**UNITEDSTATESSECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON, D.C.20549**

 

**FORM 10-Q**

 

**ý****QUARTERLY REPORT PURSUANT TO SECTION 13OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**

 

**FOR THE QUARTER ENDEDMARCH 31, 2005**

 

**o****TRANSITION REPORT PURSUANT TO SECTION 13OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**

 

**COMMISSION FILENUMBER: 814-00237**

 

**GLADSTONECAPITAL CORPORATION**

(Exact nameof registrant as specified in its charter)

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

 

**1521 WESTBRANCH DRIVE, SUITE 200**

**MCLEAN, VIRGINIA 22102**

(Address ofprincipal executive office)

 

**(703) 287-5800**

(Registrant’stelephone number, including area code)

 

Indicate by check mark whether theregistrant (1) has filed all reports required to be filed by Section 13or 15(d) of the Securities Exchange Act of 1934 during the preceding 12months and (2) has been subject to such filing requirements for the past90 days. Yes ý No o.

 

Indicate by check mark whether theregistrant is an accelerated filer (as defined in Rule 12 b-2 of theExchange Act).

Yes ý No o.

 

Indicate the number of shares outstandingof each of the issuer’s classes of common stock, as of the latest practicabledate.  The number of shares of the issuer’sCommon Stock, $0.001 par value, outstanding as of May 3, 2005 was 11,298,510.

 

 

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**GLADSTONE CAPITALCORPORATION**

**TABLE OF CONTENTS**

 
| PART I.  | FINANCIAL INFORMATION                                                                                                      |
|---------------|----------------------------------------------------------------------------------------------------------------------------|
|          |                                                                                                                       |
| Item 1.       | Financial Statements (Unaudited)                                                                                           |
|          |                                                                                                                       |
|          | Consolidated Balance Sheets  as of March 31, 2005 and September 30, 2004                                         |
|          | Schedules of Investments as  of March 31, 2005 and September 30, 2004                                            |
|          | Consolidated Statements of  Operations for the three months ended March 31, 2005 and March 31,  2004             |
|          | Consolidated  Statements of Operations for the six months ended March 31, 2005 and  March 31, 2004               |
|          | Consolidated  Statement of Stockholders’ Equity for the six months ended March 31, 2005  and March 31, 2004 |
|          | Consolidated  Statements of Cash Flows for the six months ended March 31, 2005 and March 31,  2004               |
|          | Financial Highlights for the three  and six months ended March 31, 2005 and March 31, 2004                       |
|          | 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  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 CAPITALCORPORATION**

**CONSOLIDATED BALANCESHEETS**

**(Unaudited)**

 
| ** **                                                                                                                               | ** ** | **March 31,  2005** | ** **  | **September 30,  2004** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------------|------------|---------------------|-------------|-------------------------|------------|
|                                                                                                                                     |       |                |        |                    |       |
| ASSETS                                                                                                                                   |       |                |        |                    |       |
| Investments at  fair value (Cost 3/31/2005: $181,100,807; 9/30/2004: $149,189,306)                                                       |       | $                   | 178,448,617 |                    | $          | 146,446,240 |   |
| Cash and cash  equivalents                                                                                                               |       | 19,174,183          |        | 15,969,890              |       |
| Cash and cash  equivalents pledged to creditors                                                                                          |       | —              |        | 49,984,950              |       |
| Interest  receivable – investments in debt securities                                                                               |       | 1,115,302           |        | 837,336                 |       |
| Interest  receivable – employees                                                                                                    |       | 107,187             |        | 112,960                 |       |
| Due from  custodian                                                                                                                      |       | 14,472,037          |        | 1,203,079               |       |
| Due from  affiliate                                                                                                                      |       | —              |        | 109,639                 |       |
| Deferred  financing costs                                                                                                                |       | 166,912             |        | 350,737                 |       |
| Prepaid assets                                                                                                                           |       | 155,540             |        | 191,676                 |       |
| Other assets                                                                                                                             |       | 114,220             |        | 127,220                 |       |
|                                                                                                                                     |       |                |        |                    |       |
| TOTAL ASSETS                                                                                                                             |       | $                   | 213,753,998 |                    | $          | 215,333,727 |   |
|                                                                                                                                     |       |                |        |                    |       |
| LIABILITIES AND  STOCKHOLDERS’ EQUITY                                                                                               |       |                |        |                    |       |
|                                                                                                                                     |       |                |        |                    |       |
| LIABILITIES                                                                                                                              |       |                |        |                    |       |
| Accounts payable                                                                                                                         |       | $                   | 155,872     |                    | $          | 105,921 |   |
| Fees due to  affiliate                                                                                                                   |       | 167,243             |        | 113,511                 |       |
| Borrowings under  lines of credit                                                                                                        |       | 59,100,000          |        | 40,743,547              |       |
| Accrued expenses  and deferred liabilities                                                                                               |       | 189,573             |        | 798,096                 |       |
| Repurchase  agreement                                                                                                                    |       | —              |        | 21,345,997              |       |
|                                                                                                                                     |       |                |        |                    |       |
| Total  Liabilities                                                                                                                       |       | $                   | 59,612,688  |                    | $          | 63,107,072 |   |
|                                                                                                                                     |       |                |        |                    |       |
| STOCKHOLDERS’  EQUITY                                                                                                               |       |                |        |                    |       |
| Common stock,  $0.001 par value, 50,000,000 shares authorized and 11,298,510 and 11,278,510  shares issued and outstanding, respectively |       | $                   | 11,299      |                    | $          | 11,279 |   |
| Capital in  excess of par value                                                                                                          |       | 164,498,128         |        | 164,294,781             |       |
| Notes receivable  for sale of stock to employees                                                                                         |       | (8,816,389          | )           | (9,432,678              | )          |
| Net unrealized  depreciation on investments                                                                                              |       | (2,652,189          | )           | (2,743,066              | )          |
| Unrealized  depreciation on derivative                                                                                                   |       | (223,222            | )           | (214,259                | )          |
| Distributions  less than net investment income                                                                                           |       | 1,323,683           |        | 310,598                 |       |
|                                                                                                                                     |       |                |        |                    |       |
| Total  Stockholders’ Equity                                                                                                         |       | $                   | 154,141,310 |                    | $          | 152,226,655 |   |
|                                                                                                                                     |       |                |        |                    |       |
| TOTAL  LIABILITIES AND STOCKHOLDERS’ EQUITY                                                                                         |       | $                   | 213,753,998 |                    | $          | 215,333,727 |   |

 

*THE ACCOMPANYING NOTES ARE AN INTEGRAL PART TOTHESE CONSOLIDATED FINANCIAL STATEMENTS.*

 

2

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**GLADSTONE CAPITALCORPORATION**

