to approve a proposalto enter into an amended and restated investment advisory agreement (the“Amended Advisory Agreement”) with the Adviser and an administration agreement(the “Administration Agreement”) between the Company and GladstoneAdministration LLC, a wholly-owned subsidiary of the Adviser.  (Please refer to Note 15. Advisory Agreementwith Gladstone Management Corporation for further discussion.)  In connection with the approval of theAmended Advisory Agreement, the Company will terminate the 2001 Plan, and seekagreement from all holders of stock options to exercise or terminate theiroptions within a limited period of time. The stockholders voted to replace the 2001 Plan with an incentive feecomponent of the advisory fee in place between the Company and the Adviser.  The new incentive fee will take effect on thelater of October 1, 2006, the first day of the Company’s 2007 fiscal year, orthe first day of the fiscal quarter following the termination or exercise ofthe last outstanding stock options under the 2001 Plan.  As of March 31, 2006, no formal plan has beenenacted and therefore, there is no change in the remaining contractual lives ofthe outstanding options. (Please refer to Note 17. Subsequent Events forfurther discussion.)

 

NOTE 6. INCREASE IN NETASSETS PER SHARE RESULTING FROM OPERATIONS

 

The following table setsforth the computation of basic and diluted net increase in net assets per shareresulting from operations for the three and six months ended March 31, 2006 andMarch 31, 2005:

 
| ** **                                                                                      | ** ** | **Three Months Ended March 31,** | ** **      | **Six Months Ended March 31,** | ** ** |
|-------------------------------------------------------------------------------------------------|------------|------------------------------------------------------|-----------------|----------------------------------------------------|------------|
| ** **                                                                                      | ** ** | **2006**                                             | ** **      | **2005**                                           | ** ** | **2006** | ** ** | **2005** | ** ** |
|                                                                                            |       |                                                 |            |                                               |       |   |   |   |   |
| Numerator for basic and diluted net increase in net  assets resulting from operations per share |       | $                                                    |  5,590,381 |                                               | $          | 4,275,378 |   | $ |  13,823,730 |   | $ | 9,220,326 |   |
|                                                                                            |       |                                                 |            |                                               |       |   |   |   |   |
|                                                                                            |       |                                                 |            |                                               |       |   |   |   |   |
| Denominator for basic weighted average shares                                                   |       | 11,308,510                                           |            | 11,288,833                                         |       | 11,307,510 |   | 11,283,671 |   |
| Dilutive effect of stock options                                                                |       | 227,850                                              |            | 331,770                                            |       | 247,969 |   | 330,548 |   |
| Denominator for diluted weighted average shares                                                 |       | 11,536,360                                           |            | 11,620,603                                         |       | 11,555,479 |   | 11,614,219 |   |
|                                                                                            |       |                                                 |            |                                               |       |   |   |   |   |
| Basic net increase in net assets resulting from  operations per share                           |       | $                                                    |  0.49      |                                               | $          | 0.38 |   | $ |  1.22 |   | $ | 0.82 |   |
|                                                                                            |       |                                                 |            |                                               |       |   |   |   |   |
| Diluted net increase in net assets resulting                                                    |       |                                                 |            |                                               |       |   |   |   |   |
| from operations per share                                                                       |       | $                                                    |  0.48      |                                               | $          | 0.37 |   | $ |  1.20 |   | $ | 0.79 |   |

 

There were 1,300,498options outstanding to purchase common stock at March 31, 2006. Of these,338,500 and 336,000 options were not included in the computation of dilutedearnings per share for the three and six months ended March 31, 2006,respectively, because the options’ exercise prices were greater than theaverage market price of the common shares for the period, and therefore, wereanti-dilutive.

 

NOTE 7. DIVIDENDS

 

The Company is requiredto pay out as a dividend 90% of its ordinary income and short-term capitalgains for each taxable year in order to maintain its status as a RIC underSubtitle A, Chapter 1 of Subchapter M of the Code.  It is the policy of the Company to pay out asa dividend up to 100% of those amounts. The amount to be paid out as a dividend is determined by the Board ofDirectors each quarter and is based on the annual earnings estimated by themanagement of the Company.  Based on thatestimate, three monthly dividends are declared each quarter.  At year-end the Company may pay a bonus dividend,in addition to the monthly dividends, to ensure that it has paid out at least90% of its ordinary income and short-term capital gains for the year.  Long-term capital gains are composed ofsuccess fees, prepayment fees and gains from the sale of securities held fromone year or more. The Company intends to retain long-term capital gains fromthe sale of securities, if any, and not pay them out as dividends, however, theBoard of Directors may decide to declare and pay out capital gains during any fiscalyear.  The Company currently pays amonthly dividend.  The taxcharacteristics of all dividends will be reported to stockholders on Form 1099at the end of each calendar year.  Thefollowing table lists the per share dividends paid for the three and six monthsended March 31, 2006 and March 31, 2005:

 

18

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| **Fiscal Year** | ** ** | **Record Date** | ** ** | **Payment Date** | ** ** | **Dividend per Share** | ** ** |
|----------------------|------------|----------------------|------------|-----------------------|------------|----------------------------------|------------|
| 2006                 |       | Mar. 23, 2006        |       | Mar. 31, 2006         |       | $                                | 0.135      |   |
|                 |       | Feb. 20, 2006        |       | Feb. 28, 2006         |       | $                                | 0.135      |   |
|                 |       | Jan. 19, 2006        |       | Jan. 31, 2006         |       | $                                | 0.135      |   |
|                 |       | Dec. 21, 2005        |       | Dec. 30, 2005         |       | $                                | 0.135      |   |
|                 |       | Nov. 21, 2005        |       | Nov. 30, 2005         |       | $                                | 0.135      |   |
|                 |       | Oct. 21, 2005        |       | Oct. 31, 2005         |       | $                                | 0.135      |   |
|                 |       |                 |       |                  |       |                             |       |
| 2005                 |       | Mar. 18, 2005        |       | Mar. 31, 2005         |       | $                                | 0.12       |   |
|                 |       | Feb. 11, 2005        |       | Feb. 28, 2005         |       | $                                | 0.12       |   |
|                 |       | Jan. 14, 2005        |       | Jan. 28, 2005         |       | $                                | 0.12       |   |
|                 |       | Dec. 17, 2004        |       | Dec. 30, 2004         |       | $                                | 0.12       |   |
|                 |       | Nov. 17, 2004        |       | Nov. 30, 2004         |       | $                                | 0.12       |   |
|                 |       | Oct. 18, 2004        |       | Oct. 29, 2004         |       | $                                | 0.12       |   |

 

NOTE 8. INVESTMENTVALUATION

 

The Company carries itsinvestments at fair value, as determined by its Board of Directors.  Securities that are publicly traded arevalued at the closing price on the valuation date.  Securities for which a limited market exists,such as participations in syndicated loans, are valued at the indicative bidprice on the valuation date from the respective originating syndication agent’strading desk.  Debt and equity securitiesthat are not publicly traded are valued at fair value as determined in goodfaith by the Board of Directors. The Company currently engages Standard &Poor’s Loan Evaluation Service (“S&P”) to perform independent valuations ofits investments.  The Board of Directorsuses the recommended valuations as prepared by S&P as a component of thefoundation for the final fair value determination.  In making such determination, the Board ofDirectors values non-convertible debt securities at cost plus amortizedoriginal issue discount plus payment in kind (“PIK”) interest, if any, unlessadverse factors lead to a determination of a lesser valuation.  In valuing convertible debt, equity, successor exit fees or other equity like securities, the Board of Directors determinesthe fair value based on the collateral, the issuer’s ability to make payments,the earnings of the issuer, sales to third parties of similar securities, thecomparison to publicly traded securities, discounted cash flow and otherpertinent factors.  Due to theuncertainty inherent in the valuation process, such estimates of fair value maydiffer significantly from the values that would have resulted had a readymarket for the securities existed, and the differences could be material.Additionally, changes in the market environment and other events that may occurover the life of the investments may cause the gains ultimately realized onthese investments to be different than the valuation currently assigned.  Because there is a lag between when theCompany closes a loan and when the loan can be evaluated by S&P, new loansare not valued immediately by S&P; rather, the Board of Directors makes itsown determination about the value of the loan in accordance with the Company’svaluation policy without the input of S&P. Because S&P does not perform independent valuations of mortgageloans or equity securities, the Board of Directors also determines the fairvalue of these investments without the input of S&P.  The Board of Directors considers a number ofqualitative and quantitative factors in current market conditions whenperforming valuations.

 

NOTE9. PAYMENT IN KIND INTEREST

 

The Company seeks toavoid payment in kind (“PIK”) interest, however the Company had one loan in itsportfolio that contained a PIK provision. A PIK provision requires the borrowerto accrue a payment to the Company but the borrower does not have to pay thatinterest until the loan is paid in full. The PIK interest is added to theprincipal balance of the loan and recorded as income to the Company even thoughthe cash has not been received.  Tomaintain the Company’s status as a RIC (as discussed in Note 7, above), thisnon-cash source of income must be paid out to stockholders in the form of cashdividends, even though the Company has not yet collected the cash. For thethree and six months ended March 31, 2006, the Company recorded PIK interestincome of $30,707 and $63,217, respectively and for the three and six monthsended March 31, 2005, the Company recorded PIK interest income of $130,313 and$271,276, respectively.  At March 31, 2006,the Company had no accrued PIK income on its balance sheet as compared toSeptember 30, 2005 in which the Company had accrued on its balance sheet PIKincome of $1,273,251.  On March 31, 2006,the Company’s sole investment that contained a PIK provision repaid in full.

 

NOTE 10. REPURCHASEAGREEMENT

 

A repurchase agreementinvolves the purchase by an investor, such as the Company, of a specifiedsecurity and the simultaneous agreement by the seller to repurchase it at anagreed upon future date and at a price which is greater than the purchase priceby an amount that reflects an agreed-upon interest rate. Such interest rate iseffective for the period of time during which the investor’s money is investedin the arrangement and is related to current market interest rates rather thanthe coupon rate on the purchased security. The Company requires the continualmaintenance by its custodian or the correspondent in its account with theFederal Reserve/Treasury Book Entry System of underlying securities in anamount at least equal to the repurchase price. If the seller were to

 

19

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default on itsrepurchase obligation, the Company might suffer a loss to the extent that theproceeds from the sale of the underlying securities were less than therepurchase price. A seller’s bankruptcy could delay or prevent a sale of theunderlying securities.

 

The Company had nooutstanding repurchase agreement at March 31, 2006 or at September 30,2005.  On October 1, 2004, the Companyrepaid an outstanding repurchase obligation from September 30, 2004 and thisrepayment is reflected in the Consolidated Statement of Cash Flows for the sixmonths ended March 31, 2005.

 

NOTE 11. CONTRACTUALOBLIGATIONS

 

As of March 31, 2006,the Company was a party to a signed and non-binding term sheet for twopotential investments and was due to fund another investment for the Company’sportfolio.  The Company expects to fundthese potential investments as follows:

 
| ** **                       | ** ** | **Payment Due by Period** | ** ** |
|----------------------------------|------------|------------------------------------------|------------|
| **Contractual Obligations** | ** ** | **Total**                                | ** ** | **Less than 1 Year** | ** ** | **1-3 Years** | ** ** | **3-5 Years** | ** ** | **More than  5 Years** | ** ** |
|                             |       |                                     |       |   |   |   |   |   |   |   |   |
| Investments                      |       | 22,000,000                               |       | 22,000,000 |   |   |   |   |   |   |   |
| Total                            |       | $                                        | 22,000,000 |   | $ | 22,000,000 |   | $ | — |   | $ | — |   | $ | — |   |
|                                  |            |                                          |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

All prospectiveinvestments are subject to, among other things, the satisfactory completion ofthe Company’s due diligence investigation of each borrower, acceptance of termsand structure and receipt of necessary consents. With respect to eachprospective loan, the Company will only agree to provide the loan if, amongother things, the results of its due diligence investigations are satisfactory,the terms and conditions of the loan are acceptable and all necessary consentsare received. The Company has initiated its due diligence investigations of thepotential borrowers, however there can be no guarantee that facts will not bediscovered in the course of completing the due diligence that would render aparticular investment imprudent or that any of these investments will actuallybe made.

 

NOTE 12. LINES OF CREDIT

 

In June 2004, theCompany entered into a $15.0 million line of credit agreement with BranchBanking and Trust Company (“BB&T Agreement”), which originally matured inJune 2005 and has been extended through December 31, 2006.  Interest on outstanding borrowings is basedupon the one month London Interbank Offered Rate (“LIBOR”) plus 2.5% perannum.  The unused portion of the line ofcredit is subject to a fee of 0.2% per annum. The BB&T Agreement requires the Company to meet and maintain certaincovenants and ratios with respect to leverage and liquidity. As of March 31,2006, there were no borrowings outstanding under the BB&T line of creditand $15.0 million of available borrowings. At March 31, 2006 the Company was in compliance with all covenants underthe BB&T Agreement.

 

Through itswholly-owned subsidiary Gladstone Business Loan LLC (“Business Loan”), theCompany has a $100 million revolving credit facility (the “DB Facility”) withDeutsche Bank AG, as administrative agent, pursuant to which Business Loan haspledged the loans it holds to secure future advances by certain institutionallenders. The interest rate charged on the advances under the DB Facility isbased on LIBOR, the Prime Rate or the Federal Funds Rate, depending on marketconditions, and adjusts periodically. In May 2005, the Company renewed the DBFacility through May 26, 2006.  As ofMarch 31, 2006, the outstanding principal balance under the DB Facility wasapproximately $60.3 million at an interest rate of 4.7%.  Available borrowings are subject to variousconstraints imposed by Deutsche Bank AG, based on the aggregate loan balancepledged by Business Loan, which varies as loans are added and repaid,regardless of whether such repayments are early prepayment or are made ascontractually required.  At March 31, 2006,the remaining borrowing capacity available under the DB Facility wasapproximately $39.7 million.

 

The DB Facilitycontains covenants that require Business Loan to maintain its status as aseparate entity; prohibit certain significant corporate transactions (such asmergers, consolidations, liquidations or dissolutions); and restrict materialchanges to the Company’s credit and collection policies.  The DB Facility also restricts some of theterms and provisions (including interest rates, terms to maturity and paymentsschedules) and limits the borrower and industry concentrations of loans thatare eligible to secure advances.  As ofMarch 31, 2006, Business Loan was in compliance with all of the facilitycovenants.

 

20

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The administrativeagent also requires that any interest or principal payments on pledged loans beremitted directly by the borrower into a lockbox account with the Bank of NewYork as custodian.  Deutsche Bank AG isalso the trustee of the account and once a month remits the collected funds tothe Company. At March 31, 2006, the amount due from custodian was $9,251,975and at September 30, 2005, the amount due from custodian was $2,624,074.

 

Effective July 12,2004, Gladstone Management, the Company’s affiliated external adviser alsoservices the loans pledged under the DB Facility.  As a condition to this servicing arrangement,the Company executed a performance guaranty pursuant to which it guaranteedthat Gladstone Management would comply fully with all of its obligations underthe DB Facility.  The performanceguaranty requires the Company to maintain a minimum net worth of $100 millionand to maintain “asset coverage” with respect to “senior securitiesrepresenting indebtedness” of at least 200%, in accordance with Section 18of the 1940 Act.  As of March 31, 2006,the Company was in compliance with all covenants under the performanceguaranty.  Gladstone Management servicesthese loans for an annual fee of 1.5% of the monthly aggregate outstanding loanbalance of the loans pledged under the DB Facility.  For the three and six months ended March 31,2006, the Company recorded loan servicing fees of $734,644 and $1,450,059,respectively, as compared to $585,542 and $1,116,494 for the three and sixmonths ended March 31, 2005, respectively. At March 31, 2006, the Company owed $230,182 of unpaid loan servicingfees to Gladstone Management, which are recorded in fees due to Adviser.  At September 30, 2005, the Company owed$207,619 in loan servicing fees to Gladstone Management, recorded in fees dueto Adviser.

 

Loan servicingfees received by Gladstone Management are credited to the Company’s advisoryfee payable to Gladstone Management under the advisory agreement between theCompany and Gladstone Management. Accordingly, the advisory fee payable by the Company to GladstoneManagement for the three months ended March 31, 2006 and March 31, 2005 wasreduced by $734,644 and $585,542, respectively, and for December 31, 2005 andDecember 31, 2004, was reduced by $715,415 and $530,952, respectively, inrespect of these loan servicing fees received by Gladstone Management.

 

NOTE 13. INTEREST RATECAP AGREEMENT

 

Pursuant to the DBFacility, the Company has an interest rate cap agreement that effectivelylimits the interest rate on a portion of the borrowings under the line ofcredit.

 

The use of a cap involvesrisks that are different from those associated with ordinary portfoliosecurities transactions.  Cap agreementsmay be considered to be illiquid. Although the Company will not enter into any such agreements unless itbelieves that the other party to the transaction is creditworthy, the Companydoes bear the risk of loss of the amount expected to be received under suchagreements in the event of default or bankruptcy of the agreement counterparty.

 

In February 2004, theCompany entered into an interest rate cap agreement with a notional amount of$35.0 million at a cost of $304,000.  Theinterest rate cap agreement’s current notional amount is $22.7 million and ithas a current fair value of approximately $74,019 which is recorded in otherassets on the Company’s consolidated balance sheet at March 31, 2006.  At September 30, 2005, the interest rate capagreement had a fair value of $50,253. The Company records changes in the fair value of the interest rate capagreement monthly based on the current market valuation at month end asunrealized depreciation or appreciation on derivative on the Company’sconsolidated statement of operations. The interest rate cap agreement expiresin February 2009. The agreement provides that the Company’s floating interestrate or cost of funds on a portion of the portfolio’s borrowings will be cappedat 5% when the LIBOR rate is in excess of 5%.

 

NOTE 14. SERVICES TOPORTFOLIO COMPANIES

 

The 1940 Act requiresthat a business development company make available managerial assistance to itsportfolio companies. The 1940 Act defines managerial assistance as the servicemade available to a portfolio company to provide “significant guidance andcounsel concerning the management, operations, or business objectives andpolicies of a portfolio company.” The Company offers managerial assistance andother services to its portfolio companies through its external investment adviser,Gladstone Management.  Neither theCompany nor its external investment adviser, Gladstone Management, charges afee for managerial assistance.  GladstoneManagement also offers a wide variety of services to the portfolio companiessuch as investment banking services, arranging bank financing, arranging equityfinancing, structuring financing from multiple lenders and investors, reviewingexisting credit facilities, restructuring existing loans, raising equity anddebt capital, turnaround management, merger and acquisition services andrecruiting new management personnel. Gladstone Management charges a fee for these services and credits thefunds received from portfolio companies for these other services to the Companyas a credit against the investment advisory fee due from the Company under theinvestment advisory agreement.  Such feesare normally paid in part at the time of signing a non-binding letter ofintent, with the remainder paid upon completion of the services, and aregenerally non-recurring.

 

21

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While GladstoneManagement receives all fees in connection with the Company’s investments, suchfees received by Gladstone Management are credited to the Company as areduction of the advisory fee payable to Gladstone Management under theadvisory agreement between the Company and Gladstone Management.  For the three months ended March 31, 2006 andMarch 31, 2005, Gladstone Management received $673,000 and $450,000,respectively, for fees rendered to portfolio companies and for the three monthsended December 31, 2005 and December 31, 2004, Gladstone Management received$550,000 and $286,500, respectively, of such fees. None of these fees were formanagerial assistance even though Gladstone Management provided managerialassistance to many of the Company’s portfolio companies.  Accordingly, the advisory fee payable by theCompany to Gladstone Management for the three months ended March 31, 2006 andMarch 31, 2005 was reduced by $673,000 and $450,000, respectively, and for thethree months ended December 31, 2005 and December 31, 2004 was reduced by$550,000 and $286,500, respectively, in respect of these fees received byGladstone Management.

 

NOTE 15. ADVISORYAGREEMENT WITH GLADSTONE MANAGEMENT CORPORATION

 

Effective October 1,2004, the Company entered into an advisory agreement with Gladstone Management,an unconsolidated affiliate of the Company, whereby Gladstone Management servesas an external adviser to the Company. As compensation for the services of Gladstone Management, the Companypays Gladstone Management an annual advisory fee of 1.25% of total assets (asreduced by cash and cash equivalents pledged to creditors), payable inquarterly computed increments of 0.3125%, and an annual administrative fee of0.75% of total assets (as reduced by cash and cash equivalents pledged tocreditors), payable in quarterly computed increments of 0.1875%, for a totalannual fee of 2.0% (0.50% quarterly) of total assets (as reduced by cash andcash equivalents pledged to creditors). The Company continues to pay directexpenses including, but not limited to, directors’ fees, legal and accountingfees, stockholder related expenses, and directors and officers insurance.

 

Gladstone Managementservices the loans held by Business Loan, in return for which, GladstoneManagement receives a 1.5% annual fee based on the monthly aggregate balance ofloans held by Business Loan.  Since theCompany owns these loans, all loan servicing fees paid to Gladstone Managementare also credited directly against the 2% management fee.  These credits reduce the amount of theinvestment advisory fee and are shown above the direct credits line item in thetable below.  For the three months endedMarch 31, 2006 and December 31, 2005, these loan servicing fees totaled$734,644 and $715,415, respectively, as compared to the loan servicing fees forthe three months ended March 31, 2005 and December 31, 2004 of $585,542 and$530,952, respectively, all of which were credited against the 2% managementfee in order to derive the management fee which is presented as the line itemmanagement fee in the consolidated statement of operations.  Under the advisory agreement, GladstoneManagement also provides the managerial assistance and other services to theCompany’s portfolio companies.  To theextent that Gladstone Management receives any fees directly from a portfoliocompany for such services, Gladstone Management credits these fees directlyagainst the 2% management fee and these amounts are shown in the table below asa credit to the management fee.  For thethree months ended March 31, 2006 and December 31, 2005, Gladstone Managementrecorded $673,000 and $550,000, respectively of such fees and credited this amountagainst the 2% management fee received from the Company, as compared such feesfor March 31, 2005 and December 31, 2004 of $450,000 and $286,500, thesecredits are reflected on the consolidated statement of operations as credit tomanagement fees for fees collected by Gladstone Management.  Overall, the management fee due to GladstoneManagement cannot exceed 2% of total assets (as reduced by cash and cashequivalents pledged to creditors) during any given fiscal year.

 

The following tables setforth the quarterly computation of the management fee for the three monthsended March 31, 2006 and December 31, 2005 and for the three months ended March31, 2005 and December 31, 2004, based on the quarterly increment of 0.50%(0.3125% quarterly advisory fee and 0.1875% quarterly administrative fee):

 
| ** **                                                 | ** ** | **Three Months Ended** | ** **  |
|------------------------------------------------------------|------------|----------------------------------|-------------|
| ** **                                                 | ** ** | **March 31, 2006**     | ** **  | **December 31, 2005** | ** ** |
| **Fee:**                                                   |       |                             |        |   |   |
| Total assets at                                            |       | $                                | 217,404,695 |   | $ | 211,823,244 |   |
| Less: Borrowings under line of credit at                   |       | —                           |        | (15,000,000 | )(a) |
| Total assets subject to fee as of                          |       | 217,404,695                      |        | 196,823,244 |   |
| Quarterly fee rate                                         |       | 0.50                             | %           | 0.50 | % |
| Gross management fee before loan servicing fee  credit     |       | 1,087,023                        |        | 984,116 |   |
| Less: loan servicing fee from Gladstone Business  Loan LLC |       | 734,644                          |        | 715,415 |   |
| Management fee before credit:                              |       | 352,379                          |        | 268,701 |   |
| **Direct Credit to Management Fee:**                       |       |                             |        |   |   |
| Fee revenue recorded by Gladstone Management:              |       | 673,000                          |        | 550,000 |   |
| Net management fee for the three months ended (c):         |       | $                                | (320,621    | ) | $ | (281,299 | ) |
|                                                            |            |                                  |             |  |  |  |  |  |

 

22

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| ** **                                                 | ** ** | **Three Months Ended** | ** **  |
|------------------------------------------------------------|------------|----------------------------------|-------------|
| ** **                                                 | ** ** | **March 31, 2005**     | ** **  | **December 31, 2004** | ** ** |
| **Fee:**                                                   |       |                             |        |   |   |
| Total assets at                                            |       | $                                | 213,753,998 |   | $ | 194,085,591 |   |
| Less: Borrowings under line of credit at                   |       | (18,644,179                      | )(b)        | (22,435,000 | )(b) |
| Total assets subject to fee as of                          |       | 195,109,819                      |        | 171,650,591 |   |
| Quarterly fee rate                                         |       | 0.50                             | %           | 0.50 | % |
| Gross management fee before loan servicing fee  credit     |       | 975,549                          |        | 858,254 |   |
| Less: loan servicing fee from Gladstone Business  Loan LLC |       | 585,542                          |        | 530,952 |   |
| Management fee before credit:                              |       | 390,007                          |        | 327,302 |   |
| **Direct Credit to Management Fee:**                       |       |                             |        |   |   |
| Fee revenue recorded by Gladstone Management:              |       | 450,000                          |        | 286,500 |   |
| Net management fee for the three months ended (c):         |       | $                                | (59,993     | ) | $ | 40,802 |   |

 

----

*(a)*  *This amount representsborrowings under one of the Company’s lines of credit that were held in cash andcash equivalents as of December 31, 2005. The $15.0 million was to be used to fund a new loan investment, howeverthe investment did not fund until January 2006. Solely for the purposes of calculating the amount of the management feedue to Gladstone Management, the Company treats any such amounts as “cash andcash equivalents pledged to creditors” under the terms of the Company’sadvisory agreement with Gladstone Management. As a result, such amounts are deducted from the Company’s total assetsfor purposes of computing the asset base upon which the management fee isdetermined.*

 

*(b)*  *This amount representsborrowings under one of the Company’s lines of credit that were held in cashand cash equivalents as of March 31, 2005 and December 31, 2004, for thepurpose of satisfying the Company’s asset diversification requirements underthe Code.  Solely for the purposes ofcalculating the amount of the management fee due to Gladstone Management, theCompany treats any such amounts as “cash and cash equivalents pledged tocreditors” under the terms of the Company’s advisory agreement with GladstoneManagement.  As a result, such amountsare deducted from the Company’s total assets for purposes of computing theasset base upon which the management fee is determined.*

 

*(c)  If the amount presented is in parentheses itdenotes the amount is due back to the Company from the Adviser; if the amountis positive, it indicates that the Company owes the Adviser the amount.*

 

On December 2, 2005, theCompany’s stockholders approved a proposal to enter into an amended andrestated investment advisory agreement (the “Amended Advisory Agreement”) withGladstone Management (the “Adviser”) and an administration agreement (the“Administration Agreement”) between the Company and Gladstone Administration,LLC (the “Administrator”), a wholly-owned subsidiary of the Adviser.

 

The Amended AdvisoryAgreement provides for an annual base management fee equal to 2% of theCompany’s assets and an income-based incentive fee which will reward theAdviser if the Company’s quarterly net investment income (before giving effectto the incentive fee) exceeds 1.75% of net assets.  The agreement also provides for an annualcapital gains-based incentive fee, whereby the Adviser will receive an annual feeequal to 20% of the Company’s realized capital gains (net of realized capitallosses and unrealized capital depreciation since inception of theCompany).  Under the AdministrationAgreement, the Company will pay separately for its allocable portion of theAdministrator’s overhead expenses in performing its obligations, includingrent, and the Company’s allocable portion of the salaries and benefits expensesof its chief financial officer, chief compliance officer and controller andtheir respective staffs.