**SCHEDULE OFINVESTMENTS**

**AS OF MARCH 31,2005**

**(UNAUDITED)**

 
| **Company (1)**                    | ** ** | **Industry**                                      | ** ** | **Investment (2)**                                           | ** ** | **Cost**   | ** ** | **Fair Value** | ** ** |
|------------------------------------|------------|---------------------------------------------------|------------|--------------------------------------------------------------|------------|------------|------------|----------------|------------|
|                               |       |                                              |       |                                                         |       |       |       |           |       |
| Advanced Homecare Management, Inc. |       | Home health nursing services                      |       | Senior Subordinated Term Debt (7)  (11.9%, Due 12/2010) |       | $          | 7,500,000  |           | $          | 7,509,375 |   |
|                               |       |                                              |       |                                                         |       |       |       |           |       |
| Allied Extruders, Inc.             |       | Polyethylene film manufacturer                    |       | Senior Term Debt (3)  (12.3%, Due 7/2009)                    |       | 4,000,000  |       | 4,005,000      |       |
|                               |       |                                              |       |                                                         |       |       |       |           |       |
| ARI Holdings, Inc.                 |       | Manufacturing-auto parts                          |       | Senior Term Debt (8)                                         |       | 3,920,000  |       | 3,920,000      |       |
|                               |       |                                              |       | (9.8%, Due 2/2008)                                           |       |       |       |           |       |
|                               |       |                                              |       |                                                         |       |       |       |           |       |
| Badanco Acquisition Corp.          |       | Manufacturing-luggage                             |       | Senior Term Debt (8)                                         |       | 7,350,000  |       | 7,350,000      |       |
|                               |       |                                              |       | (8.2%, Due 2/2010)                                           |       |       |       |           |       |
|                               |       |                                              |       | Senior Term Debt (8)                                         |       | 8,650,000  |       | 8,650,000      |       |
|                               |       |                                              |       | (11.8%, Due 2/2010)                                          |       |       |       |           |       |
|                               |       |                                              |       |                                                         |       |       |       |           |       |
| Benetech, Inc.                     |       | Dust management systems for the coal and electric |       | Senior Term Debt (6)  (8.5%, Due 5/2009)                     |       | 3,006,250  |       | 3,021,281      |       |
|                               |       | utility industries                                |       | Senior Term Debt (3) (6)                                     |       | 3,250,000  |       | 3,282,500      |       |
|                               |       |                                              |       | (11.5%, Due 5/2009)                                          |       |       |       |           |       |
|                               |       |                                              |       |                                                         |       |       |       |           |       |
| Consolidated Bedding, Inc.         |       | Manufacturing-mattresses                          |       | Senior Subordinated Term Debt (8)                            |       | 3,001,835  |       | 3,001,835      |       |
|                               |       |                                              |       | (12.0%, Due 3/2009)                                          |       |       |       |           |       |
|                               |       |                                              |       |                                                         |       |       |       |           |       |
| Coyne International Enterprises    |       | Industrial services                               |       | Senior Term Debt (3) (5) (6)  (13.0%, PIK 2%, Due 7/2007)    |       | 8,517,337  |       | 8,474,750      |       |
|                               |       |                                              |       |                                                         |       |       |       |           |       |
| Finn Corporation                   |       | Manufacturing-landscape equipment                 |       | Senior Subordinated Term Debt (6)  (13.0%, Due 2/2006)       |       | 10,500,000 |       | 7,402,500      |       |
|                               |       |                                              |       | Common Stock Warrants                                        |       | 37,000     |       | 599,176        |       |
|                               |       |                                              |       |                                                         |       |       |       |           |       |
| Gammill, Inc.                      |       | Designer and assembler of quilting machines and   |       | Senior Term Debt (6)  (9.5%, Due 12/2008)                    |       | 3,962,292  |       | 3,962,292      |       |
|                               |       | accessories                                       |       | Senior Term Debt (3) (6)                                     |       | 4,720,313  |       | 4,690,811      |       |
|                               |       |                                              |       | (12.0%, Due 12/2008)                                         |       |       |       |           |       |
|                               |       |                                              |       |                                                         |       |       |       |           |       |
| Global Materials                   |       | Manufacturing-steel wool                          |       | Senior Term Debt (3) (6)                                     |       | 5,500,000  |       | 5,513,750      |       |
| Technologies, Inc.                 |       | products and metal fibers                         |       | (13.0%, Due 11/2009)                                         |       |       |       |           |       |
|                               |       |                                              |       |                                                         |       |       |       |           |       |
| John Henry Holdings, Inc.          |       | Manufacturing-packaging products                  |       | Senior Subordinated Term Debt (7)  (9.9%, Due 6/2011)        |       | 5,473,565  |       | 5,418,829      |       |
|                               |       |                                              |       |                                                         |       |       |       |           |       |
| Maidenform, Inc.                   |       | Intimate apparel                                  |       | Senior Subordinated Term Debt (6)                            |       | 10,003,304 |       | 10,150,000     |       |
|                               |       |                                              |       | (10.2%, Due 5/2011)                                          |       |       |       |           |       |
|                               |       |                                              |       |                                                         |       |       |       |           |       |
| Marcal Paper Mills, Inc.           |       | Manufacturing-paper products                      |       | Senior Subordinated Term Debt (6)  (13.0%, Due 12/2006)      |       | 6,625,000  |       | 6,376,563      |       |
|                               |       |                                              |       | First Mortgage Loan (5)                                      |       | 9,301,053  |       | 9,301,053      |       |
|                               |       |                                              |       | (16%, PIK 1%, Due 12/2006)                                   |       |       |       |           |       |
|                               |       |                                              |       |                                                         |       |       |       |           |       |
| MedAssets, Inc.                    |       | Pharmaceuticals and healthcare GPO                |       | Senior Term Debt (6)  (7.6%, Due 3/2007)                     |       | 1,391,451  |       | 1,393,160      |       |
|                               |       |                                              |       | Senior Subordinated Term Debt (6)                            |       | 6,502,813  |       | 6,573,125      |       |
|                               |       |                                              |       | (12.9%, Due 3/2008)                                          |       |       |       |           |       |
|                                    |            |                                                   |            |                                                              |            |            |            |                |            |  |  |

 

3

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| **Company (1)**               | ** ** | **Industry**                               | ** ** | **Investment (2)**                                     | ** ** | **Cost**   | ** **      | **Fair Value** | ** ** |
|-------------------------------|------------|--------------------------------------------|------------|--------------------------------------------------------|------------|------------|-----------------|----------------|------------|
|                          |       |                                       |       |                                                   |       |       |            |           |       |
| Mistras Holdings Corp.        |       | Nondestructive testing                     |       | Senior Term Debt (3) (6)                               |       | 9,666,666  |            | 9,497,499      |       |
|                          |       | instruments, systems                       |       | (10.5%, Due 8/2008)                                    |       |       |            |           |       |
|                          |       | and services                               |       | Senior Term Debt (3) (6)                               |       | 4,833,334  |            | 4,742,709      |       |
|                          |       |                                       |       | (12.5%, Due 8/2008)                                    |       |       |            |           |       |
|                          |       |                                       |       | Senior Term Debt (3) (6)                               |       | 1,000,000  |            | 986,750        |       |
|                          |       |                                       |       | (13.5%, Due 8/2008)                                    |       |       |            |           |       |
|                          |       |                                       |       |                                                   |       |       |            |           |       |
| Polar Corporation             |       | Manufacturing-trailer parts                |       | Senior Subordinated Term Debt (6)  (9.5%, Due 6/2010)  |       | 5,556,627  |            | 5,639,976      |       |
|                          |       |                                       |       |                                                   |       |       |            |           |       |
| Regency Gas Services LLC      |       | Midstream gas gathering and processing     |       | Senior Subordinated Term Debt (7)  (8.8%, Due 12/2010) |       | 3,023,453  |            | 3,075,000      |       |
|                          |       |                                       |       |                                                   |       |       |            |           |       |
| Santana Plastics              |       | Manufacturing-polyethylene bathroom        |       | Senior Term Debt (6)  (10.5%, Due 11/2009)             |       | 6,000,000  |            | 6,007,500      |       |
|                          |       | partitions                                 |       | Senior Term Debt (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 (8)                                   |       | 3,412,500  |            | 3,412,500      |       |
|                          |       |                                       |       | (8.5%, Due 2/2010)                                     |       |       |            |           |       |
|                          |       |                                       |       | Senior Term Debt (8)                                   |       | 3,000,000  |            | 3,000,000      |       |
|                          |       |                                       |       | (12.0%, Due 2/2010)                                    |       |       |            |           |       |
|                          |       |                                       |       |                                                   |       |       |            |           |       |
| Tech Lighting LLC             |       | Manufacturing-low voltage lighting systems |       | Senior Subordinated Term Debt (6)  (9.3%, Due 10/2010) |       | 9,013,681  |            | 9,033,750      |       |
|                          |       |                                       |       |                                                   |       |       |            |           |       |
| Woven Electronics Corporation |       | Custom electrical cable assemblies         |       | Senior Term Debt (3) (6)  (7.7%, Due 3/2009)           |       | 2,474,000  |            | 2,486,370      |       |
|                          |       |                                       |       | Senior Term Debt (4) (6)                               |       | 11,958,333 |            | 12,018,125     |       |
|                          |       |                                       |       | (11.5%, Due 3/2009)                                    |       |       |            |           |       |
|                          |       |                                       |       |                                                   |       |       |            |           |       |
| Xspedius Communications       |       | Service-                                   |       | Senior Subordinated Term Debt (8)                      |       | 6,000,000  |            | 6,000,000      |       |
| LLC                           |       | telecommunications                         |       | (9.6%, Due 3/2010)                                     |       |       |            |           |       |
|                          |       |                                       |       |                                                   |       |       |            |           |       |
| **Total:**                    | ** ** | ** **                                 | ** ** | ** **                                             | ** ** | **$**      | **181,100,807** |           | **$**      | **178,448,617** | ** ** |
|                               |            |                                            |            |                                                        |            |            |                 |                |            |  |  |

 

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(1) We do not “Control,” and are not an “Affiliate” of, anyof our portfolio companies, each as defined in the Investment Company Act of1940, as amended (the “1940 Act”). In general, under the 1940 Act, we would “Control”a portfolio company if we owned 25% or more of its voting securities and wouldbe an “Affiliate” of a portfolio company if we owned 5% or more of its votingsecurities.

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

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

(4) Last Out Tranche of senior debt, meaning if the companyis liquidated 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 7 “Payment in Kind Interest” heretoand Note 2 “Summary of Significant Accounting Policies” of the Company’s Form 10-Kfor the fiscal year ended September 30, 2004.

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

(7) Marketable securities are valued based on the bid price,as of March 31, 2005, from the respective originating syndication agent’strading 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 at March 31,2005.

 

*THE ACCOMPANYING NOTES ARE AN INTEGRAL PART TOTHESE CONSOLIDATED FINANCIAL STATEMENTS.*

 

4

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**GLADSTONE CAPITALCORPORATION**

**SCHEDULE OFINVESTMENTS**

**AS OF SEPTEMBER 30,2004**

 
| **Company (1)**                     | ** ** | **Industry**                                      | ** ** | **Investment (2)**                                      | ** ** | **Cost**   | ** ** | **Fair Value** | ** ** |
|-------------------------------------|------------|---------------------------------------------------|------------|---------------------------------------------------------|------------|------------|------------|----------------|------------|
|                                |       |                                              |       |                                                    |       |       |       |           |       |
| A and G, Inc.                       |       | Activewear products                               |       | Senior Term Debt (3) (6)                                |       | $          | 12,250,000 |           | $          | 12,250,000 |   |
| (d/b/a Alstyle)                     |       |                                              |       | (11.0%, Due 6/2008)                                     |       |       |       |           |       |
|                                |       |                                              |       |                                                    |       |       |       |           |       |
| Allied Extruders, Inc.              |       | Polyethylene film manufacturer                    |       | Senior Term Debt (3)  (12.3%, Due 7/2009)               |       | 4,000,000  |       | 4,000,000      |       |
|                                |       |                                              |       |                                                    |       |       |       |           |       |
| America’s Water Heater Rentals |       | Household appliances rental                       |       | Senior Term Debt (4) (6) (8)  (12.5%, Due 2/2009)       |       | 12,000,000 |       | 12,840,000     |       |
|                                |       |                                              |       |                                                    |       |       |       |           |       |
| ARI Holdings, Inc.                  |       | Manufacturing-auto parts                          |       | Senior Term Debt (6)                                    |       | 1,190,141  |       | 1,188,653      |       |
|                                |       |                                              |       | (9.75%, Due 6/2008)                                     |       |       |       |           |       |
|                                |       |                                              |       | Senior Subordinated Term Debt (5) (6)                   |       | 3,657,164  |       | 3,634,306      |       |
|                                |       |                                              |       | (11%, PIK 4%, Due 12/2008)                              |       |       |       |           |       |
|                                |       |                                              |       |                                                    |       |       |       |           |       |
| Bear Creek Corporation              |       | Premium horticultural and food products           |       | Senior Subordinated Term Debt (7) (9.1%, Due 6/2010)    |       | 6,000,000  |       | 6,090,000      |       |
|                                |       |                                              |       |                                                    |       |       |       |           |       |
| Benetech, Inc.                      |       | Dust management systems for the coal and electric |       | Senior Term Debt (6)  (8.5%, Due 5/2009)                |       | 3,168,750  |       | 3,160,828      |       |
|                                |       | utility industries                                |       | Senior Term Debt (3) (6)                                |       | 3,250,000  |       | 3,241,875      |       |
|                                |       |                                              |       | (11.5%, Due 5/2009)                                     |       |       |       |           |       |
|                                |       |                                              |       |                                                    |       |       |       |           |       |
| Burt’s Bees, Inc.              |       | Personal & household products                 |       | Senior Term Debt (7)  (5.4%, Due 11/2009)               |       | 975,000    |       | 987,188        |       |
|                                |       |                                              |       |                                                    |       |       |       |           |       |
| Coyne International Enterprises     |       | Industrial services                               |       | Senior Term Debt (3) (5) (6)(13.0%, PIK 2%, Due 7/2007) |       | 15,700,625 |       | 15,308,110     |       |
|                                |       |                                              |       |                                                    |       |       |       |           |       |
| Finn Corporation                    |       | Manufacturing-landscape equipment                 |       | Senior Subordinated Term Debt (6)  (13.0%, Due 2/2006)  |       | 10,500,000 |       | 7,612,500      |       |
|                                |       |                                              |       | Common Stock Warrants                                   |       | 37,000     |       | 474,984        |       |
|                                |       |                                              |       |                                                    |       |       |       |           |       |
| Gammill, Inc.                       |       | Designer and assembler of quilting machines and   |       | Senior Term Debt (6)  (9.5%, Due 12/2008)               |       | 4,708,013  |       | 4,731,553      |       |
|                                |       | accessories                                       |       | Senior Term Debt (3) (6)                                |       | 4,750,000  |       | 4,767,813      |       |
|                                |       |                                              |       | (12.0%, Due 12/2008)                                    |       |       |       |           |       |
|                                |       |                                              |       |                                                    |       |       |       |           |       |
| Inca Metal Products Corporation     |       | Material handling and storage products            |       | Senior Term Debt (3) (6)  (4.6%, Due 9/2006)            |       | 2,387,548  |       | 2,136,855      |       |
| Kingway Acquisition, Inc.           |       |                                              |       |                                                    |       |       |       |           |       |
| Clymer Acquisition, Inc.            |       |                                              |       |                                                    |       |       |       |           |       |
|                                |       |                                              |       |                                                    |       |       |       |           |       |
| Maidenform, Inc.                    |       | Intimate apparel                                  |       | Senior Subordinated Term Debt (7)                       |       | 10,003,571 |       | 10,175,000     |       |
|                                |       |                                              |       | (9.4%, Due 5/2011)                                      |       |       |       |           |       |
|                                |       |                                              |       |                                                    |       |       |       |           |       |
| Marcal Paper Mills, Inc.            |       | Manufacturing-paper products                      |       | Senior Subordinated Term Debt (6)  (13.0%, Due 12/2006) |       | 6,800,000  |       | 6,188,000      |       |
|                                |       |                                              |       | First Mortgage Loan (5)                                 |       | 9,254,715  |       | 9,254,715      |       |
|                                |       |                                              |       | (16%, Due 12/2006)                                      |       |       |       |           |       |
|                                |       |                                              |       |                                                    |       |       |       |           |       |
| MedAssets, Inc.                     |       | Pharmaceuticals and healthcare GPO                |       | Senior Term Debt (7)  (5.9%, Due 3/2007)                |       | 1,815,497  |       | 1,806,887      |       |
|                                |       |                                              |       | Senior Subordinated Term Debt (7)                       |       | 6,503,282  |       | 6,500,000      |       |
|                                |       |                                              |       | (11.2%, Due 3/2008)                                     |       |       |       |           |       |
|                                     |            |                                                   |            |                                                         |            |            |            |                |            |  |  |

 

5

----

 
| Mistras Holdings Corp.        |       | Nondestructive testing             |       | Senior Term Debt (3) (6)                     |       | 9,833,333  |            | 9,759,583  |   |
|-------------------------------|------------|------------------------------------|------------|----------------------------------------------|------------|------------|-----------------|------------|--------|
|                          |       | instruments, systems               |       | (10.5%, Due 8/2008)                          |       |       |            |       |   |
|                          |       | and services                       |       | Senior Term Debt (3) (6)                     |       | 4,916,667  |            | 4,867,500  |   |
|                          |       |                               |       | (12.5%, Due 8/2008)                          |       |       |            |       |   |
|                          |       |                               |       | Senior Term Debt (3) (6)                     |       | 1,000,000  |            | 1,000,000  |   |
|                          |       |                               |       | (13.5%, Due 8/2008)                          |       |       |            |       |   |
|                          |       |                               |       |                                         |       |       |            |       |   |
| Woven Electronics Corporation |       | Custom electrical cable assemblies |       | Senior Term Debt (3) (6)  (6.5%, Due 3/2009) |       | 2,488,000  |            | 2,484,890  |   |
|                          |       |                               |       | Senior Term Debt (4) (6)                     |       | 12,000,000 |            | 11,985,000 |   |
|                          |       |                               |       | (11.5%, Due 3/2009)                          |       |       |            |       |   |
|                          |       |                               |       |                                         |       |       |            |       |   |
| **Total:**                    | ** ** | ** **                         | ** ** | ** **                                   | ** ** | **$**      | **149,189,306** |       | **$**  | **146,446,240** | ** ** |
|                               |            |                                    |            |                                              |            |            |                 |            |        |  |  |

 

----

(1) We do not “Control,” and are not an “Affiliate” of, anyof our portfolio companies, each as defined in the Investment Company Act of1940, as amended (the “1940 Act”). In general, under the 1940 Act, we would “Control”a portfolio company if we owned 25% or more of its voting securities and wouldbe an “Affiliate” of a portfolio company if we owned 5% or more of its votingsecurities.

(2) Percentage represents interest rates in effect at September 30,2004 and due date represents the contractual maturity date.

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

(4) Last Out Tranche of senior debt, meaning if the companyis liquidated 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 7 “Payment in Kind Interest”hereto and Note 2 “Summary of Significant Accounting Policies” of the Company’sForm 10-K for the fiscal year ended September 30, 2004.

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

(7) Marketable securities are valued based on the bid price,as of September 30, 2004, from the respective originating syndicationagent’s trading desk.

(8) Includes a success fee with a fair value of $660,000 andno cost basis.

 

*THE ACCOMPANYING NOTES ARE AN INTEGRAL PART TOTHESE CONSOLIDATED FINANCIAL STATEMENTS.*

 

6

----

 