 

In connection with theapproval of the Amended Advisory Agreement, the Company will terminate the 2001Plan, and seek agreement from all holders of stock options to exercise orterminate their options within a limited period of time.  The Amended Advisory Agreement and theAdministration Agreement will become effective upon the later of (i) October 1,2006, or (ii) the first day of the first fiscal quarter following the date thatall existing stock options are exercised. The Amended Advisory Agreement andAdministration Agreement will not become effective as long as the 2001 Plan isin effect or as long as there are any outstanding stock options.  The current investment advisory agreementwith Gladstone Management will continue in effect until these new agreementsbecome effective.

 

23

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NOTE16. FEDERAL AND STATE INCOME TAXES

 

TheCompany has historically operated, and intends to continue to operate, in amanner to qualify for treatment as a RIC under Subchapter M of the Code. As aRIC, the Company is not subject to federal or state income tax on the portionof its taxable income and gains distributed to stockholders. To qualify as aRIC, the Company is required to distribute to its stockholders at least 90% ofinvestment company taxable income, as defined by the Code and, as such, no incometax provisions have been recorded for the individual companies of GladstoneCapital Corporation and Gladstone Business Loan LLC.

 

During the six months ended March 31, 2006, Gladstone CapitalCorporation recorded approximately $50,000 in connection with penaltiesincurred on misclassified revenue on its fiscal year 2004 corporate tax return.

 

GladstoneCapital Advisers, Inc., a wholly-owned subsidiary of Gladstone CapitalCorporation, is subject to federal and state income taxation on the income ithas recorded, such as fees received from portfolio companies, resulting inaggregate federal and state income taxes of $138,678 during the six monthsended March 31, 2005.

 

NOTE17. SUBSEQUENT EVENTS

 

In April 2006, the Companypurchased a $1.0 million syndicated loan participation in Bresnan BroadbandHoldings LLC, a $1.0 million syndicated loan participation in CavalierTelephone Corp, and reentered an $8.0 million syndicated loan participation inJohn Henry Holdings, Inc. John Henry Holdings, Inc., Polar Corporation, andSantana Plastics repaid their entire investments of approximately $7.1 million,$10.0 million, and $7.8 million, respectively.

 

In April 2006, the Company’sBoard of Directors declared the following monthly dividends:

 
| **Fiscal Year** | ** ** | **Record Date** | ** ** | **Payment Date** | ** ** | **Dividend per Share** | ** ** |
|----------------------|------------|----------------------|------------|-----------------------|------------|----------------------------------|------------|
| 2006                 |       | June 22, 2006        |       | June 30, 2006         |       | $                                | 0.135      |   |
|                 |       | May 22, 2006         |       | May 31, 2006          |       | $                                | 0.135      |   |
|                 |       | April 20, 2006       |       | April 28, 2006        |       | $                                | 0.135      |   |

 

On April 11, 2006, theCompany’s Board of Directors approved an offer to current stock option holdersto amend the terms of all outstanding stock options under the 2001 Plan toaccelerate the contractual expiration date of these options to September 30,2006. The offer is conditioned upon the acceptance by 100% of the current stockoption holders. If the offer is accepted by 100% of the current stock optionholders, then, effective October 1, 2006, the Company will implement the AmendedAdvisory Agreement and the Administration Agreement. The Company’s Board ofDirectors also accelerated in full the vesting of all outstanding options otherthan options held by the Company’s non-employee Directors. The impact of thismodification to the 2001 Plan will be the recognition of compensation expenseof approximately $13,000 in the third quarter of fiscal year 2006.

 

In addition, the Board of Directors of the Adviser has voluntarilyagreed to waive, on a temporary basis, certain fees paid by the Company to theAdviser under the Advisory Agreement. The Company currently pays 1.25% of itstotal assets (as reduced by cash and cash equivalents pledged to creditors) andthe waiver provides that the 1.25% will be reduced to 0.5% for the portion oftotal assets that consists of investments in senior and second lien syndicatedloans. The Adviser also agreed to waive the administrative fee of 0.75% for thesenior syndicated loans; however, there is no waiver of the administrative feefor second lien syndicated loans.

 

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**ITEM 2. MANAGEMENT’SDISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.**

 

**All statements containedherein, other than historical facts, may constitute “forward-looking statements”within the meaning of Section 27A of the Securities Act of 1933, as amended,and Section 21E of the Securities Exchange Act of 1934, as amended. Thesestatements may relate to, among other things, future events or our futureperformance or financial condition. In some cases, you can identifyforward-looking statements by terminology such as “may,” “might,” “believe,” “will,”“provided,” “anticipate,” “future,” “could,” “growth,” “plan,” “intend,” “expect,”“should,” “would,” “if,” “seek,” “possible,” “potential,” “likely” or thenegative of such terms or comparable terminology. These forward-lookingstatements involve known and unknown risks, uncertainties and other factorsthat may cause our actual results, levels of activity, performance orachievements to be materially different from any future results, levels ofactivity, performance or achievements expressed or implied by suchforward-looking statements. Such factors include, among others: (1) adversechanges in interest rates; (2) our failure or inability to establish ormaintain referral arrangements with leveraged buyout funds and venture capitalfunds to generate loan opportunities; (3) the loss of one or more of ourexecutive officers, in particular David Gladstone, Terry Lee Brubaker, orGeorge Stelljes III; (4) our inability to extend, refinance or maintain ourcredit facilities on terms reasonably acceptable to us, if at all in futureequity capital resources; (5) our inability to successfully securitize our loanportfolio on terms reasonably acceptable to us, if at all; (6) the decision ofour competitors to aggressively seek to make senior and subordinated loans tosmall and medium-sized businesses on terms more favorable than we intend toprovide; and (7) those factors listed under the caption “Risk Factors” of theAnnual Report on Form 10-K as filed with the Securities and Exchange Commissionon December 13, 2005 and under Part II, Item 1A of this Form 10-Q. We cautionreaders not to place undue reliance on any such forward-looking statements,which are made pursuant to the Private Securities Litigation Reform Act of 1995and, as such, speak only as of the date made. We undertake no obligation topublicly update or revise any forward-looking statements, whether as a resultof new information, future events or otherwise, after the date of this Form10-Q**.

 

*The following analysisof our financial condition and results of operations should be read inconjunction with our financial statements and the notes thereto containedelsewhere in this report.*

 

**OVERVIEW**

 

We were incorporated under the General Corporation Laws of the State ofMaryland on May 30, 2001. Our investment objectives are to achieve a high levelof current income by investing in debt securities, consisting primarily ofsenior notes, second lien notes, and senior subordinated notes of establishedprivate businesses that are backed by leveraged buyout funds, venture capitalfunds or others, with a particular emphasis on second lien and seniorsubordinated notes. In addition, we may acquire existing loans, which meet thisprofile, from leveraged buyout funds, venture capital funds and others. We alsoseek to provide our stockholders with long-term capital growth through theappreciation in the value of warrants, or other equity instruments that we mayreceive when we extend loans. We operate as a closed-end, non-diversified managementinvestment company, and have elected to be treated as a business developmentcompany under the 1940 Act.

 

We seek out small and medium-sized businesses that meet certaincriteria, including some or all of the following:  (1) the potential for growth in cash flow,(2) adequate assets for loan collateral, (3) experienced management teams witha significant ownership interest in the borrower, (4) profitable operationsbased on the borrower’s cash flow, (5) reasonable capitalization of theborrower (usually by buyout funds or venture capital funds) and (6) thepotential to realize appreciation and gain liquidity in our equity position, ifany. We anticipate that liquidity in our equity position will be achievedthrough a merger or acquisition of the borrower, a public offering by theborrower or by exercise of our right to require the borrower to buy back itswarrants. We lend to borrowers that need funds to finance growth, restructuretheir balance sheets or effect a change of control.

 

Our loans typically range from $5 million to $15 million, mature in nomore than seven years and accrue interest at a fixed or variable rate thatexceeds the prime rate. Some of our loans may contain a provision that callsfor some portion of the interest payments to be deferred and added to theprincipal balance so that the interest is paid, together with the principal, atmaturity. This form of deferred interest is often called “payment in kind” or “PIK”interest, and, when earned, we record PIK interest as interest income and addthe PIK interest to the principal balance of the loans. We seek to avoid PIKinterest with all potential investments under review. There was no PIK accruedon our balance sheet as of March 31, 2006.

 

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Because our loans will generally be subordinated debt of privatecompanies who typically cannot or will not expend the resources to have theirdebt securities rated by a credit rating agency, we expect that most, if notall, of the debt securities we acquire will be unrated. We cannot accuratelypredict what ratings these loans might receive if they were in fact rated, andtherefore we cannot determine whether or not they could be considered to be “investmentgrade” quality.

 

To the extent possible, our loans generally are collateralized by asecurity interest in the borrower’s assets. Interest payments are generallymade monthly or quarterly (except to the extent of any PIK interest) withamortization of principal generally being deferred for several years. Theprincipal amount of the loans and any accrued but unpaid interest generallybecome due at maturity at five to seven years. When we receive a warrant topurchase stock in a borrower in connection with a loan, the warrant willtypically have an exercise price equal to the fair value of the portfoliocompany’s common stock at the time of the loan and entitle us to purchase amodest percentage of the borrower’s stock.

 

Original issue discounts (“OID”) arise when we extend a loan andreceive an equity interest in the borrower at the same time. To the extent thatthe price paid for the equity is not at market value, the Company must allocatepart of the price paid for the loan, to the value of the equity. Then theamount allocated to the equity, the OID, must be amortized over the life of theloan. As with PIK interest, the amortization of OID also produces income thatmust be recognized for purposes of satisfying the regulated investment company(“RIC”) distribution requirements, whereas the cash is received, if at all,when the equity instrument is sold.

 

In addition, as a business development company under the 1940 Act, weare required to make available significant managerial assistance to ourportfolio companies. Effective October 1, 2004, our investment adviser,Gladstone Management Corporation (“Gladstone Management” or the “Adviser”)began to provide these services on our behalf through its officers who are alsoour officers. In addition, Gladstone Management provides other services to ourportfolio companies, for which it receives fees, in connection with ourinvestments. The fees for these services are generally paid to GladstoneManagement in part at the time a prospective portfolio company signs anon-binding term sheet with us (as further described in the followingparagraph), with the remainder paid at the closing of the investment. Thesefees are generally non-recurring, however in some instances they may have arecurring component which is also paid to Gladstone Management. Any such feesreceived, with the exception of the recurring fees, by Gladstone Management arecredited against the management advisory fee payable to Gladstone Managementpursuant to the terms of our advisory agreement, which has the effect ofreducing our expenses to the extent of any such fees received by GladstoneManagement. The specific services Gladstone Management provides vary byportfolio company, but generally include a wide variety of services to theportfolio companies such as investment banking services, arranging bankfinancing, arranging equity financing structuring financing from multiplelenders and investors, reviewing existing credit facilities, restructuringexisting loans, raising equity and debt capital, turnaround management, mergerand acquisition services and recruiting new management personnel.

 

Prior to making an investment, we ordinarily enter into a non-bindingterm sheet with the potential borrower. These non-binding term sheets aregenerally subject to a number of conditions, including but not limited to thesatisfactory completion of our due diligence investigations of the potentialborrower’s business and reaching agreement on the legal documentation for theloan. Upon execution of the non-binding term sheet, the potential borrowergenerally pays Gladstone Management a non-refundable fee for its servicesrendered through the date of the non-binding term sheet. Prior to theexternalization of our management on October 1, 2004, we recognized this as feerevenue upon execution of the non-binding term sheet. Effective October 1,2004, these fees are received by Gladstone Management and are offset againstamounts due to Gladstone Management, which has the effect of reducing ourexpenses to the extent of any such fees received by Gladstone Management.

 

In the event that we expend significant effort in considering andnegotiating a potential investment that ultimately is not consummated, wegenerally will seek reimbursement from the proposed borrower for our reasonableexpenses incurred in connection with the proposed transaction. Any amountscollected for expenses incurred by Gladstone Management in connection withunconsummated investments will be reimbursed to Gladstone Management. Amountscollected for these expenses incurred by us will be reimbursed to us and willbe recognized as “other income” in the period in which such reimbursement isreceived. Also, in the event that we have incurred significant legal fees inconnection with the transaction, we will typically seek reimbursement for theseexpenses from the proposed borrower. However, there can be no guarantee that wewill be successful in collecting any such reimbursements.

 

The only significant continuing revenue associated with the investmentswe have already closed is interest income and, potentially, capital gainsrealized in connection with the liquidation of any associated equity interest(e.g., warrants).

 

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During the six months ended March 31, 2006, we extended, directly orthrough participations, approximately $65.2 million of new loans to a total ofnine companies. Also, during the six months ended March 31, 2006, fourborrowers repaid loans ahead of contractual maturity at par value, we sold oneinvestment at a gain of approximately $0.4 million and we sold three loaninvestments at a loss of approximately $1.2 million, for an aggregate return ofcapital of approximately $54.6 million and we received scheduled contractualprincipal repayments of approximately $8.9 million, for total principal repaymentsof approximately $63.5 million. Since our initial public offering in August2001, we have made 93****differentloans to, or investments in, 55****companiesfor a total of approximately $431.3****million,before giving effect to principal repayments on investments and divestitures.

 

We are continuously working toward the consummation of moreinvestments. These prospective loans are subject to, among other things, thesatisfactory completion of our due diligence investigation of each borrower,acceptance of terms and structure and necessary consents. With respect to eachprospective loan, we will only agree to provide the loan if, among otherthings, the results of our due diligence investigations are satisfactory, theterms and conditions of the loan are acceptable and all necessary consents arereceived. Our management has initiated its due diligence investigations of thepotential borrowers, however we cannot assure you that we will not discoverfacts in the course of completing our due diligence that would render aparticular investment imprudent or that any of these loans will actually bemade.

 

**External Adviser**

 

Effective October 1, 2004, pursuant to our advisory agreement withGladstone Management, we pay Gladstone Management an annual advisory fee of 1.25%of our total assets (as reduced by cash and cash equivalents pledged tocreditors), payable in quarterly computed increments of 0.3125%, and an annualadministrative fee of 0.75% of our total assets (as reduced by cash and cashequivalents pledged to creditors), payable in quarterly computed increments of0.1875%. This fee is then directly reduced by the amount of loan servicing feespaid to Gladstone Management and any other fees received by GladstoneManagement from our borrowers and potential borrowers. We continue to paydirect expenses including, but not limited to, directors’ fees, legal andaccounting fees, stockholder related expenses, and directors and officersinsurance.