**GLADSTONE CAPITALCORPORATION**

**CONSOLIDATEDSTATEMENT OF OPERATIONS**

**(UNAUDITED)**

 
| ** **                                                                              | ** ** | **Three Months Ended** | ** ** |
|-----------------------------------------------------------------------------------------|------------|------------------------|------------|
| ** **                                                                              | ** ** | **March 31,  2005**    | ** ** | **March 31,  2004** | ** ** |
| INVESTMENT  INCOME                                                                      |       |                   |       |   |   |
| Interest income  – investments                                                     |       | $                      | 5,198,180  |   | $ | 3,878,817 |   |
| Interest income  – cash and cash equivalents                                       |       | 5,130                  |       | 17,334 |   |
| Interest income  – notes receivable from employees                                 |       | 113,599                |       | 109,538 |   |
| Fee income  (Refer to Note 12)                                                          |       | —                 |       | 356,231 |   |
| Other income                                                                            |       | 569,620                |       | 6,000 |   |
| Total investment  income                                                                |       | 5,886,529              |       | 4,367,920 |   |
|                                                                                    |       |                   |       |   |   |
| EXPENSES                                                                                |       |                   |       |   |   |
| Loan servicing  (Refer to Note 10)                                                      |       | 585,542                |       | — |   |
| Management fee  (Refer to Notes 10 and 13)                                              |       | 390,007                |       | — |   |
| Professional  fees                                                                      |       | 156,383                |       | 271,075 |   |
| Amortization of  deferred financing costs                                               |       | 91,912                 |       | 69,881 |   |
| Interest                                                                                |       | 439,521                |       | 101,952 |   |
| Stockholder related  costs                                                              |       | 104,541                |       | 67,320 |   |
| Directors fees                                                                          |       | 24,000                 |       | 32,877 |   |
| Insurance                                                                               |       | 43,890                 |       | 63,274 |   |
| Salaries and  benefits                                                                  |       | —                 |       | 419,769 |   |
| Rent                                                                                    |       | —                 |       | 33,964 |   |
| General and  administrative                                                             |       | 69,475                 |       | 181,183 |   |
| Expenses before  credit from Gladstone Management                                       |       | 1,905,271              |       | 1,241,295 |   |
| Credit to  management fee for fees collected by Gladstone Management (Refer to Note 13) |       | (450,000               | )          | — |   |
| Total expenses  net of credit to management fee                                         |       | 1,455,271              |       | 1,241,295 |   |
|                                                                                    |       |                   |       |   |   |
| NET INVESTMENT  INCOME BEFORE INCOME TAXES                                              |       | 4,431,258              |       | 3,126,625 |   |
| Income tax  expense                                                                     |       | —                 |       | — |   |
| NET INVESTMENT  INCOME                                                                  |       | 4,431,258              |       | 3,126,625 |   |
|                                                                                    |       |                   |       |   |   |
| REALIZED AND  UNREALIZED GAIN (LOSS) ON INVESTMENTS:                                    |       |                   |       |   |   |
| Realized gain on  sale of investment                                                    |       | 20,000                 |       | 12,500 |   |
| Unrealized  appreciation (depreciation) on derivative                                   |       | 15,848                 |       | (5,067 | ) |
| Net unrealized  depreciation on investments                                             |       | (191,728               | )          | (305,475 | ) |
| Net realized and  unrealized loss on investments                                        |       | (155,880               | )          | (298,042 | ) |
|                                                                                    |       |                   |       |   |   |
| NET INCREASE IN  STOCKHOLDERS’ EQUITY RESULTING FROM OPERATIONS                    |       | $                      | 4,275,378  |   | $ | 2,828,583 |   |
|                                                                                    |       |                   |       |   |   |
| NET INCREASE IN  STOCKHOLDERS’ EQUITY RESULTING FROM OPERATIONS PER COMMON SHARE:  |       |                   |       |   |   |
| Basic                                                                                   |       | $                      | 0.38       |   | $ | 0.28 |   |
| Diluted                                                                                 |       | $                      | 0.37       |   | $ | 0.27 |   |
|                                                                                    |       |                   |       |   |   |
| WEIGHTED AVERAGE  SHARES OF COMMON STOCK OUTSTANDING:                                   |       |                   |       |   |   |
| Basic                                                                                   |       | 11,288,833             |       | 10,087,615 |   |
| Diluted                                                                                 |       | 11,620,603             |       | 10,375,281 |   |

 

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

 

7

----

 

**GLADSTONE CAPITALCORPORATION**

**CONSOLIDATEDSTATEMENT OF OPERATION****S**

**(UNAUDITED)**

 
| ** **                                                                                   | ** ** | **Six Months Ended** | ** ** |
|----------------------------------------------------------------------------------------------|------------|----------------------|------------|
| ** **                                                                                   | ** ** | **March 31,  2005**  | ** ** | **March 31,  2004** | ** ** |
| INVESTMENT  INCOME                                                                           |       |                 |       |   |   |
| Interest income  – investments                                                          |       | $                    | 10,905,523 |   | $ | 7,418,513 |   |
| Interest income  – cash and cash equivalents                                            |       | 21,470               |       | 65,955 |   |
| Interest income  – notes receivable from employees                                      |       | 228,317              |       | 218,170 |   |
| Fee income  (Refer to Note 12)                                                               |       | —               |       | 611,231 |   |
| Other income                                                                                 |       | 809,620              |       | 22,000 |   |
| Total investment  income                                                                     |       | 11,964,930           |       | 8,335,869 |   |
|                                                                                         |       |                 |       |   |   |
| EXPENSES                                                                                     |       |                 |       |   |   |
| Loan servicing  (Refer to Note 10)                                                           |       | 1,116,494            |       | — |   |
| Management fee  (Refer to Notes 10 and 13)                                                   |       | 717,309              |       | — |   |
| Professional  fees                                                                           |       | 395,105              |       | 423,846 |   |
| Amortization of  deferred financing costs                                                    |       | 183,824              |       | 153,432 |   |
| Interest                                                                                     |       | 611,251              |       | 180,152 |   |
| Stockholder  related costs                                                                   |       | 176,310              |       | 119,980 |   |
| Directors fees                                                                               |       | 51,000               |       | 57,210 |   |
| Insurance                                                                                    |       | 90,162               |       | 137,285 |   |
| Salaries and  benefits                                                                       |       | —               |       | 810,476 |   |
| Rent                                                                                         |       | —               |       | 71,724 |   |
| General and  administrative                                                                  |       | 112,635              |       | 316,503 |   |
| Expenses before  credit from Gladstone Management                                            |       | 3,454,090            |       | 2,270,608 |   |
| Credit to  management fee for fees collected by Gladstone Management (Refer to Note 13) |       | (736,500             | )          | — |   |
| Total expenses  net of credit to management fee                                              |       | 2,717,590            |       | 2,270,608 |   |
|                                                                                         |       |                 |       |   |   |
| NET INVESTMENT  INCOME BEFORE INCOME TAXES                                                   |       | 9,247,340            |       | 6,065,261 |   |
| Income tax  expense                                                                          |       | 138,678              |       | — |   |
| NET INVESTMENT  INCOME                                                                       |       | 9,108,662            |       | 6,065,261 |   |
|                                                                                         |       |                 |       |   |   |
| REALIZED AND  UNREALIZED GAIN (LOSS) ON INVESTMENTS:                                         |       |                 |       |   |   |
| Realized gain on  sale of investment                                                         |       | 29,750               |       | 12,500 |   |
| Unrealized  depreciation on derivative                                                       |       | (8,963               | )          | (5,067 | ) |
| Net unrealized  appreciation (depreciation) on investments                                   |       | 90,877               |       | (1,863,037 | ) |
| Net realized and  unrealized gain (loss) on investments                                      |       | 111,664              |       | (1,855,604 | ) |
|                                                                                         |       |                 |       |   |   |
| NET INCREASE IN  STOCKHOLDERS’ EQUITY RESULTING FROM OPERATIONS                         |       | $                    | 9,220,326  |   | $ | 4,209,657 |   |
|                                                                                         |       |                 |       |   |   |
| NET INCREASE IN  STOCKHOLDERS’ EQUITY RESULTING FROM OPERATIONS PER COMMON SHARE:       |       |                 |       |   |   |
| Basic                                                                                        |       | $                    | 0.82       |   | $ | 0.42 |   |
| Diluted                                                                                      |       | $                    | 0.79       |   | $ | 0.41 |   |
|                                                                                         |       |                 |       |   |   |
| WEIGHTED AVERAGE  SHARES OF COMMON STOCK OUTSTANDING:                                        |       |                 |       |   |   |
| Basic                                                                                        |       | 11,283,671           |       | 10,084,729 |   |
| Diluted                                                                                      |       | 11,614,219           |       | 10,354,405 |   |

 

*THE ACCOMPANYINGNOTES ARE AN INTEGRAL PART TO THESE CONSOLIDATED FINANCIAL STATEMENTS.*

 

8

----

 

**GLADSTONE CAPITALCORPORATION**

**CONSOLIDATEDSTATEMENT OF STOCKHOLDERS’ EQUITY**

**(UNAUDITED)**

 
| ** **                                                           | ** ** | ** **        | ** ** | ** **     | ** ** | ** **        | ** ** | ** **        | ** ** | **Distributions**   | ** ** | ** **         | ** ** | ** **          | ** ** | ** **             | ** ** | ** ** | ** ** |
|----------------------------------------------------------------------|------------|-------------------|------------|----------------|------------|-------------------|------------|-------------------|------------|---------------------|------------|--------------------|------------|---------------------|------------|------------------------|------------|------------|------------|
| ** **                                                           | ** ** | ** **        | ** ** | ** **     | ** ** | ** **        | ** ** | **Notes**         | ** ** | **Less  Than/(in**  | ** ** | **Realized**       | ** ** | **Unrealized**      | ** ** | **Unrealized**         | ** ** | ** ** | ** ** |
| ** **                                                           | ** ** | ** **        | ** ** | ** **     | ** ** | **Capital  in**   | ** ** | **Receivable**    | ** ** | **Excess  of) Net** | ** ** | **Gain on**        | ** ** | **Appreciation/**   | ** ** | **Appreciation/**      | ** ** | **Total**  | ** ** |
| ** **                                                           | ** ** | **Common  Stock** | ** ** | **Excess  of** | ** ** | **From  Sale of** | ** ** | **Investment**    | ** ** | **Sale of**         | ** ** | **(Depreciation)** | ** ** | **(Depreciation)**  | ** ** | **Stockholders’** | ** ** |
| ** **                                                           | ** ** | **Shares**        | ** ** | **Amount**     | ** ** | **Par  Value**    | ** ** | **Common  Stock** | ** ** | **Income**          | ** ** | **Investment**     | ** ** | **of  Investments** | ** ** | **of  Derivatives**    | ** ** | **Equity** | ** ** |
|                                                                 |       |              |       |           |       |              |       |              |       |                |       |               |       |                |       |                   |       |       |       |
| Balance at  September 30, 2003                                  |       | 10,081,844        |       | $              | 10,082     |              | $          | 140,416,674       |       | $                   | (8,985,940 | )                  | $          | (416,094            | )          | $                      | —     |       | $          | (222,340 | ) | $ | — |   | $ | 130,802,382 |   |
|                                                                 |       |              |       |           |       |              |       |              |       |                |       |               |       |                |       |                   |       |       |       |
| Issuance of  Common Stock under Stock option Plan                    |       | 23,334            |       | 23             |       | 349,987           |       | (350,010          | )          | —              |       | —             |       | —              |       | —                 |       | —     |       |
|                                                                 |       |              |       |           |       |              |       |              |       |                |       |               |       |                |       |                   |       |       |       |
| Repayment of Principal  on Notes Receivable                          |       | —            |       | —         |       | —            |       | 103,252           |       | —              |       | —             |       | —              |       | —                 |       | 103,252    |       |
|                                                                 |       |              |       |           |       |              |       |              |       |                |       |               |       |                |       |                   |       |       |       |
| Shelf Offering  Costs                                                |       | —            |       | —         |       | (43,598           | )          | —            |       | —              |       | —             |       | —              |       | —                 |       | (43,598    | )          |
|                                                                 |       |              |       |           |       |              |       |              |       |                |       |               |       |                |       |                   |       |       |       |
| Net Increase in  Stockholders’ Equity Resulting from Operations |       | —            |       | —         |       | —            |       | —            |       | 6,065,261           |       | 12,500             |       | (1,863,037          | )          | (5,067                 | )          | 4,209,657  |       |
|                                                                 |       |              |       |           |       |              |       |              |       |                |       |               |       |                |       |                   |       |       |       |
| Distributions  Declared ($0.66 per common share)                     |       | —            |       | —         |       | —            |       | —            |       | (6,656,584          | )          | —             |       | —              |       | —                 |       | (6,656,584 | )          |
|                                                                 |       |              |       |           |       |              |       |              |       |                |       |               |       |                |       |                   |       |       |       |
| Balance at  March 31, 2004                                      |       | 10,105,178        |       | $              | 10,105     |              | $          | 140,723,063       |       | $                   | (9,232,698 | )                  | $          | (1,007,417          | )          | $                      | 12,500     |       | $          | (2,085,377 | ) | $ | (5,067 | ) | $ | 128,415,109 |   |
|                                                                 |       |              |       |           |       |              |       |              |       |                |       |               |       |                |       |                   |       |       |       |
| Balance at September 30, 2004                                   |       | 11,278,510        |       | $              | 11,279     |              | $          | 164,294,781       |       | $                   | (9,432,678 | )                  | $          | 298,098             |       | $                      | 12,500     |       | $          | (2,743,066 | ) | $ | (214,259 | ) | $ | 152,226,655 |   |
|                                                                 |       |              |       |           |       |              |       |              |       |                |       |               |       |                |       |                   |       |       |       |
| Issuance of  Common Stock under Stock Option Plan                    |       | 20,000            |       | 20             |       | 314,580           |       | (157,100          | )          | —              |       | —             |       | —              |       | —                 |       | 157,500    |       |
|                                                                 |       |              |       |           |       |              |       |              |       |                |       |               |       |                |       |                   |       |       |       |
| Repayment of  Principal on Notes Receivable                          |       | —            |       | —         |       | —            |       | 773,389           |       | —              |       | —             |       | —              |       | —                 |       | 773,389    |       |
|                                                                 |       |              |       |           |       |              |       |              |       |                |       |               |       |                |       |                   |       |       |       |
| Shelf Offering  Costs                                                |       | —            |       | —         |       | (111,233          | )          | —            |       | —              |       | —             |       | —              |       | —                 |       | (111,233   | )          |
|                                                                 |       |              |       |           |       |              |       |              |       |                |       |               |       |                |       |                   |       |       |       |
| Net Increase in  Stockholders’ Equity Resulting from Operations |       | —            |       | —         |       | —            |       | —            |       | 9,108,662           |       | 29,750             |       | 90,877              |       | (8,963                 | )          | 9,220,326  |       |
|                                                                 |       |              |       |           |       |              |       |              |       |                |       |               |       |                |       |                   |       |       |       |
| Distributions  Declared ($0.72 per common share)                     |       | —            |       | —         |       | —            |       | —            |       | (8,125,327          | )          | —             |       | —              |       | —                 |       | (8,125,327 | )          |
|                                                                 |       |              |       |           |       |              |       |              |       |                |       |               |       |                |       |                   |       |       |       |
| Balance at March 31,  2005                                      |       | 11,298,510        |       | $              | 11,299     |              | $          | 164,498,128       |       | $                   | (8,816,389 | )                  | $          | 1,281,433           |       | $                      | 42,250     |       | $          | (2,652,189 | ) | $ | (223,222 | ) | $ | 154,141,310 |   |

 

*THE ACCOMPANYING NOTES ARE AN INTEGRAL PART TOTHESE CONSOLIDATED FINANCIAL STATEMENTS.*

 

9

----

 

**GLADSTONE CAPITALCORPORATION**

**CONSOLIDATEDSTATEMENT OF CASH FLOWS**

**(UNAUDITED)**

 
| ** **                                                                                                                                   | ** ** | **Six Months Ended** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------------------|------------|----------------------|------------|
| ** **                                                                                                                                   | ** ** | **March 31,  2005**  | ** ** | **March 31,  2004** | ** ** |
| **CASH  FLOWS FROM OPERATING ACTIVITIES**                                                                                                    |       |                 |       |   |   |
|                                                                                                                                         |       |                 |       |   |   |
| Net increase in  stockholders’ equity resulting from operations                                                                         |       | $                    | 9,220,326  |   | $ | 4,209,657 |   |
| Adjustments to  reconcile net increase in stockholders’ equity resulting from operations to  net cash provided by operating activities: |       |                 |       |   |   |
| Depreciation                                                                                                                                 |       | —               |       | 14,438 |   |
| Net amortization  of premiums and discounts                                                                                                  |       | (8,267               | )          | — |   |
| Amortization of  deferred financing costs                                                                                                    |       | 183,824              |       | 117,328 |   |
| Unrealized  depreciation on derivative                                                                                                       |       | 8,963                |       | 5,067 |   |
| Change in net  unrealized (appreciation) depreciation                                                                                        |       | (90,877              | )          | 1,863,037 |   |
| Increase in  interest receivable                                                                                                             |       | (272,193             | )          | (228,868 | ) |
| (Increase)  decrease in funds due from custodian                                                                                             |       | (13,268,958          | )          | 982,000 |   |
| Decrease in  prepaid assets                                                                                                                  |       | 36,136               |       | 27,949 |   |
| Decrease  (increase) in due from affiliate                                                                                                   |       | 109,639              |       | (426,267 | ) |
| Decrease  (increase) in other assets                                                                                                         |       | 4,038                |       | (329,717 | ) |
| Increase in  accounts payable                                                                                                                |       | 49,951               |       | 63,548 |   |
| (Decrease)  increase in accrued expenses and deferred liabilities                                                                            |       | (608,523             | )          | 219,141 |   |
| Increase in fees  due to affiliate                                                                                                           |       | 53,732               |       | — |   |
| Increase in  investment balance due to payment in kind interest                                                                              |       | (275,483             | )          | (275,316 | ) |
| Net cash (used  in) provided by operating activities                                                                                         |       | (4,857,692           | )          | 6,241,997 |   |
|                                                                                                                                         |       |                 |       |   |   |
| **CASH  FLOWS FROM INVESTING ACTIVITIES:**                                                                                                   |       |                 |       |   |   |
|                                                                                                                                         |       |                 |       |   |   |
| Purchase of  investments                                                                                                                     |       | (91,463,375          | )          | (36,000,000 | ) |
| Principal  repayments on investments                                                                                                         |       | 59,835,625           |       | 5,178,541 |   |
| Proceeds from  repurchase agreements                                                                                                         |       | —               |       | 186,206,000 |   |
| Repayment of  repurchase agreements                                                                                                          |       | (21,345,997          | )          | (171,550,000 | ) |
| Receipt of  principal on notes receivable - employees                                                                                        |       | 773,389              |       | 103,252 |   |
| Purchase of  furniture & equipment                                                                                                       |       | —               |       | (4,558 | ) |
| Net cash used in  investing activities                                                                                                       |       | (52,200,358          | )          | (16,066,765 | ) |
|                                                                                                                                         |       |                 |       |   |   |
| **CASH  FLOWS FROM FINANCING ACTIVITIES:**                                                                                                   |       |                 |       |   |   |
|                                                                                                                                         |       |                 |       |   |   |
| Borrowings from  the lines of credit                                                                                                         |       | 100,400,000          |       | 20,500,000 |   |
| Repayments on  the lines of credit                                                                                                           |       | (82,043,547          | )          | — |   |
| Distributions  paid                                                                                                                          |       | (8,125,327           | )          | (9,983,593 | ) |
| Shelf offering  costs                                                                                                                        |       | (111,233             | )          | (43,598 | ) |
| Exercise of  stock options                                                                                                                   |       | 157,500              |       |   |   |
| Net cash  provided by financing activities                                                                                                   |       | 10,277,393           |       | 10,472,809 |   |
|                                                                                                                                         |       |                 |       |   |   |
| **NET  (DECREASE) INCREASE IN CASH AND CASH EQUIVALENTS (1)**                                                                                |       | (46,780,657          | )          | 648,041 |   |
| **CASH  AND CASH EQUIVALENTS, BEGINNING OF PERIOD**                                                                                          |       | 65,954,840           |       | 101,166,221 |   |
| **CASH  AND CASH EQUIVALENTS, END OF PERIOD**                                                                                                |       | $                    | 19,174,183 |   | $ | 101,814,262 |   |
|                                                                                                                                         |       |                 |       |   |   |
| **CASH  PAID DURING PERIOD FOR INTEREST**                                                                                                    |       | $                    | 417,143    |   | $ | — |   |
| **CASH  PAID DURING PERIOD FOR INCOME TAXES**                                                                                                |       | $                    | 138,678    |   | $ | — |   |
| **NON-CASH  FINANCING ACTIVITIES**                                                                                                           |       |                 |       |   |   |
| Notes receivable  issued in exchange for common stock associated with the exercise of employee  stock options                                |       | $                    | 157,100    |   | $ | 350,010 |   |