 

Gladstone Management services our loan portfolio pursuant to a loanservicing agreement with Gladstone Business Loan LLC (“Business Loan”) inreturn for a 1.5% annual fee, based on the monthly aggregate outstanding loanbalance of the loans pledged under the facility. For the three months endedMarch 31, 2006 and March 31, 2005 we incurred $734,644 and $585,542,respectively and for the six months ended March 31, 2006 and March 31, 2005, weincurred approximately $1,450,059 and $1,116,494, respectively, in loanservicing fees.

 

For the three months ended March 31, 2006, the gross management fee,before reductions for loan servicing fees and other fees was approximately $1.1million. After being reduced by loan servicing fees of approximately $735,000and other fees received by Gladstone Management of $673,000, our net managementfee for the three months ended March 31, 2006 was a credit of approximately$321,000. For the three months ended March 31, 2005, the gross management fee,before reductions for loan servicing fees and other fees was approximately$976,000. After being reduced by loan servicing fees of approximately $586,000and other fees received by Gladstone Management of $450,000, our net managementfee for the three months ended March 31, 2005 was a credit of approximately$60,000. For the three months ended December 31, 2005 and December 31, 2004,the gross management fee, before reductions for loan servicing fees and otherfees was approximately $984,000 and $858,000, respectively. After being reducedby loan servicing fees of approximately $715,000 and $531,000, respectively,and other fees received by Gladstone Management of approximately $550,000 and$286,500, respectively, our net management fees for the three months endedDecember 31, 2005 and December 31, 2004 was a credit of $281,299 and $40,802,respectively. Since the fees are computed quarterly it is necessary to sum thetwo quarters in order to derive the year to date management fee, therefore forthe six months ended March 31, 2006 and March 31, 2005 gross management feesbefore reductions were approximately $2.1 million and $1.8 million,respectively, and the aggregate net management fees after reductions werecredits of approximately $602,000 and $19,200, respectively, for the six monthsended March 31, 2006 and March 31, 2005.

 

On December 2, 2005, our stockholders approved a proposal to enter intoan amended and restated investment advisory agreement (the “Amended AdvisoryAgreement”) with Gladstone Management and an administration agreement (the “AdministrationAgreement”) between the Company and Gladstone Administration, LLC (the “Administrator”),a wholly-owned subsidiary of the Adviser.

 

The Amended Advisory Agreement provides for an annual base managementfee equal to 2% of our assets and an income-based incentive fee which willreward the Adviser if our quarterly net investment income (before giving effectto the incentive fee) exceeds 1.75% of our net assets. The agreement alsoprovides for an annual capital gains-based incentive fee, whereby the Adviserwill receive an annual fee equal to 20% of our realized capital gains (net ofrealized capital losses and unrealized capital depreciation since inception ofthe Company). Under the Administration Agreement, we will pay separately forour allocable portion of the Administrator’s overhead expenses in performingour obligations, including rent, and our allocable portion of the salaries andbenefits expenses of our chief financial officer, chief compliance officer andcontroller and their respective staffs.

 

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The Amended Advisory Agreement and Administration Agreement will notbecome effective as long as the Amended and Restated 2001 Equity Incentive Plan(the “Plan”) is in effect or as long as there are any outstanding stock options.In connection with the approval of the Amended Advisory Agreement, and pursuant to an offer approvedby our Board of Directors on April 11, 2006, we have extended an offer tocurrent stock option holders to amend the terms of all outstanding stockoptions under the Plan to accelerate the contractual expiration date of theseoptions to September 30, 2006. The offer was filed with the U.S. Securities andExchange Commission on April 12, 2006, and is conditioned upon the acceptanceby 100% of the current stock option holders. If the offer is accepted by 100%of the current stock option holders, then, effective October 1, 2006, theCompany will implement the Amended Advisory Agreement and theAdministration Agreement. The offer to amend the stock options is currentlyscheduled to expire on May 31, 2006, however it may be extended at ourdiscretion. The Amended Advisory Agreement and Administration Agreement willnot become effective as long as the Plan is in effect or as long as there areany outstanding stock options. The current investment advisory agreement withGladstone Management will continue in effect until these new agreements becomeeffective.

 

Our Board of Directors also accelerated in full the vesting of alloutstanding options other than options held by the non-employee Directorseffective April 11, 2006. This action resulted in accelerated vesting of 34,500outstanding options.

 

As of April 25, 2006 there are 1,300,498 outstanding options under thePlan, and no further options will be granted. The shares underlying these stockoptions have been registered under the Securities Act of 1933 (as amended). 1,270,498of these options are now vested following the April 11, 2006 acceleration of34,500 unvested options by our Board of Directors. Upon exercise, the holdersof these options will be able to publicly resell their shares withoutrestriction. Sales of substantial amounts of our common stock in the publicmarket, pursuant to such registration statement, such option exercises, underRule 144 or otherwise, or the availability of such shares for sale, includingas a result of the recent actions taken by our Board of Directors to facilitatethe implementation of the Amended Advisory Agreement and AdministrationAgreement, could adversely affect the prevailing market prices for our commonstock, and could dilute the interests of existing stockholders. This would beparticularly the case if a significant number of option holders elect not to “exerciseand hold” their options, but rather seek to monetize their option holdingsthrough broker-assisted cashless exercises. If this occurs, it could impair ourability to raise additional capital through the sale of equity securitiesshould we desire to do so.

 

In addition, the Board of Directors of the Adviser has voluntarilyagreed to waive, on a temporary basis, certain fees paid by us to the Adviserunder the Advisory Agreement. We currently pay 1.25% of our total assets (asreduced by cash and cash equivalents pledged to creditors) and the waiverprovides that the 1.25% will be reduced to 0.5% for the portion of total assetsthat consists of investments in senior and second lien syndicated loans. TheAdviser also agreed to waive the administrative fee of 0.75% for the seniorsyndicated loans; however, there is no waiver of the administrative fee forsecond lien syndicated loans.

 

**Off-Balance Sheet Arrangements**

 

We do not have any significant off-balance sheet arrangements asdefined in Item 303(a)(4)(ii) of SEC Regulation S-K as of March 31, 2006.

 

**Recent Accounting Pronouncements**

 

***FSP FAS 123(R)-2***

 

In October 2005, the Financial Accounting Standards Board (“FASB”)released FASB Staff Position No. FAS 123(R)-2 (“FSP FAS 123(R)-2”), “*Practical Accommodation to the Application of GrantDate as Defined in FASB Statement No. 123(R).”* FSP FAS 123(R)-2 provides guidance on the application of grant date as defined inSFAS No. 123(R)*.* The FASBaddresses the notion of “mutual understanding,” specifically that a mutualunderstanding shall be presumed to exist at the date the award is approved inaccordance with the relevant corporate governance requirements if, the award isa unilateral grant and therefore the recipient does not have the ability tonegotiate the terms and conditions of the award with the employer and, the keyterms and conditions of the award are expected to be communicated to anindividual recipient within a relatively short time period for the date ofapproval. We applied FSP FAS 123(R)-2 in conjunction with our adoption of SFASNo. 123(R) on October 1, 2005.

 

**Critical Accounting Policies**

 

The preparation of financial statements and related disclosures inconformity with accounting principles generally accepted in the United Statesrequires management to make estimates and assumptions that affect the reportedconsolidated amounts of assets and liabilities, and disclosure of contingentassets and liabilities at the date of the financial statements, and revenuesand expenses during the period reported. Actual results could differ materiallyfrom those estimates. Our accounting policies are more fully described in the “Notesto Consolidated Financial Statements” contained elsewhere in this report. Wehave identified our investment valuation process as our most criticalaccounting policy.

 

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**Investment Valuation**

 

The most significant estimate inherent in the preparation of ourconsolidated financial statements is the valuation of investments and therelated amounts of unrealized appreciation and depreciation of investmentsrecorded.

 

*General Valuation Policy:* We value ourinvestment portfolio each quarter. We carry our investments at fair value, asdetermined in good faith by our Board of Directors. Securities that arepublicly traded, if any, are valued at the closing price of the exchange or securitiesmarket on which they are listed on the valuation date. Securities which are nottraded on a public exchange or securities market, but for which a limitedmarket exists and that have been rated by a nationally recognized statisticalrating organizations (“NRSRO”), such as certain participations in syndicatedloans, are valued at the indicative bid price offered by the syndication agenton the valuation date.

 

Debt and equity securities that are not publicly traded, for which alimited market does not exist, or for which a limited market exists but thathave not been rated by a NRSRO (or for which we have various degrees of tradingrestrictions) are valued at fair value as determined in good faith by our Boardof Directors. In making the good faith determination of the value of thesesecurities, we start with the cost basis of the security, which includes theamortized original issue discount, and PIK interest, if any. We then apply themethods set out below in “Valuation Methods.” Members of our portfolio management team prepare the valuations of ourinvestments in portfolio companies using the most recent portfolio companyfinancial statements and forecasts. These individuals also consult withportfolio company senior management and ownership to obtain further updates onthe portfolio company’s performance, including information such as industrytrends, new product development, and other operational issues. Due to theuncertainty inherent in the valuation process, such estimates of fair value maydiffer significantly from the values that would have been obtained had a readymarket for the securities existed, and the differences could be material. Additionally,changes in the market environment and other events that may occur over the lifeof the investments may cause the gains or losses ultimately realized on theseinvestments to be different than the valuations currently assigned. There is nosingle standard for determining fair value in good faith, as fair value dependsupon circumstances of each individual case. In general, fair value is theamount that we might reasonably expect to receive upon the current sale of thesecurity.

 

We currently engage Standard & Poor’s Loan Evaluation Service (“S&P”)to help evaluate the value of the majority of our loan securities (other thanthose which are publicly traded or for which a limited market exists, asdescribed above), as well as for evaluations on success fees (conditionalinterest included in some loan securities). We and S&P only evaluate thevalue of a success fee if the probability of receiving the success fee on agiven loan is above 6-8%, a threshold of significance, in which case a value isassigned. Upon completing our collection of data with respect to theinvestments (including the information described under “Credit Information,”the risk ratings of the loans described under “Loan Grading and Risk Rating”and the factors described under “Valuation Methods”), this valuation data ispresented to S&P. S&P makes its independent assessment of the data thatwe have assembled and assesses its own data to determine market values for thesecurities. With regard to its work, S&P has issued the followingparagraph:

 

S&P provides evaluated price opinions which are reflective of whatS&P believes the bid side of the market would be for each loan aftercareful review and analysis of descriptive, market and credit information. Eachprice reflects S&P’s best judgment based upon careful examination of avariety of market factors. Because of fluctuation in the market and in otherfactors beyond its control, S&P cannot guarantee these evaluations. Theevaluations reflect the market prices, or estimates thereof, on the datespecified. The prices are based on comparable market prices for similarsecurities. Market information has been obtained from reputable secondarymarket sources. Although these sources are considered reliable, S&P cannotguarantee their accuracy.

 

With our assessment and S&P value estimates as a backdrop, ourBoard of Directors votes to accept or not accept the analyses and valuesrecommended by management and S&P. At March 31, 2006 and September 30,2005, the Board of Directors elected to accept the valuations recommended byS&P on the loans in our portfolio as denoted on the Schedule of Investmentsas of March 31, 2006 and September 30, 2005 in our consolidated financialstatements. Subsequent to September 30, 2005, the fair value of our investmentin ARI Holdings, Inc. was reduced from the value proposed by S&P becausethe investment was sold in November 2005 at a value less than that indicated byS&P on September 30, 2005. Our Board of Directors determined to reduce thevalue proposed by S&P to the value of the sale price and as such the saleprice of the investment is reflected in the fair value on our Schedule ofInvestments as of September 30, 2005 in our consolidated financial statements.

 

Because there is a delay between when we close a loan and when the loancan be evaluated by S&P, new loans are not valued immediately by S&P;rather, the Board of Directors makes its own determination about the value ofthese loans in accordance with our valuation policy. These new loans areusually valued at par. Because S&P does not provide values for mortgageloans or equity securities, our Board of Directors also determines the fairvalue of these investments using our valuation policy without the input ofS&P. At March 31, 2006, we had one mortgage loan in our portfolio for at acost basis of $1.0 million.

 

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*Credit Information:*****We monitor a wide variety of key credit statistics thatprovide information regarding our portfolio companies to help us assess creditquality and portfolio performance. We require our portfolio companies toprovide annual audited and either monthly or quarterly unaudited financialstatements. Using these statements, we calculate and evaluate the creditstatistics. For purposes of analyzing the financial performance of ourportfolio companies, we may make certain adjustments to their cash flowstatements to reflect the pro forma results of a company consistent with achange of control transaction, to reflect anticipated cost savings resultingfrom a merger or restructuring, costs related to new product development,compensation to previous owners, and other acquisition or restructuring relateditems. For those investments for which S&P prepares valuationrecommendations, we provide this credit information to S&P for its use inpreparing its recommendations. For those investments for which S&P does notprepare valuation recommendations, management uses this credit information inconnection with its preparation of valuation recommendations.

 

*Loan Grading and Risk Rating:*****Aspart of our valuation procedures we risk rate all of our loans. Our risk ratingsystem uses a scale of 0 to 10. This system is used to estimate theprobability of default on our debt securities and the probability of loss ifthere is a default. These types of systems are referred to as risk ratingsystems and are used by banks and rating agencies. The risk rating systemcovers both qualitative and quantitative aspects of the business and thesecurities we hold. For thoseinvestments for which S&P prepares valuation recommendations, we compilethis information and provide it to S&P for its consideration in determiningits valuation recommendations. For those investments for which S&P does notprepare valuation recommendations, management uses this information to developvaluation recommendations.

 

We seek to have our risk rating system mirror the risk rating systemsof major risk rating organizations such as those provided by nationallyrecognized statistical rating organizations (“NRSRO”) as defined in Rule 2a-7under the 1940 Act. While we seek to mirror the NRSRO systems, we cannotprovide any assurance that our risk rating system provides the same risk ratingas a NRSRO. The following chart is an estimate of the relationship of our riskrating system to the designations used by two NRSROs as they risk rate debtsecurities of major companies. Because we have established our system to ratedebt securities of companies that are unrated by any NRSRO, there can be noassurance that the correlation to the NRSRO set out below is accurate. Webelieve our risk rating would be significantly higher than a typical NRSRO riskrating because the risk rating of the typical NRSRO is designed for largerbusinesses that can afford to pay an NRSRO to rate their securities. However,our risk rating has been designed to risk rate the securities of smallerbusinesses that are not rated by a typical NRSRO. Therefore, when we use ourrisk rating on larger business securities, the risk rating is higher than atypical NRSRO rating. The primary difference between our risk rating and therating of a typical NRSRO is that our risk rating uses more quantitativedeterminants and includes qualitative determinants that are not used in theNRSRO rating. It is our understanding that most debt securities of middlemarket companies do not exceed the grade of BBB on a NRSRO scale, so therewould be no debt securities in the middle market that would meet the definitionof AAA, AA or A. Therefore, our scale begins with the designation BBB as thebest risk rating.

 
| **Company’s  System** | ** ** | **First  NRSRO** | ** ** | **Second  NRSRO** | ** ** | **Gladstone Capital’s Description(a)**                                                |
|----------------------------|------------|------------------|------------|-------------------|------------|------------------------------------------------------------------------------------------------------|
| **>10**                 |       | Baa2             |       | BBB               |       | Probability of Default (PD during the next ten years is 4% and the  Expected Loss (EL) is 1% or less |
| **10**                     |       | Baa3             |       | BBB-              |       | PD is 5% and the EL is 1% to 2%                                                                      |
| **9**                      |       | Ba1              |       | BB+               |       | PD is 10% and the EL is 2% to 3%                                                                     |
| **8**                      |       | Ba2              |       | BB                |       | PD is 16% and the EL is 3% to 4%                                                                     |
| **7**                      |       | Ba3              |       | BB-               |       | PD is 17.8% and the EL is 4% to 5%                                                                   |
| **6**                      |       | B1               |       | B+                |       | PD is 22% and the EL is 5% to 6.5%                                                                   |
| **5**                      |       | B2               |       | B                 |       | PD is 25% and the EL is 6.5% to 8%                                                                   |
| **4**                      |       | B3               |       | B-                |       | PD is 27% and the EL is 8% to 10%                                                                    |
| **3**                      |       | Caa1             |       | CCC+              |       | PD is 30% and the EL is 10.0% to 13.3%                                                               |
| **2**                      |       | Caa2             |       | CCC               |       | PD is 35% and the EL is 13.3% to 16.7%                                                               |
| **1**                      |       | Caa3             |       | CC                |       | PD is 65% and the EL is 16.7% to 20%                                                                 |
| **0**                      |       | N/a              |       | D                 |       | PD is 85% or there is a Payment Default: and the EL is greater than  20%                             |

 

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*(a) the default rates set here are for a ten yearterm debt, if the company’s debt security is less than ten years then theprobability of default is adjusted to a lower percentage for the shorter periodwhich may move the security higher on our risk rating scale.*

* *

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* *

The above scale gives an indication of the probability of default andthe magnitude of the loss if there is a default. The following table lists therisk ratings for all of the debt securities outstanding at March 31, 2006,December 31, 2005 and September 30, 2005:

 
| **Rating**       | ** ** | **Mar. 31, 2006** | ** ** | **Dec. 31, 2005** | ** ** | **Sept. 30, 2005** | ** ** |
|------------------|------------|-------------------|------------|-------------------|------------|--------------------|------------|
| Average          | ** ** | **7.1**           | ** ** | **7.1**           | ** ** | **7.0**            | ** ** |
| Weighted Average | ** ** | **7.1**           | ** ** | **7.2**           | ** ** | **7.1**            | ** ** |
| Highest          | ** ** | **9.0**           | ** ** | **9.0**           | ** ** | **9.0**            | ** ** |
| Lowest           | ** ** | **4.0**           | ** ** | **5.0**           | ** ** | **5.0**            | ** ** |

 

Our policy is to stop accruing interest on an investment if wedetermine that interest is no longer collectible. Currently, none of ourinvestments are on non-accrual. At March 31, 2006, no payments were past due onany of our debt securities. At September 30, 2005, ARI Holdings, Inc. was pastdue on its payments and was placed on non-accrual. This investment was sold inNovember 2005 at an approximate loss of $1.1 million. We do not risk rate ourequity securities.

 

*Valuation Methods:*  For debt securities, we first determine ifthe debt security is publicly traded (i.e., if it is listed on an exchange orsecurities market). If it is publicly traded, then we determine the value basedon the closing price for the security on the exchange or securities market onwhich it is listed on the valuation date. If the security is not publiclytraded, but a limited market for the security exists, such as for syndicatedloans, and if the security has been rated by a NRSRO, then we value the loan atthe indicative bid price offered by the syndication agent on the valuation date.At March 31, 2006, none of the debt securities in our portfolio were publiclytraded and there was a limited market for 11 debt securities in our portfolio. AtSeptember 30, 2005, none of the debt securities in our portfolio were publiclytraded and there was a limited market for 12 debt securities in our portfolio.

 

For debt securities that either are not publicly traded, for whichthere is no market, or for which there is a market but have not been rated by aNRSRO, we begin with the risk rating designation of the security describedabove. Using the risk rating designation above, we seek to determine the valueof the security as if we intended to sell the security in a current sale. Todetermine the current sale price of the security, we consider some or all ofthe following factors:

 

•                  financialstanding of the issuer of the security;

 

•                  comparison ofthe business and financial plan of the issuer with actual results;

 

•                  the cost of thesecurity;

 

•                  the size of thesecurity held as it relates to the liquidity of the market for such securities;

 

•                  contractualrestrictions on the disposition of the security;

 

•                  pending publicoffering of the issuer of the security;

 

•                  pendingreorganization activity affecting the issuer, such as mergers or debtrestructuring;

 

•                  reported pricesof similar securities of the issuer or comparable issuers;

 

•                  ability of theissuer to obtain needed financing;

 

•                  changes in theeconomy affecting the issuer;

 

•                  recent purchasesor sale of a security of the issuer;

 

•                  pricing by otherbuyers or sellers of similar securities;

 

•                  financialstatements of the borrower;

 

•                  reports fromportfolio company senior management and ownership;

 

•                  the type ofsecurity;

 

•                  cost at date ofpurchase;

 

•                  size of holding;

 

•                  discount frommarket value of unrestricted securities of the same class at the time ofpurchase;

 

•                  special reportsprepared by analysts;

 

•                  information asto any transactions or offers with respect to the security;

 

•                  existence ofmerger proposals or tender offers affecting the securities;

 

•                  the collateral;

 

•                  the issuer’sability to make payments;

 

•                  the current andforecasted earnings of the issuer;

 

•                  sales to thirdparties of similar securities;

 

•                  statisticalratios compared to lending standards;

 

•                  statisticalratios compared to other similar securities; and

 

31

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•                  other pertinentfactors.

 

For those debt securities for which S&P prepares valuationrecommendations, we provide the foregoing information to S&P for its use inpreparing its recommendations.

 

For convertible debt, equity, success fees or other equity-likesecurities, we first determine if there is any market for the security. Ifthere is a market, then we determine the value based on the market prices forthe security, even if that market is not robust. At March 31, 2006 andSeptember 30, 2005 there was no market for any of the equity securities weowned. If there is no market for the equity securities, then we use the sameinformation we would use for a debt security valuation described above, exceptrisk-rating, as well as standard valuation techniques used by major valuationfirms to value the equity securities of private companies. These valuationtechniques consist of: discounted cash flow of the expected sale price in thefuture, valuation of the securities based on recent sales in comparabletransactions, and a review of similar companies that are publicly traded andthe market multiple of their equity securities. At March 31, 2006 and September30, 2005 we had $37,000 invested, at cost, in equity securities compared to ourdebt portfolio with a cost basis of $205,996,242 and $205,338,554,respectively.

 

At March 31, 2006, we had total unrealizedappreciation of $1,072,832, which was mainly composed of unrealized appreciationof $693,178 on our warrants of Finn Corporation, $101,232 of unrealizedappreciation on our senior subordinated term debt investment in Country RoadCommunications LLC, and $71,297 of unrealized appreciation on our senior termdebt investments in Benetch, Inc. This unrealized appreciation was offset byunrealized depreciation of $644,790, most notably composed of unrealizeddepreciation of $362,916 on our senior term debt investments in MistrasHoldings Corporation and unrealized depreciation of $119,898 on our seniorsubordinated term debt investment in Consolidated Bedding, Inc. In theaggregate, we recorded net unrealized appreciation of $428,042 on our totalinvestment portfolio.

 

At September 30, 2005, we had total unrealized depreciation of$6,231,296, which was mainly composed of unrealized depreciation in our seniorsubordinated term debt investment in Finn Corporation (excluding the warrants)of $3,150,000 (which was repaid in full in December 2005), our seniorsubordinated term debt investment in Xspedius Communications of $1,493,182, andour senior term debt in ARI Holdings, Inc. of $1,053,939 (which wassubsequently sold at the September 30, 2005 reflected fair value), partiallyoffset by unrealized appreciation, most notably on the value of our warrants ofFinn Corporation, which had an unrealized appreciation of $645,114 and oursenior term debt investment in Woven Electronics Corporation, which hadunrealized appreciation of $431,436. This aforementioned unrealizedappreciation plus unrealized appreciation of $625,955 on certain otherinvestments, primarily in our originated loan investments and certain syndicateparticipations, most notably Infor Global Solutions, which had unrealizedappreciation of $248,750, resulted in overall net unrealized depreciation of$4,528,791.

 

**Tax Status**

 

*Federal Income Taxes*

 

We intend to continue to qualify for treatment as a RIC under SubtitleA, Chapter 1 of Subchapter M of the Code. As a RIC, we are not subject tofederal income tax on the portion of our taxable income and gains distributedto stockholders. To qualify as a RIC, we are required to distribute tostockholders at least 90% of investment company taxable income, as defined bythe Code. We have a policy to pay out as a dividend up to 100% of that amount.

 

**Revenue Recognition**

 

*Interest Income Recognition*

 

Interest income is recorded on the accrual basis to the extent thatsuch amounts are expected to be collected. We will stop accruing interest oninvestments and write off any previously accrued and uncollected interest whenit is determined that interest is no longer collectible. Conditional interestor a success fee is recorded when earned upon full repayment of a loaninvestment.

 

*Payment in Kind Interest*

 

In the future, we may once again hold some loans in our portfolio whichcontain a PIK interest provision. The PIK interest, computed at the contractualrate specified in each loan agreement, is added to the principal balance of theloan and recorded as interest income. To maintain our status as a RIC, thisnon-cash source of income must be paid out to stockholders in the form ofdividends, even though we have not yet collected the cash.

 

32

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**RESULTS OF OPERATIONS**

 

*Comparisonof the three months ended March 31, 2006 to the three months ended March 31,2005*

 

**Investment Income**

 

Investment income for the three months ended March 31, 2006 wasapproximately $7.0 million as compared to approximately $5.9 million for thethree months ended March 31, 2005. Interest income from our investmentportfolio increased from March 31, 2005 due to the increase in new loans of$117.5 million, offset by principal repayments and investment sales ofapproximately $91.7 million.

 

Interest income from our investments in debt securities of privatecompanies was approximately $6.9 million, including approximately $556,000 ofsuccess fees from the full repayment of Woven Electronics Corporation and$31,000 of PIK interest, for the three months ended March 31, 2006 as comparedto approximately $5.2 million for the three months ended March 31, 2005, whichincluded approximately $130,000 of PIK interest. This increase****wasprimarily a result of a net increase in investments of approximately $25.8million over March 31, 2005. This increase consisted of $117.5 million of newinvestments, offset by principal repayments and investment sales ofapproximately $91.7 million.

 

The annualized weighted average yield on our portfolio for the threemonths ended March 31, 2006 was 12.7% (without giving effect to PIK interest)and 12.7% (after giving effect to PIK interest). The annualized weightedaverage yield on our portfolio for the three months ended March 31, 2005 was11.6% (without giving effect to PIK interest) and 13.5% (after giving effect toPIK interest).

 

Interest income from invested cash and cash equivalents for the threemonths ended March 31, 2006 was approximately $5,000, as compared toapproximately $5,000 for the three months ended March 31, 2005.

 

For the three months ended March 31, 2006 and March 31, 2005, werecorded approximately $107,000 and $114,000, respectively, in interest incomefrom loans to our employees in connection with the exercise of employee stockoptions.

 

For the three months ended March 31, 2006, we recorded approximately$14,000 of prepayment fees and other income as compared to $570,000 of otherincome for the three months ended March 31, 2005. The income for both periodsconsisted of prepayment penalty fees received upon the full repayment ofcertain loan investments ahead of contractual maturity and prepayment feesreceived upon the early unscheduled principal repayments ahead of scheduledpayment dates which, in both instances, were based on a percentage of theoutstanding principal amount of the loan at the date of prepayment.

 

**Operating Expenses**

 

Operating expenses for the three months ended March 31, 2006 wereapproximately $1.8 million, as compared to approximately $1.5 million for thethree months ended March 31, 2005. Operating expenses for the three monthsended March 31, 2006 reflected a significant increase in interest expense, loanservicing fees, and stock option compensation expense.

 

Loan servicing fees of approximately $735,000 were incurred for thethree months ended March 31, 2006 as compared to approximately $586,000 for thethree months ended March 31, 2005. These fees were incurred in connection witha loan servicing agreement between Gladstone Business Loan LLC (“Business Loan”)and Gladstone Management, which is based on the size of the portfolio. Thesefees were directly credited against the amount of the management fee due toGladstone Management.