 

----

(1) Cash and cash equivalents consistof demand deposits and highly liquid investments with original maturities ofthree months or less when purchased.

* *

*THE ACCOMPANYINGNOTES ARE AN INTEGRAL PART TO THESE CONSOLIDATED FINANCIAL STATEMENTS.*

 

10

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**GLADSTONE CAPITALCORPORATION**

**FINANCIAL HIGHLIGHTS**

**(UNAUDITED)**

 
| ** **                                                       | ** ** | **Three Months Ended**   | ** **  |
|------------------------------------------------------------------|------------|--------------------------|-------------|
| ** **                                                       | ** ** | **March 31,  2005** | ** **  | **March 31,  2004** | ** ** |
|                                                             |       |                     |        |   |   |
| Per Share Data (1)                                               |       |                     |        |   |   |
| Net asset value  at beginning of period                          |       | $                        | 13.58       |   | $ | 12.79 |   |
| *Income  from investment operations:*                            |       |                     |        |   |   |
| Net investment  income (2)                                       |       | 0.39                     |        | 0.31 |   |
| Realized gain on  sale of investment (2)                         |       | —                   |        | — |   |
| Net unrealized  gain/(loss) on investments (2)                   |       | (0.02                    | )           | (0.03 | ) |
| Net unrealized  (loss) on derivatives (2)                        |       | —                   |        | — |   |
| Total from investment  operations                                |       | 0.37                     |        | 0.28 |   |
| Less  distributions:                                             |       |                     |        |   |   |
| Distributions  from net investment income                        |       | (0.36                    | )           | (0.33 | ) |
| Total  distributions                                             |       | (0.36                    | )           | (0.33 | ) |
| Issuance of  common stock under stock option plan                |       | 0.01                     |        | (0.03 | ) |
| Repayment of  principal on notes receivable                      |       | 0.06                     |        | — |   |
| Dilutive effect  of share issuance                               |       | (0.02                    | )           | — |   |
| Net asset value  at end of period                                |       | $                        | 13.64       |   | $ | 12.71 |   |
|                                                             |       |                     |        |   |   |
| Per share market  value at beginning of period                   |       | $                        | 23.70       |   | $ | 22.35 |   |
| Per share market  value at end of period                         |       | 21.22                    |        | 22.41 |   |
| Total Return (3)(4)                                              |       | -9.07                    | %           | 1.76 | % |
| Shares  outstanding at end of period                             |       | 11,298,510               |        | 10,105,178 |   |
|                                                             |       |                     |        |   |   |
| Ratios/Supplemental  Data                                        |       |                     |        |   |   |
| Net assets at  end of period                                     |       | $                        | 154,141,310 |   | $ | 128,415,109 |   |
| Average net  assets                                              |       | $                        | 152,288,314 |   | $ | 127,521,641 |   |
| Ratio of  expenses to average net assets-annualized (5)          |       | 5.00                     | %           | 3.87 | % |
| Ratio of net  expenses to average net assets-annualized (6)      |       | 3.82                     | %           | 3.87 | % |
| Ratio of net  investment income to average net assets-annualized |       | 11.64                    | %           | 9.68 | % |

 

----

(1)   Basic per share data.

(2)   Based on weighted average basic per share data.

(3)   Total return equals the increase of the ending market value overthe beginning market value plus monthly dividends divided by the monthlybeginning market value, assuming monthly dividend reinvestment.

(4)   Amounts were not annualized.

(5)   Ratio of expenses to average net assets is computed using expensesbefore credit from Gladstone Management and income tax expense.

(6)   Ratio of net expenses to average net assets is computed usingtotal expenses net of credits to management fee and income tax expense.

 

*THE ACCOMPANYING NOTES ARE AN INTEGRAL PART TOTHESE CONSOLIDATED FINANCIAL STATEMENTS.*

 

11

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| ** **                                                       | ** ** | **Six Months  Ended  March 31,  2005** | ** **  | **Six Months  Ended  March 31,  2004** | ** ** |
|------------------------------------------------------------------|------------|----------------------------------------|-------------|----------------------------------------|------------|
|                                                             |       |                                   |        |                                   |       |
| Per Share Data (1)                                               |       |                                   |        |                                   |       |
| Net asset value  at beginning of period                          |       | $                                      | 13.50       |                                   | $          | 12.97 |   |
| *Income  from investment operations:*                            |       |                                   |        |                                   |       |
| Net investment  income (2)                                       |       | 0.81                                   |        | 0.60                                   |       |
| Realized gain on  sale of investment (2)                         |       | —                                 |        | —                                 |       |
| Net unrealized  gain/(loss) on investments (2)                   |       | 0.01                                   |        | (0.18                                  | )          |
| Net unrealized  (loss) on derivatives (2)                        |       | —                                 |        | —                                 |       |
| Total from  investment operations                                |       | 0.82                                   |        | 0.42                                   |       |
| Less  distributions:                                             |       |                                   |        |                                   |       |
| Distributions  from net investment income                        |       | (0.72                                  | )           | (0.66                                  | )          |
| Total distributions                                              |       | (0.72                                  | )           | (0.66                                  | )          |
| Offering costs                                                   |       | (0.01                                  | )           | —                                 |       |
| Issuance of  common stock under stock option plan                |       | 0.01                                   |        | (0.03                                  | )          |
| Repayment of  principal on notes receivable                      |       | 0.07                                   |        | 0.01                                   |       |
| Dilutive effect  of share issuance                               |       | (0.03                                  | )           | —                                 |       |
| Net asset value  at end of period                                |       | $                                      | 13.64       |                                   | $          | 12.71 |   |
|                                                             |       |                                   |        |                                   |       |
| Per share market  value at beginning of period                   |       | $                                      | 22.71       |                                   | $          | 19.45 |   |
| Per share market  value at end of period                         |       | 21.22                                  |        | 22.41                                  |       |
| Total Return (3)(4)                                              |       | -3.66                                  | %           | 18.76                                  | %          |
| Shares  outstanding at end of period                             |       | 11,298,510                             |        | 10,105,178                             |       |
|                                                             |       |                                   |        |                                   |       |
| Ratios/Supplemental  Data                                        |       |                                   |        |                                   |       |
| Net assets at  end of period                                     |       | $                                      | 154,141,310 |                                   | $          | 128,415,109 |   |
| Average net  assets                                              |       | $                                      | 151,859,115 |                                   | $          | 128,261,840 |   |
| Ratio of  expenses to average net assets-annualized (5)          |       | 4.73                                   | %           | 3.55                                   | %          |
| Ratio of net  expenses to average net assets-annualized (6)      |       | 3.76                                   | %           | 3.55                                   | %          |
| Ratio of net  investment income to average net assets-annualized |       | 12.00                                  | %           | 9.45                                   | %          |

 

----

(1)   Basic per share data.

(2)   Based on weighted average basic per share data.

(3)   Total return equals the increase of the ending market value overthe beginning market value plus monthly dividends divided by the monthlybeginning market value, assuming monthly dividend reinvestment.

(4)   Amounts were not annualized.

(5)   Ratio of expenses to average net assets is computed using expensesbefore credit from Gladstone Management and income tax expense.

(6)   Ratio of net expenses to average net assets is computed usingtotal expenses net of credits to management fee and income tax expense.

 

*THE ACCOMPANYING NOTES ARE AN INTEGRAL PART TOTHESE CONSOLIDATED FINANCIAL STATEMENTS.*

 

12

----

 

**GLADSTONE CAPITALCORPORATION**

**NOTES TO CONSOLIDATEDFINANCIAL STATEMENTS**

**March 31, 2005**

**(UNAUDITED)**

 

NOTE1. ORGANIZATION

 

GladstoneCapital Corporation (the “Company”) was incorporated under the GeneralCorporation Laws of the State of Maryland on May 30, 2001 as a closed-endinvestment company.  The Company haselected to be treated as a business development company, or BDC, under theInvestment Company Act of 1940, as amended (the “1940 Act”).  In addition, the Company has elected to betreated for tax purposes as a regulated investment company, or RIC, under theInternal Revenue Code of 1986, as amended (the “Code”).  The Company’s investment objectives are toachieve a high level of current income by investing in debt and equitysecurities of established private businesses.