 

EffectiveOctober 1, 2004, we entered into an advisory agreement with GladstoneManagement whereby Gladstone Management serves as our external adviser. Ascompensation for the services of Gladstone Management, we pay GladstoneManagement an annual advisory fee of 1.25% of total assets (as reduced by cashand cash equivalents pledged to creditors), payable in quarterly computedincrements of 0.3125%, and an annual administrative fee of 0.75% of totalassets (as reduced by cash and cash equivalents pledged to creditors), payablein quarterly computed increments of 0.1875%, for a total fee of 2% of totalassets (as reduced by cash and cash equivalents pledged to creditors). Wecontinue to pay direct expenses including, but not limited to, directors’ fees,legal and accounting fees, stockholder related expenses, and directors andofficers insurance. Under the advisory agreement, Gladstone Management providesmanagerial assistance and other services to our portfolio companies andlikewise Gladstone Management directly receives any fees for such services. Anysuch fees are credited directly against the 2% management fee payable toGladstone Management. The 2% management fee is also directly reduced by theamount of the monthly loan servicing fees we pay to Gladstone

 

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Management.Overall, the management fee due to Gladstone Management cannot exceed 2% oftotal assets (as reduced by cash and cash equivalents pledged to creditors)during any given fiscal year.

 

Thefollowing table sets forth the computation of the management fee for the threemonths ended March 31, 2006 and March 31, 2005, based on the quarterlyincrement of 0.50% (0.3125% quarterly advisory fee plus 0.1875% quarterlyadministrative fee):

 
| ** **                                                 | ** ** | **March 31, 2006** | ** **  | **March 31, 2005** | ** ** |
|------------------------------------------------------------|------------|--------------------|-------------|--------------------|------------|
| **Fee:**                                                   |       |               |        |               |       |
| Total assets at                                            |       | $                  | 217,404,695 |               | $          | 213,753,998 |   |
| Less: Borrowings under line of credit at                   |       | —             |        | (18,644,179        | )(a)       |
| Total assets subject to fee as of                          |       | 217,404,695        |        | 195,109,819        |       |
| Quarterly fee rate                                         |       | 0.50               | %           | 0.50               | %          |
| Gross management fee before loan servicing  fee credit     |       | 1,087,023          |        | 975,549            |       |
| Less: loan servicing fee from Gladstone  Business Loan LLC |       | 734,644            |        | 585,542            |       |
| Management  fee before credit:                             |       | 352,379            |        | 390,007            |       |
| **Direct Credit to Management Fee:**                       | ** ** | ** **         | ** **  | ** **         | ** ** |
| Fee revenue recorded by Gladstone  Management:             |       | 673,000            |        | 450,000            |       |
| Net management fee for the three months  ended (b):        |       | $                  | (320,621    | )                  | $          | (59,993 | ) |
|                                                            |            |                    |             |                    |            |  |  |  |

 

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*(a)*  *This amount representsborrowings under one of our lines of credit that were held in cash and cashequivalents as of March 31, 2005, for the purpose of satisfying our assetdiversification requirements under the Code. Solely for the purposes ofcalculating the amount of the management fee due to Gladstone Management, wetreat any such amounts as “cash and cash equivalents pledged to creditors”under the terms of our advisory agreement with Gladstone Management. As aresult, such amounts are deducted from our total assets for purposes ofcomputing the asset base upon which the management fee is determined.*

 

*(b)  If the amount presented is in parentheses itdenotes the amount is due back to us from the Adviser; if the amount ispositive, it indicates that we owe the Adviser the stated amount.*

 

Professional fees, consisting primarily of legal and audit fees, forthe three months ended March 31, 2006 were approximately $111,000 as comparedto approximately $156,000 for the three months ended March 31, 2005. The decreaseis due primarily to a decrease in non-reimbursable legal fees.

 

Amortization of deferred financing costs, in connection with our linesof credit, was approximately $32,000 for the three months ended March 31, 2006and approximately $92,000 for the three months ended March 31, 2005. Thedecrease is due to the completion of the amortization cycle related to certaindeferred financing costs.

 

Interest expense for the three months ended March 31, 2006 wasapproximately $948,000 as compared to approximately $440,000 for the threemonths ended March 31, 2005. This increase is primarily a result of increasedborrowings under our line of credit during the three months ended March 31,2006, which borrowings were used, in part, to finance our increased investments,of which these borrowings remained outstanding for longer periods of time and,to a lesser extent, an increase in the interest rates on our borrowings.

 

Stockholder related costs for the three months ended March 31, 2006were approximately $116,000, as compared to approximately $105,000 for thethree months ended March 31, 2005. Stockholder related costs include suchrecurring items as transfer agent fees, securities fees, and electronic filingfees.

 

Directors’ fees for the three months ended March 31, 2006 were $30,000,as compared to approximately $24,000 for the three months ended March 31, 2005due to the addition of a new director in December 2005.

 

Insurance expense for the three months ended March 31, 2006 wasapproximately $51,000, as compared to approximately $44,000 for the threemonths ended March 31, 2005. The increase is primarily the result of anincrease in the amortization of our directors and officers insurance premiums.

 

Stock option compensation expense for the three months ended March 31,2006 was approximately $34,000. This is the result of the adoption of theStatement of Financial Accounting Standards No. 123 (revised 2004) (“SFASNo. 123(R)”) *Share-based Payment*.SFAS No. 123(R) replaces SFAS No. 123, *Accounting for Stock-Based Compensation*and supersedesAccounting Principles Board (“APB”) Opinion No. 25, *Accounting for Stock Issued to Employees* (“APB No. 25”)*.*SFAS No. 123(R) is effective for awards thatare granted, modified, or settled in cash for annual periods beginning afterJune 15, 2005. The Company adopted SFAS No. 123(R) on October 1, 2005using the modified prospective approach. Under the modified prospectiveapproach, stock-based compensation expense will be recorded for the unvestedportion of previously issued awards that remain outstanding at October 1,2005 using the 

 

34

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same estimate of the grant date fair value and the same attributionmethod used to determine the pro forma disclosure under SFAS No. 123. SFASNo. 123(R) also requires that all share-based payments to employees afterOctober 1, 2005, including employee stock options, be recognized in thefinancial statements as stock-based compensation expense based on the fairvalue on the date of grant. There was no stock option compensation expenserecorded for the three months ended March 31, 2005.

 

General and administrative expenses were approximately $61,000 for thethree months ended March 31, 2006, as compared to approximately $69,000 for thethree months ended March 31, 2005. The expenses primarily represent directexpenses such as travel related specifically to our portfolio companies, loanevaluation services for our portfolio companies, press releases and backupservicer expenses.

 

**Realized Gain/(Loss) on Sale of Investments**

 

During the three months ended March 31, 2006, we sold our investment inInfor Global Solutions Ltd. for a gain of approximately $378,000. During thethree months ended March 31, 2005, we sold our $2.0 million syndicatedparticipation in Marietta Corp. for a gain of $20,000.

 

**Net Unrealized Appreciation on Derivative**

 

During the three months ended March 31, 2006, we recorded netunrealized appreciation of approximately $25,000 due to an increase in the fairmarket value of our interest rate cap agreement, as compared to unrealizedappreciation of approximately $16,000 during the three months ended March 31,2005. The increase in the fair market value is attributable to the one monthLIBOR climbing closer to 5% which is when the Company would start to receivepayments.

 

**Net Unrealized Depreciation on Investments**

 

For the three months ended March 31, 2006, we recorded net unrealizeddepreciation on investments of approximately $16,000 as compared to netunrealized depreciation of approximately $192,000, for the three months endedMarch 31, 2005. The unrealized appreciation decreased during the three monthsended March 31, 2006 mainly in part to the early repayment or sale of loansthat were previously valued at a premium.

 

**Net Increase in Net Assets from Operations**

 

Overall, we realized a netincrease in net assets resulting from operations of approximately $5.6 millionfor the three months ended March 31, 2006. Based on a weighted-average of11,308,510 (basic) and 11,536,360 (diluted) shares outstanding, our netincrease in net assets from operations per weighted average common share forthe three months ended March 31, 2006 was $0.49 (basic) and $0.48 (diluted).

 

Forthe three months ended March 31, 2005, we realized a net increase in net assetsresulting from operations of approximately $4.3 million. Based on aweighted-average of 11,288,833 (basic) and 11,620,603 (diluted) sharesoutstanding, our net increase in net assets resulting from operations perweighted average common share for the three months ended March 31, 2005 was$0.38 (basic) and $0.37 (diluted).

 

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*Comparisonof the six months ended March 31, 2006 to the six months ended March 31, 2005*

 

**Investment Income**

 

Investment income for the six months ended March 31, 2006 wasapproximately $13.0 million as compared to approximately $12.0 million for thesix months ended March 31, 2005. The increase is mainly attributable to anincrease in interest income from our investment portfolio which had newinvestments of $117.5 million, offset by principal repayments and investmentsale of approximately $91.7 million, for net new investments of $25.8 millionfrom March 31, 2005 through March 31, 2006.

 

Interest income from our investments in debt securities of privatecompanies was approximately $12.7 million, including approximately $556,000 ofsuccess fees from the full repayment of Woven Electronics Corporation and$63,000 of PIK interest, for the six months ended March 31, 2006 as compared toapproximately $10.9 million for the six months ended March 31, 2005, whichincluded approximately $271,000 of PIK interest. This increase****wasprimarily a result of a net increase in investments of approximately $25.8million over March 31, 2005. This increase consisted of $117.5 million of newinvestments, offset by principal repayments and investment sales ofapproximately $91.7 million. There was also an increase in investments that arevariable rate or that the variable rate has exceeded the floor which contributedto the growth in interest income.

 

The annualized weighted average yield on our portfolio for the sixmonths ended March 31, 2006 was 12.6% (without giving effect to PIK interest)and 12.6% (after giving effect to PIK interest). The annualized weightedaverage yield on our portfolio for the six months ended March 31, 2005 was13.0% (without giving effect to PIK interest) and 13.5% (after giving effect toPIK interest). The decline is due to the early repayments of principal balanceson certain loans, which had higher interest rates.

 

Interest income from invested cash and cash equivalents for the sixmonths ended March 31, 2006 was approximately $14,000, as compared toapproximately $21,000 for the six months ended March 31, 2005. This decrease****was primarily a result of a decrease ininvested cash and cash equivalents.

 

For the six months ended March 31, 2006 and March 31, 2005, we recordedapproximately $214,000 and $228,000, respectively, in interest income fromloans to our employees in connection with the exercise of employee stockoptions.

 

For the six months ended March 31, 2006, we recorded approximately$81,000 of prepayment fees and other income as compared to $810,000 of otherincome for the six months ended March 31, 2005. The income for both periodsconsisted of prepayment penalty fees received upon the full repayment ofcertain loan investments ahead of contractual maturity and prepayment feesreceived upon the early unscheduled principal repayments ahead of scheduledpayment dates which, in both instances, were based on a percentage of theoutstanding principal amount of the loan at the date of prepayment.

 

**Operating Expenses**

 

Operating expenses for the six months ended March 31, 2006 wereapproximately $3.3 million, as compared to approximately $2.7 million for thesix months ended March 31, 2005. Operating expenses for the six months endedMarch 31, 2006 reflected a significant increase in interest expense, loanservicing fees, stockholder related costs and stock option compensation expense.

 

Loan servicing fees of approximately $1.5 million were incurred for thesix months ended March 31, 2006 as compared to approximately $1.1 million forthe six months ended March 31, 2005. These fees were incurred in connectionwith a loan servicing agreement between Gladstone Business Loan LLC (“BusinessLoan”) and Gladstone Management, which is based on the size of the portfolio. Thesefees were directly credited against the amount of the management fee due toGladstone Management.

 

EffectiveOctober 1, 2004, we entered into an advisory agreement with GladstoneManagement whereby Gladstone Management serves as our external adviser. Ascompensation for the services of Gladstone Management, we pay GladstoneManagement an annual advisory fee of 1.25% of total assets (as reduced by cashand cash equivalents pledged to creditors), payable in quarterly computedincrements of 0.3125%, and an annual administrative fee of 0.75% of totalassets (as reduced by cash and cash equivalents pledged to creditors), payablein quarterly computed increments of 0.1875%, for a total fee of 2% of totalassets (as reduced by cash and cash equivalents pledged to creditors). Wecontinue to pay direct expenses including, but not limited to, directors’ fees,legal and accounting fees, stockholder related expenses, and directors andofficers insurance. Under the advisory agreement, Gladstone Management providesmanagerial assistance and other services to our portfolio companies andlikewise Gladstone Management directly receives any fees for such services. Anysuch fees are credited directly against the 2% management fee payable toGladstone Management. The 2% management fee is also directly reduced by theamount of the monthly loan servicing fees we pay to Gladstone

 

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Management.Overall, the management fee due to Gladstone Management cannot exceed 2% oftotal assets (as reduced by cash and cash equivalents pledged to creditors)during any given fiscal year.

 

Thefollowing table sets forth the computation of the management fee for the sixmonths ended March 31, 2006 and March 31, 2005, based on the quarterlyincrement of 0.50% (0.3125% quarterly advisory fee plus 0.1875% quarterlyadministrative fee):

 
| ** **                                                 | ** ** | **Three Months Ended** | ** **  |
|------------------------------------------------------------|------------|------------------------|-------------|
| ** **                                                 | ** ** | **March 31, 2006**     | ** **  | **December 31, 2005** | ** ** |
| **Fee:**                                                   |       |                   |        |   |   |   |   |
| Total assets  at                                           |       | $                      | 217,404,695 |   | $ | 211,823,244 |   |
| Less:  Borrowings under line of credit at                  |       | —                 |        | (15,000,000 | )(a) |
| Total assets  subject to fee as of                         |       | 217,404,695            |        | 196,823,244 |   |
| Quarterly  fee rate                                        |       | 0.50                   | %           | 0.50 | % |
| Gross  management fee before loan servicing fee credit     |       | 1,087,023              |        | 984,116 |   |
| Less: loan  servicing fee from Gladstone Business Loan LLC |       | 734,644                |        | 715,415 |   |
| Management fee before credit:                              |       | 352,379                |        | 268,701 |   |
| **Direct  Credit to Management Fee:**                      | ** ** | ** **             | ** **  | ** ** | ** ** |
| Fee revenue  recorded by Gladstone Management:             |       | 673,000                |        | 550,000 |   |
| Net  management fee for the three months ended (c):        |       | $                      | (320,621    | ) | $ | (281,299 | ) |
|                                                            |            |                        |             |  |  |  |  |  |

 
| ** **                                                 | ** ** | **Three Months Ended** | ** **  |
|------------------------------------------------------------|------------|------------------------|-------------|
| ** **                                                 | ** ** | **March 31, 2005**     | ** **  | **December 31, 2004** | ** ** |
| **Fee:**                                                   |       |                   |        |   |   |
| Total assets at                                            |       | $                      | 213,753,998 |   | $ | 194,085,591 |   |
| Less: Borrowings under line of credit at                   |       | (18,644,179            | )(b)        | (22,435,000 | )(b) |
| Total assets subject to fee as of                          |       | 195,109,819            |        | 171,650,591 |   |
| Quarterly fee rate                                         |       | 0.50                   | %           | 0.50 | % |
| Gross management fee before loan servicing  fee credit     |       | 975,549                |        | 858,254 |   |
| Less: loan servicing fee from Gladstone  Business Loan LLC |       | 585,542                |        | 530,952 |   |
| Management  fee before credit:                             |       | 390,007                |        | 327,302 |   |
| **Direct Credit to Management Fee:**                       | ** ** | ** **             | ** **  | ** ** | ** ** |
| Fee revenue recorded by Gladstone  Management:             |       | 450,000                |        | 286,500 |   |
| Net management fee for the three months  ended (c):        |       | $                      | (59,993     | ) | $ | 40,802 |   |

 

 

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*(a)*  *This amount representsborrowings under one of our lines of credit that were held in cash and cashequivalents as of December 31, 2005. The $15.0 million was to be used to fund anew loan investment, however the investment did not fund until*

*January2006. Solely for the purposes of calculating the amount of the management feedue to Gladstone Management, we treat any such amounts as “cash and cashequivalents pledged to creditors” under the terms of our advisory agreementwith Gladstone Management. As a result, such amounts are deducted from ourtotal assets for purposes of computing the asset base upon which the managementfee is determined.*

 

*(b)*  *This amount representsborrowings under one of our lines of credit that were held in cash and cashequivalents as of March 31, 2005 and December 31, 2004, for the purpose ofsatisfying our asset diversification requirements under the Code. Solely forthe purposes of calculating the amount of the management fee due to GladstoneManagement, we treat any such amounts as “cash and cash equivalents pledged tocreditors” under the terms of our advisory agreement with Gladstone Management.As a result, such amounts are deducted from our total assets for purposes ofcomputing the asset base upon which the management fee is determined.*

 

*(c)  If the amount presented is in parentheses itdenotes the amount is due back to us from the Adviser; if the amount ispositive, it indicates that we owe the Adviser the stated amount.*

 

Professional fees, consisting primarily of legal and audit fees, forthe six months ended March 31, 2006 were approximately $233,000 as compared toapproximately $395,000 for the six months ended March 31, 2005. The decrease isdue primarily to a decrease in non-reimbursable legal fees.

 

Amortization of deferred financing costs, in connection with our linesof credit, was approximately $59,000 for the six months ended March 31, 2006and approximately $184,000 for the six months ended March 31, 2005. Thedecrease is due to the completion of the amortization cycle related to certaindeferred financing costs.

 

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Interest expense for the six months ended March 31, 2006 wasapproximately $1.6 million as compared to approximately $611,000 for the sixmonths ended March 31, 2005. This increase is primarily a result of increasedborrowings under our lines of credit during the six months ended March 31,2006, which borrowings were used, in part, to finance our increasedinvestments, borrowings remaining outstanding for longer periods of time and,to a lesser extent, an increase in the interest rates on our borrowings.

 

Stockholder related costs for the six months ended March 31, 2006 wereapproximately $245,000, as compared to approximately $176,000 for the sixmonths ended March 31, 2005. Stockholder related costs include such recurringitems as transfer agent fees, securities fees, and electronic filing fees. Theincrease is due mainly to the printing and mailing of the special proxy reportto stockholders, and the printing and mailing of the annual report tostockholders and the annual proxy to stockholders.

 

Directors’ fees for the six months ended March 31, 2006 were $54,000,as compared to approximately $51,000 for the six months ended March 31, 2005due to the addition of a new director in December 2005.

 

Insurance expense for the six months ended March 31, 2006 wasapproximately $101,000, as compared to approximately $90,000 for the six monthsended March 31, 2005. The increase is primarily the result of an increase inthe amortization of our directors and officers insurance premiums.

 

Stock option compensation expense for the six months ended March 31,2006 was approximately $77,000. This is the result of the adoption of theStatement of Financial Accounting Standards No. 123 (revised 2004) (“SFASNo. 123(R)”) *Share-based Payment*.SFAS No. 123(R) replaces SFAS No. 123, *Accounting for Stock-Based Compensation*and supersedesAccounting Principles Board (“APB”) Opinion No. 25, *Accounting for Stock Issued to Employees* (“APB No. 25”)*.*SFAS No. 123(R) is effective for awards thatare granted, modified, or settled in cash for annual periods beginning afterJune 15, 2005. The Company adopted SFAS No. 123(R) on October 1, 2005using the modified prospective approach. Under the modified prospectiveapproach, stock-based compensation expense will be recorded for the unvestedportion of previously issued awards that remain outstanding at October 1, 2005using the same estimate of the grant date fair value and the same attributionmethod used to determine the pro forma disclosure under SFAS No. 123. SFASNo. 123(R) also requires that all share-based payments to employees afterOctober 1, 2005, including employee stock options, be recognized in thefinancial statements as stock-based compensation expense based on the fairvalue on the date of grant. There was no stock option compensation expenserecorded for the six months ended March 31, 2005.

 

General and administrative expenses were approximately $117,000 for thesix months ended March 31, 2006, as compared to approximately $113,000 for thesix months ended March 31, 2005. The expenses primarily represent directexpenses such as travel related specifically to our portfolio companies, loanevaluation services for our portfolio companies, press releases and backupservicer expenses.

 

**Income Tax Expense**

 

During the six months ended March 31, 2006, Gladstone CapitalCorporation recorded approximately $50,000 in connection with penaltiesincurred on misclassified revenue on its fiscal year 2004 corporate tax return.

 

Gladstone Capital Advisers, Inc., a wholly-owned subsidiary ofGladstone Capital Corporation, is subject to federal and state income taxationon the income it has recorded such as managerial assistance and other fees. Duringthe six months ended March 31, 2005, Gladstone Capital Advisers incurredaggregate federal and state income taxes of $138,678 resulting from taxableincome it received during the 2004 fiscal year. Following the externalizationof our management effective October 1, 2004 substantially all revenuespreviously received by Gladstone Capital Advisers are now received by GladstoneManagement. As a result, we do not anticipate incurring significant tax expenseas a result of the activities of Gladstone Capital Advisers in the future.

 

**Realized Gain/(Loss) on Sale of Investments**

 

During the six months ended March 31, 2006, we sold our investments inARI Holdings, Inc. and Marcal Paper Mills, Inc. for an aggregate loss ofapproximately $1.2 million, partially offset by a gain of $377,500 on the saleof our investment in Infor Global Solutions Ltd, for a total net realized lossof approximately $803,000. During the six months ended March 31, 2005, we soldour $975,000 syndicated participation in Burt’s Bees, Inc. for a gain of $9,750and we sold our $2.0 million syndicated participation in Marietta Corp. for again of $20,000, for a total net realized gain of approximately $30,000.

 

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**Net Unrealized Depreciation on Derivative**

 

During the six months ended March 31, 2006, we recorded net unrealizedappreciation of approximately $24,000 due to an increase in the fair marketvalue of our interest rate cap agreement, as compared to unrealizeddepreciation of approximately $9,000 during the six months ended March 31,2005.

 

**Net Unrealized Appreciation on Investments**

 

For the six months ended March 31, 2006, we recorded net unrealizedappreciation on investments of approximately $5.0 million as compared to netunrealized appreciation of approximately $91,000, for the six months endedMarch 31, 2005. The unrealized appreciation is mainly attributable to the earlyrepayment or sale of loans that were underperforming as of September 30, 2005,most notably Finn Corporation and ARI Holdings, Inc.

 

**Net Increase in Net Assets from Operations**

 

Overall, we realized a netincrease in net assets resulting from operations of approximately $13.8 millionfor the six months ended March 31, 2006. Based on a weighted-average of11,307,510 (basic) and 11,555,479 (diluted) shares outstanding, our netincrease in net assets from operations per weighted average common share forthe six months ended March 31, 2006 was $1.22 (basic) and $1.20 (diluted).

 

Forthe six months ended March 31, 2005, we realized a net increase in netassets resulting from operations of approximately $9.2 million for the sixmonths ended March 31, 2005. Based on a weighted-average of 11,283,671 (basic)and 11,614,219 (diluted) shares outstanding, our net increase in stockholders’equity from operations per weighted average common share for the six monthsended March 31, 2005 was $0.82 (basic) and $0.79 (diluted).

 

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**LIQUIDITYAND CAPITAL RESOURCES**

 

At March 31, 2006, we had investments in debt securities of, or loansto 28 private companies, totaling approximately $206.0 million (cost basis) oftotal assets.

 

During the six months ended March 31, 2006 and March 31, 2005, thefollowing investment activity occurred:

 
| **Quarter Ended** | ** ** | **New Investments** | ** ** | **Principal Repayments** | ** ** | **Net Gain/(Loss)  on Disposal** | ** ** |
|-------------------|------------|---------------------|------------|--------------------------|------------|----------------------------------|------------|
|              |       |                |       |                     |       |                             |       |
| March 31, 2006    |       | $                   | 38,471,109 |                     | $          | 24,815,067                       |       | $ | 377,500 |   |
| December 31, 2005 |       | 26,688,457          |       | 38,702,066               |       | (1,180,595                       | )          |
|              |       | $                   | 65,159,566 |                     | $          | 63,517,133                       |       | $ | (803,095 | ) |
|              |       |                |       |                     |       |                             |       |
| March 31, 2005    |       | $                   | 44,513,875 |                     | $          | 33,859,918                       |       | $ | 20,000 |   |
| December 31, 2004 |       | 46,949,500          |       | 25,975,707               |       | 9,750                            |       |
|              |       | $                   | 91,463,375 |                     | $          | 59,835,625                       |       | $ | 29,750 |   |
|                   |            |                     |            |                          |            |                                  |            |  |  |  |  |  |  |  |  |  |  |  |

 

 

The following tablesummarizes the contractual principal amortization and maturity of ourinvestment portfolio by fiscal year:

 
| **Fiscal Year Ended September 30,** | ** ** | **Amount** | ** **  |
|-------------------------------------|------------|------------|-------------|
|                                |       |       |        |
| 2006                                |       | $          | 4,329,826   |   |
| 2007                                |       | 9,436,898  |        |
| 2008                                |       | 21,877,798 |        |
| 2009                                |       | 22,361,475 |        |
| 2010                                |       | 50,191,287 |        |
| Thereafter                          |       | 97,835,958 |        |
|                                |       | $          | 206,033,242 |   |
|                                     |            |            |             |  |  |

 

 

Net cash provided byoperating activities for the six months ended March 31, 2006, consistingprimarily of the items described in “Results of Operations”, was approximately$3.2 million as compared to net cash used in operating activities ofapproximately $4.9 million for the six months ended March 31, 2005. Net cashused in investing activities was approximately $1.6 million for the six monthsended March 31, 2006 and mainly consisted of $65.2 million of new investmentspartially offset by principal repayments of $63.5 million, as compared to netcash used in investing activities of approximately $52.2 million for the sixmonths ended March 31, 2005, which consisted mainly of new investments of $91.5million and the repayment of a repurchase agreement of approximately $21.3million, partially offset by principal repayments of approximately $59.8million. Net cash used in financing activities for the six months ended March31, 2006 was approximately $1.8 million and mainly consisted of repayments ofborrowings on the line of credit of approximately $62.5 million andapproximately $9.2 million for the payment of dividends. These outflows werepartially offset by approximately $69.8 million of cash received fromborrowings on the line of credit and the exercise of stock options forapproximately $86,000. Net cash provided by financing activitieswas approximately $10.3 million for the six months ended March 31, 2005 andconsisted primarily of cash provided from borrowings on our lines of credit,net of repayments, of approximately $18.4 million and the exercise of stockoptions which provided approximately $158,000, offset by the payment ofdividends of approximately $8.1 million and some costs incurred subsequent tothe shelf offering in September 2004.

 

During the six monthsended March 31, 2006, cash and cash equivalents decreased from approximately$504,000 to approximately $311,000.

 

Subsequent to March 31,2006, we funded three new additional loan investment in the aggregate amount of$10.0 million using borrowings from our line of credit and received an earlyrepayment of approximately $24.9 million, of which the net proceeds were usedto pay down the line of credit.

 

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In order to qualify as a regulated investment company and to avoidcorporate level tax on the income we distribute to our stockholders, we arerequired, under Subchapter M of the Internal Revenue Code, to distribute atleast 90% of our ordinary income and short-term capital gains to ourstockholders on an annual basis. In accordance with these requirements, wedeclared and paid monthly cash dividends of $0.135 per common share forJanuary, February, and March 2006, October, November, and December 2005 and $0.12per common share for October, November and December 2004 and January, February,and March 2005, $0.13 for April, May, and June 2005, and $0.135 for July,August and September 2005. In April 2006, our Board of Directors declared amonthly dividend of $0.135 per common share for each April, May and June 2006.

 

We anticipate continuing to borrow funds and, from time to time issuingadditional equity securities to obtain additional capital to make furtherinvestments. To this end, we have an effective registration statement on filewith the Securities and Exchange Commission (“SEC”) that would permit us toissue, through one or more transactions, up to an aggregate of $48.8 million insecurities, which may consist of shares of our common stock, preferred stock,and/or debt securities.

 

**Revolving Credit Facilities**

 

Through our wholly-owned subsidiary, Business Loan, we have a $100million revolving credit facility (the “DB Facility”) with Deutsche Bank AG, asadministrative agent, which currently matures on May 26, 2006. Pursuant to theDB Facility, Business Loan has pledged the loans it holds to secure futureadvances by certain institutional lenders. Interest rates charged on theadvances under the DB Facility will be based on the London Interbank OfferedRate (“LIBOR”), the Prime Rate or the Federal Funds Rate, depending on marketconditions, and will adjust periodically. As of March 31, 2006, our outstandingprincipal balance under this DB Facility was approximately $60.3 million at aninterest rate of 4.7%. Available borrowings are subject to various constraintsimposed by Deutsche Bank AG, based on the aggregate loan balance pledged byBusiness Loan, which varies as loans or added and repaid, regardless of whethersuch repayments are early prepayment or are made as contractually required. AtMarch 31, 2006, the remaining borrowing capacity available under the DBFacility was approximately $39.7 million. We are in the process of negotiatinga renewal of this DB Facility, however there can be no guarantee that we willbe able to renew the DB Facility on terms that are favorable to us, if at all. Inthe event that we are not able to renew the DB Facility this could have amaterial adverse impact on our liquidity and ability to fund new investments. InOctober 2005, our Board of Directors approved a resolution to seek to increasethis credit facility to $150 million.

 

The DB Facility contains covenants that, among other things, requireBusiness Loan to maintain its status as a separate entity; prohibit certainsignificant corporate transactions (such as mergers, consolidations,liquidations or dissolutions); and restrict material changes to our credit andcollection policies. The DB Facility also restricts some of the terms andprovisions (including interest rates, terms to maturity and payments schedules)and limits the borrower and industry concentrations of loans that are eligibleto secure advances. As of March 31, 2006, Business Loan was in compliance withall of the DB Facility covenants. We currently intend to securitize all of theloans held by Business Loan and to use the proceeds from the securitization topay down any amounts then outstanding under the revolving credit facility. However,there can be no assurance that we will be able to successfully securitize anyof these loans on terms acceptable to us, if at all.

 

The administrative agent also requires that any interest or principalpayments on pledged loans be remitted directly by the borrower into a lockboxaccount with the Bank of New York as custodian. Deutsche Bank AG is also thetrustee of the account and once a month remits the collected funds to theCompany. For the six months ended March 31, 2006, the amount due from custodianincreased by approximately $6.6 million.

 

Gladstone Management, our affiliated external adviser, services theloans pledged under the DB Facility. As a condition to this servicingarrangement, we executed a performance guaranty pursuant to which we guaranteedthat Gladstone Management would comply fully with all of its obligations underthe facility. The performance guaranty requires us to maintain a minimum networth of $100 million and to maintain “asset coverage” with respect to “seniorsecurities representing indebtedness” of at least 200%, in accordance withSection 18 of the 1940 Act. As of March 31, 2006, we were in compliancewith our covenants under the performance guaranty.

 

We also have a $15.0 million line of credit agreement with BranchBanking and Trust Company (“BB&T Agreement”) which originally matured onJune 1, 2005. The line of credit was subsequently modified for quarterlyextensions and in December 2005, it was modified to extend the maturity datethrough December 31, 2006. Interest on outstanding borrowings is based on theone month LIBOR plus 2.5% per annum. The unused portion of the line of creditis subject to a fee of 0.2% per annum. The BB&T Agreement requires us tomeet and maintain certain covenants and ratios with respect to leverage andliquidity. As of March 31, 2006, there were no borrowings outstanding under theBB&T line of credit with a remaining borrowing capacity available under theBB&T Agreement of $15.0 million. As of March 31, 2006, we were incompliance with all covenants under the BB&T Agreement.

 

Both lines of credit are available for general corporate purposes.

 

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**ITEM 3. QUANTITATIVEAND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.**

 

We are subject to financial market risks, including changes in interestrates.  We expect that ultimately approximately 20% of the loans in ourportfolio will be made at fixed rates and approximately 80% will be made atvariable rates.  Currently our portfolio has approximately 62% of thetotal loan portfolio cost basis at variable rates with a floor, approximately3% of the total loan portfolio cost basis is at a variable rate with a floorand ceiling, and the remaining 35% of the total loan portfolio cost basis is atvariable rates without a floor or ceiling.

 

In addition, we have two variable rate borrowing facilities. We have a$100 million revolving credit facility with Deutsche Bank AG which matures inMay 2006. We also have a $15 million line of credit agreement with BranchBanking and Trust Company which matured in December 2005 and was modified toextend the maturity through December 2006.

 

In February2004, we entered into an interest rate cap agreement in order to fulfill anobligation under our line of credit to enter into certain hedging transactionsin connection with our borrowings under the line of credit.  We purchasedthis interest rate cap agreement with a notional amount of $35 million for aone-time, up-front payment of $304,000.  The interest rate cap agreemententitles us to receive payments, if any, equal to the amount by which interestpayments on $35 million at one monthLIBOR exceed the payments on $35 million at 5%.  The cap expires inFebruary 2009.  This interest rate cap agreement effectively caps ourinterest payments on our line of credit borrowing, up to the notional amount ofthe interest rate cap, at five percent.  This mitigates our exposure toincreases in interest rates on our borrowings on our lines of credit, which areat variable rates. At March 31, 2006, the cap agreement had a fair market valueof $74,019 and a current notional amount of $22.7 million. At March 31, 2006, the onemonth LIBOR rate was approximately 4.83%.

 

To illustratethe potential impact of changes in interest rates on our net increase in netassets resulting from operations, we have performed the following analysis,which assumes that our balance sheet remains constant and no further actionsbeyond the interest rate cap agreement are taken to alter our existing interestrate sensitivity. Under this analysis, a hypothetical increase in the one monthLIBOR by 1% would increase our net increase in net assets resulting fromoperations by approximately $1.8 million or 8.8%, over the next twelve months,compared to the net increase in net assets resulting from operations for thetwelve months ended March 31, 2006. A hypothetical decrease in the one monthLIBOR by 1% would decrease net increase in net assets resulting from operationsby approximately $1.8 million, or 8.8%, over the next twelve months, comparedto the net increase in net assets resulting from operations for the twelvemonths ended March 31, 2006. Although management believes that this analysis isindicative of our existing interest rate sensitivity, it does not adjust forpotential changes in credit quality, size and composition of our loan portfolioon the balance sheet and other business developments that could affect netincrease in net assets resulting from operations. Accordingly, no assurancescan be given that actual results would not differ materially from the resultsunder this hypothetical analysis.

 

In the event that we securitize a portion of our loan portfolio, webelieve that we will likely be required to enter into further hedgingarrangements in the future with respect to securitized loans. While hedgingactivities may mitigate our exposure to adverse fluctuations in interest rates,certain hedging transactions that we may enter into in the future, such asinterest rate swap agreements, may also limit our ability to participate in thebenefits of lower interest rates with respect to our portfolio of investments.

 

**ITEM 4. CONTROLS ANDPROCEDURES.**

 

As of March 31, 2006, we,including our Chief Executive Officer and Chief Financial Officer, evaluatedthe effectiveness of the design and operation of our disclosure controls andprocedures. Based on that evaluation, our management, including the ChiefExecutive Officer and Chief Financial Officer, concluded that our disclosurecontrols and procedures were effective in timely alerting management, includingthe Chief Executive Officer and Chief Financial Officer, of materialinformation about us required to be included in periodic Securities andExchange Commission filings. However, in evaluating the disclosure controls andprocedures, management recognized that any controls and procedures, no matterhow well designed and operated can provide only reasonable assurance ofachieving the desired control objectives, and management necessarily wasrequired to apply its judgment in evaluating the cost-benefit relationship ofpossible controls and procedures.

 

There have been no changesin our internal control over financial reporting that occurred during thequarter ended March 31, 2006, that have materially affected, or are reasonablylikely to materially affect, our internal control over financial reporting.

 

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**PARTII–OTHER INFORMATION**

 

**ITEM 1. LEGALPROCEEDINGS.**

 

Neither we, nor any of our subsidiaries,are currently subject to any material legal proceeding, nor, to our knowledge,is any material legal proceeding threatened against us or any of oursubsidiaries.

 

**ITEM 1A. RISKFACTORS.**

 

Our business is subject to certain risks and events that, if theyoccur, could adversely affect our financial condition and results of operationsand the trading price of our common stock. For a discussion of these risks,please refer to the “Risk Factors” section of our Annual Report on Form 10-Kfor the fiscal year ended September 30, 2005, filed by us with the Securitiesand Exchange Commission on December 13, 2005. In connection with ourpreparation of this quarterly report, management has reviewed and consideredthese risk factors and has determined that the following risk factor should beread in connection with the existing risk factors disclosed in our AnnualReport on Form 10-K for the fiscal year ended September 30, 2005.

 

***The recentacceleration of vesting of all outstanding options except those of ournon-employee directors, coupled with the new expiration dates of ouroutstanding options, could result in significant selling pressure from optionholders, which could reduce our stock price.***

 

As a result of our recent decision to accelerate the vesting of themajority of our outstanding options and the offer to amend our outstandingoptions to shorten the remaining exercise period of these options toSeptember 30, 2006, there could be significant downward pressure on ourcommon stock price. This would be particularly the case if a significant numberof option holders elect not to “buy and hold,” but rather seek to monetizetheir option holdings (e.g., through a broker-assisted cashless exercise). Thisdownward pressure could reduce the current market price of our common stock anddilute the interests of existing stockholders.

 

Additional risks and uncertainties not presently known to us or that wecurrently deem immaterial also may impair our business operations. If any ofthe risks actually occur, our business could be harmed. In that event, thetrading price of our Common Stock could decline.

 

**ITEM 2. UNREGISTERED SALESOF EQUITY SECURITIES AND USE OF PROCEEDS.**

 

Not applicable.

 

**ITEM 3. DEFAULTS UPONSENIOR SECURITIES.**

 

Not applicable.

 

**ITEM 4. SUBMISSION OFMATTERS TO A VOTE OF SECURITY HOLDERS.**

 

The 2006 Annual Meeting of Stockholderswas held on February 23, 2006. The stockholders voted and approved thefollowing matters:

 

•                  The election of four Class II directors to hold office until the2009 Annual Meeting of Stockholders.

 
| **Nominee**        | ** ** | **Shares Voted For** | ** ** | **Authority Withheld** | ** ** |
|--------------------|------------|----------------------|------------|------------------------|------------|
| Terry Lee Brubaker |       | 9,891,214            |       | 449,983                |       |
| Maurice W. Coulon  |       | 9,900,090            |       | 441,107                |       |
| David A.R. Dullum  |       | 9,912,508            |       | 428,689                |       |
| Gerard Mead        |       | 9,903,774            |       | 437,423                |       |

 

•                  To ratification of PricewaterhouseCoopers LLP as independentauditors for the fiscal year ending September 30, 2006

 
| Shares voted for     |   | 10,239,003 |   |
|----------------------|--------|------------|--------|
| Shares voted against |   | 60,449     |   |
| Shares abstained     |   | 41,745     |   |

 

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**ITEM 5. OTHERINFORMATION.**

 

Not applicable

 

**ITEM 6. EXHIBITS**

 

See the exhibit index.

 

**SIGNATURE**

 

Pursuant to the requirements of theSecurities Exchange Act of 1934, the registrant has duly caused this report tobe signed on its behalf by the undersigned thereunto duly authorized.

 
| ** ** | **GLADSTONE CAPITAL CORPORATION** |
|------------|-----------------------------------|
|       |                              |
|       | By:                               | /s/ HARRY BRILL |   |
|       |                              |
|       | Harry Brill                       |
|       | Chief Financial Officer           |

 

Date: May 3, 2006

 

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**EXHIBIT INDEX**

 
| **Exhibit** | ** ** | **Description**                                                                                                                                                                                                                           |
|-------------|------------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|        |       |                                                                                                                                                                                                                                      |
| 3.1         |       | Articles  of Amendment and Restatement of the Articles of Incorporation, incorporated  by reference to Exhibit a.2 to Pre-Effective Amendment No. 1 to the  Registration Statement on Form N-2 (File No. 333-63700), filed July 27, 2001. |
|        |       |                                                                                                                                                                                                                                      |
| 3.2         |       | By-laws,  incorporated by reference to Exhibit b to Pre-Effective Amendment No. 1 to  the Registration Statement on Form N-2 (File No. 333-63700), filed July 27,  2001.                                                                  |
|        |       |                                                                                                                                                                                                                                      |
| 3.3         |       | Amendment  to by-laws, incorporated by reference to Exhibit 3.3 to the Company’s  Quarterly Report on Form 10-Q for the quarter ended December 31, 2003 (File  No. 814-00237), filed February 17, 2004.                              |
|        |       |                                                                                                                                                                                                                                      |
| 11          |       | Computation  of Per Share Earnings (included in the notes to the unaudited financial  statements contained in this report).                                                                                                               |
|        |       |                                                                                                                                                                                                                                      |
| 31.1        |       | Certification  of Chief Executive Officer pursuant to section 302 of The Sarbanes-Oxley Act  of 2002.                                                                                                                                     |
|        |       |                                                                                                                                                                                                                                      |
| 31.2        |       | Certification  of Chief Financial Officer pursuant to section 302 of The Sarbanes-Oxley Act  of 2002.                                                                                                                                     |
|        |       |                                                                                                                                                                                                                                      |
| 32.1        |       | Certification  of Chief Executive Officer pursuant to section 906 of The Sarbanes-Oxley Act  of 2002.                                                                                                                                     |
|        |       |                                                                                                                                                                                                                                      |
| 32.2        |       | Certification  of Chief Financial Officer pursuant to section 906 of The Sarbanes-Oxley Act  of 2002.                                                                                                                                     |

 

All other exhibits for which provision ismade in the applicable regulations of the Securities and Exchange Commissionare not required under the related instruction or are inapplicable andtherefore have been omitted.

 

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