 

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

 

GladstoneBusiness Loan LLC, a wholly-owned subsidiary of the Company, was established onFebruary 3, 2003 for the purpose of owning the Company’s portfolio of loaninvestments.  The financial statements ofthis subsidiary are consolidated with those of the Company.

 

NOTE2. UNAUDITED INTERIM FINANCIAL STATEMENTS

 

Interimfinancial statements of the Company are prepared in accordance with accountingprinciples generally accepted in the United States of America (“GAAP”) forinterim financial information and pursuant to the requirements for reporting onForm 10-Q and Article 10 of Regulation S-X.  Accordingly, certain disclosures accompanyingannual financial statements 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-Kfor the fiscal year ended September 30, 2004, as filed with the Securitiesand Exchange Commission.

 

NOTE3. STOCK OPTIONS

 

Thefollowing tables set forth the pro-forma effect of fair value option accountingfor the three and six months ended March 31, 2005 and March 31, 2004in accordance with Statement of Financial Accounting Standards (SFAS) StatementNo. 148 “Accounting for Stock-Based Compensation – Transition andDisclosure”.

 

13

----

 
| ** **                                                                                                   | ** ** | **Three Months Ended** | ** ** |
|--------------------------------------------------------------------------------------------------------------|------------|------------------------|------------|
| ** **                                                                                                   | ** ** | **March 31,  2005**    | ** ** | **March 31,  2004** | ** ** |
|                                                                                                         |       |                   |       |   |   |
| Net increase in  stockholders’ equity resulting from operations as reported:                            |       | $                      | 4,275,378  |   | $ | 2,828,583 |   |
|                                                                                                         |       |                   |       |   |   |
| Deduct: Total  stock-based compensation expense determined using the fair value based method  for all awards |       | (76,222                | )          | (406,271 | ) |
|                                                                                                         |       |                   |       |   |   |
| Pro forma net  increase in stockholders’ equity resulting from operations                               |       | $                      | 4,199,156  |   | $ | 2,422,312 |   |
|                                                                                                         |       |                   |       |   |   |
| Per share:                                                                                                   |       |                   |       |   |   |
| As reported -  basic                                                                                         |       | $                      | 0.38       |   | $ | 0.28 |   |
| As reported -  diluted                                                                                       |       | $                      | 0.37       |   | $ | 0.27 |   |
|                                                                                                         |       |                   |       |   |   |
| Pro forma-basic                                                                                              |       | $                      | 0.37       |   | $ | 0.24 |   |
| Pro  forma-diluted                                                                                           |       | $                      | 0.36       |   | $ | 0.23 |   |

 
| ** **                                                                                                   | ** ** | **Six Months Ended** | ** ** |
|--------------------------------------------------------------------------------------------------------------|------------|----------------------|------------|
| ** **                                                                                                   | ** ** | **March 31,  2005**  | ** ** | **March 31,  2004** | ** ** |
|                                                                                                         |       |                 |       |   |   |
| Net increase in  stockholders’ equity resulting from operations as reported:                            |       | $                    | 9,220,326  |   | $ | 4,209,657 |   |
|                                                                                                         |       |                 |       |   |   |
| Deduct: Total  stock-based compensation expense determined using the fair value based method  for all awards |       | (148,577             | )          | (810,301 | ) |
|                                                                                                         |       |                 |       |   |   |
| Pro forma net  increase in stockholders’ equity resulting from operations                               |       | $                    | 9,071,749  |   | $ | 3,399,356 |   |
|                                                                                                         |       |                 |       |   |   |
| Per share:                                                                                                   |       |                 |       |   |   |
| As reported -  basic                                                                                         |       | $                    | 0.82       |   | $ | 0.42 |   |
| As reported -  diluted                                                                                       |       | $                    | 0.79       |   | $ | 0.41 |   |
|                                                                                                         |       |                 |       |   |   |
| Pro forma-basic                                                                                              |       | $                    | 0.80       |   | $ | 0.34 |   |
| Pro  forma-diluted                                                                                           |       | $                    | 0.78       |   | $ | 0.33 |   |

 

In December 2004, the Financial AccountingStandards Board (“FASB”) approved the revision of SFAS 123, “Accounting forStock-Based Compensation, and issued the revised SFAS Statement No. 123(R),“Share-Based Payment.”  SFAS 123(R)effectively replaces SFAS 123, and supersedes APB Opinion No. 25, “Accountingfor Stock Issued to Employees.”  The newstandard is effective for awards that are granted, modified, or settled in cashfor annual periods beginning after June 15, 2005.  The adoption of SFAS 123(R) will require theCompany to begin expensing unvested or newly granted stock options ascompensation cost at the start of the Company’s 2006 fiscal year. 

 

TheCompany currently accounts for the issuance of stock options through theAmended and Restated 2001 Equity Incentive Plan (the “Plan”) in accordance withAPB Opinion No. 25, “Accounting for Stock Issued to Employees.”  In connection with the externalization of theCompany’s management, all of its officers and employees became direct employeesof Gladstone Management Corporation as of October 1, 2004, the start offiscal year 2005.  However, these individualscontinue to be eligible to receive stock options under the Plan.  Effective October 1, 2004, the Companyaccounted for any options granted to employees of Gladstone ManagementCorporation, who qualify as leased employees of the Company under FIN 44, “Accountingfor Certain Transactions Involving Stock Compensation, an Interpretation of APBOpinion No. 25.”

 

14

----

 

NOTE4. INCREASE IN STOCKHOLDERS’ EQUITY PER SHARE RESULTING FROM OPERATIONS

 

Thefollowing table sets forth the computation of basic and diluted net increase instockholders’ equity per share resulting from operations for the three monthsended March 31, 2005 and March 31, 2004:

 
| ** **                                                                                            | ** ** | **Three Months Ended** | ** ** |
|-------------------------------------------------------------------------------------------------------|------------|------------------------|------------|
| ** **                                                                                            | ** ** | **March 31,  2005**    | ** ** | **March 31,  2004** | ** ** |
|                                                                                                  |       |                   |       |   |   |
| Numerator for  basic and diluted net increase in stockholders’ equity resulting from  operations |       | $                      | 4,275,378  |   | $ | 2,828,583 |   |
|                                                                                                  |       |                   |       |   |   |
| Denominator for  basic weighted average shares                                                        |       | 11,288,833             |       | 10,087,615 |   |
| Dilutive effect  of stock options                                                                     |       | 331,770                |       | 287,666 |   |
| Denominator for  diluted weighted average shares                                                      |       | 11,620,603             |       | 10,375,281 |   |
|                                                                                                  |       |                   |       |   |   |
| Basic net  increase in stockholers’ equity per share resulting from operations                   |       | $                      | 0.38       |   | $ | 0.28 |   |
|                                                                                                  |       |                   |       |   |   |
| Diluted net  increase in stockholers’ equity per share resulting from operations                 |       | $                      | 0.37       |   | $ | 0.27 |   |

 
| ** **                                                                                            | ** ** | **Six Months Ended** | ** ** |
|-------------------------------------------------------------------------------------------------------|------------|----------------------|------------|
| ** **                                                                                            | ** ** | **March 31,  2005**  | ** ** | **March 31,  2004** | ** ** |
|                                                                                                  |       |                 |       |   |   |
| Numerator for  basic and diluted net increase in stockholders’ equity resulting from  operations |       | $                    | 9,220,326  |   | $ | 4,209,657 |   |
|                                                                                                  |       |                 |       |   |   |
| Denominator for  basic weighted average shares                                                        |       | 11,283,671           |       | 10,084,729 |   |
| Dilutive effect  of stock options                                                                     |       | 330,548              |       | 269,676 |   |
| Denominator for  diluted weighted average shares                                                      |       | 11,614,219           |       | 10,354,405 |   |
|                                                                                                  |       |                 |       |   |   |
| Basic net  increase in stockholers’ equity per share resulting from operations                   |       | $                    | 0.82       |   | $ | 0.42 |   |
|                                                                                                  |       |                 |       |   |   |
| Diluted net  increase in stockholers’ equity per share resulting from operations                 |       | $                    | 0.79       |   | $ | 0.41 |   |

 

NOTE 5. DIVIDENDS

 

The Company is required to pay out as a dividend 90% of its ordinaryincome and short-term capital gains for each taxable year in order to maintainits status as a RIC under Subtitle A, Chapter 1 of Subchapter M of theCode.  It is the policy of the Company topay out as a dividend up to 100% of those amounts.  The amount to be paid out as a dividend isdetermined by the Board of Directors each quarter and is based on the annualearnings estimated by the management of the Company.  Based on that estimate, three monthlydividends are declared each quarter.  Atyear-end the Company may pay a bonus dividend, in addition to the quarterlydividends, to ensure that it has paid out at least 90% of its ordinary incomeand short-term capital gains for the year. The Company has a policy of retaining long-term capital gains, if any,and not paying them out as dividends. Effective October 31, 2003, the Company began paying a monthlydividend.  The following table lists theper share dividends paid since December 2001:

 

15

----

 
| **Fiscal Year** | ** ** | **Record Date**    | ** ** | **Payment Date**   | ** ** | **Dividend per Share** | ** ** | **Monthly or Quarterly** | ** ** |
|-----------------|------------|--------------------|------------|--------------------|------------|------------------------|------------|--------------------------|------------|
| 2005            |       | Mar. 18, 2005 |       | Mar. 31, 2005 |       | $                      | 0.12       |                     | Monthly    |   |
|            |       | Feb. 11, 2005 |       | Feb. 28, 2005 |       | $                      | 0.12       |                     | Monthly    |   |
|            |       | Jan. 14, 2005 |       | Jan. 28, 2005 |       | $                      | 0.12       |                     | Monthly    |   |
|            |       | Dec. 17, 2004 |       | Dec. 30, 2004 |       | $                      | 0.12       |                     | Monthly    |   |
|            |       | Nov. 17, 2004 |       | Nov. 30, 2004 |       | $                      | 0.12       |                     | Monthly    |   |
|            |       | Oct. 18, 2004 |       | Oct. 29, 2004 |       | $                      | 0.12       |                     | Monthly    |   |
|            |       |               |       |               |       |                   |       |                     |       |
| 2004            |       | Sep. 17, 2004 |       | Sep. 30, 2004 |       | $                      | 0.12       |                     | Monthly    |   |
|            |       | Aug. 18, 2004 |       | Aug. 31, 2004 |       | $                      | 0.12       |                     | Monthly    |   |
|            |       | Jul. 19, 2004 |       | Jul. 30, 2004 |       | $                      | 0.12       |                     | Monthly    |   |
|            |       | Jun. 17, 2004 |       | Jun. 30, 2004 |       | $                      | 0.115      |                     | Monthly    |   |
|            |       | May 17, 2004  |       | May 28, 2004  |       | $                      | 0.115      |                     | Monthly    |   |
|            |       | Apr. 19, 2004 |       | Apr. 30, 2004 |       | $                      | 0.115      |                     | Monthly    |   |
|            |       | Mar. 18, 2004 |       | Mar. 31, 2004 |       | $                      | 0.11       |                     | Monthly    |   |
|            |       | Feb. 16, 2004 |       | Feb. 27, 2004 |       | $                      | 0.11       |                     | Monthly    |   |
|            |       | Jan. 19, 2004 |       | Jan. 30, 2004 |       | $                      | 0.11       |                     | Monthly    |   |
|            |       | Dec. 18, 2003 |       | Dec. 31, 2003 |       | $                      | 0.11       |                     | Monthly    |   |
|            |       | Nov. 17, 2003 |       | Nov. 28, 2003 |       | $                      | 0.11       |                     | Monthly    |   |
|            |       | Oct. 20, 2003 |       | Oct. 31, 2003 |       | $                      | 0.11       |                     | Monthly    |   |
|            |       |               |       |               |       |                   |       |                     |       |
| 2003            |       | Sept. 30, 2003     |       | Oct. 6, 2003  |       | $                      | 0.33       |                     | Quarterly  |   |
|            |       | Jun. 30, 2003 |       | Jul. 7, 2003  |       | $                      | 0.29       |                     | Quarterly  |   |
|            |       | Mar. 31, 2003 |       | Apr. 7, 2003  |       | $                      | 0.25       |                     | Quarterly  |   |
|            |       | Dec. 31, 2002 |       | Jan. 7, 2003  |       | $                      | 0.23       |                     | Quarterly  |   |
|            |       |               |       |               |       |                   |       |                     |       |
| 2002            |       | Sept. 30, 2002     |       | Oct. 7, 2002  |       | $                      | 0.21       |                     | Quarterly  |   |
|            |       | Jun. 28, 2002 |       | Jul. 8, 2002  |       | $                      | 0.21       |                     | Quarterly  |   |
|            |       | Mar. 28, 2002 |       | Apr. 8, 2002  |       | $                      | 0.21       |                     | Quarterly  |   |
|            |       | Dec. 31, 2001 |       | Jan. 15, 2002 |       | $                      | 0.18       |                     | Quarterly  |   |

 

NOTE 6. INVESTMENT VALUATION

 

TheCompany carries its investments at fair value, as determined by its Board ofDirectors.  Securities that are publiclytraded are valued 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 good faithby 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.

 

16

----

 

NOTE7. PAYMENT IN KIND INTEREST

 

TheCompany seeks to avoid PIK interest, however the Company has a few loans in itsportfolio that contain 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 off 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 5, above), thisnon-cash source of income must be paid out to stockholders in the form ofdividends, even though the Company has not yet collected the cash. For the threeand six months ended March 31, 2005, the Company recorded PIK interestincome of $130,313 and $271,276, respectively, and for the three and six monthsended March 31, 2004, the Company recorded PIK interest income of $137,862and $276,405, respectively.  At March 31,2005 and September 30, 2004 the Company had accrued on its balance sheets,a total in PIK income of $1,197,285 and $1,138,727 respectively.  The Company does not hold any investmentsissued at original issue discount and accordingly, has not realized any originalissue discount income for the three and six months ended March 31, 2005 orMarch 31, 2004.

 

NOTE8. REPURCHASE AGREEMENT

 

Arepurchase agreement involves the purchase by an investor, such as the Company,of a specified security and the simultaneous agreement by the seller torepurchase it at an agreed upon future date and at a price which is greaterthan the purchase price by an amount that reflects an agreed-upon interest rate.Such interest rate is effective for the period of time during which theinvestor’s money is invested in the arrangement and is related to currentmarket interest rates rather than the coupon rate on the purchased security.The Company requires the continual maintenance by its custodian or thecorrespondent in its account with the Federal Reserve/Treasury Book EntrySystem of underlying securities in an amount at least equal to the repurchaseprice. If the seller were to default on its repurchase obligation, the Companymight suffer a loss to the extent that the proceeds from the sale of theunderlying securities were less than the repurchase price. A seller’sbankruptcy could delay or prevent a sale of the underlying securities.

 

The Company had nooutstanding repurchase agreement as of March 31, 2005.  On September 29, 2004, the Companyentered into a repurchase agreement (the “Repurchase Agreement”) with FerrisBaker Watts for $44,984,950. On September 30, 2004, this amount wasreduced to $21,345,997 with the application of the net proceeds from the Company’spublic offering of common stock in September 2004.  This remaining balance was settled on October 1,2004.  The Repurchase Agreement wasrecorded at cost and was fully collateralized by a United States Treasury Billwith a fair value of $50,000,000, a carrying value of $49,984,950 that maturedon October 7, 2004 and earned interest of $2,133.  The interest rate charged on the RepurchaseAgreement was 4.25% for a cost of $7,831. 

 

NOTE9. CONTRACTUAL OBLIGATIONS

 

Asof March 31, 2005, the Company was a party to a signed and non-binding termsheet for one potential investment for the Company’s portfolio.  The Company expects to fund this potentialinvestment as follows:

 
| ** **                  | ** ** | **Payment Due by Period** | ** ** |
|-----------------------------|------------|---------------------------|------------|
| **Contractual Obligations** | ** ** | **Total**                 | ** ** | **Less than 1 Year** | ** ** | **1-3 Years** | ** ** | **3-5 Years** | ** ** | **More than  5 Years** | ** ** |
|                        |       |                      |       |   |   |   |   |   |   |   |   |
| Investments                 |       | 6,325,000                 |       | 6,325,000 |   |   |   |   |   |   |   |
| Total                       |       | $                         | 6,325,000  |   | $ | 6,325,000 |   | $ | — |   | $ | — |   | $ | — |   |
|                             |            |                           |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

Allprospective investments are subject to, among other things, the satisfactorycompletion of the Company’s due diligence investigation of each borrower,acceptance of terms and structure and receipt of necessary consents. Withrespect to each prospective loan, the Company will only agree to provide theloan if, among other things, the results of its due diligence investigationsare satisfactory, the terms and conditions of the loan are acceptable and allnecessary consents are received. The Company has initiated its due diligenceinvestigations of the potential borrowers, however there can be no guaranteethat facts will not be discovered in the course of completing the due diligencethat would render a particular investment imprudent or that any of theseinvestments will actually be made.

 

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NOTE10. LINES OF CREDIT

 

InJune 2004, the Company entered into a $15.0 million line of creditagreement with Branch Banking and Trust Company (“BB&T Agreement”) whichmatures on June 1, 2005.  Intereston outstanding borrowings is based upon the one month London Interbank OfferedRate (“LIBOR”) plus 2.5% per annum.  Theunused portion of the line of credit is subject to a fee of 0.2% perannum.  The BB&T Agreement requiresthe Company to meet and maintain certain covenants and ratios with respect toleverage and liquidity. As of March 31, 2005, there was $14.0 millionoutstanding under the BB&T line of credit at an interest rate of 5.22% and $1.0million of available borrowings.  At March 31,2005 the Company was in compliance with all covenants under the BB&TAgreement.

 

Through its wholly-ownedsubsidiary Gladstone Business Loan LLC (“Business Loan”), the Company has a$100 million revolving credit facility (the “DB Facility) with Deutsche Bank AG,as administrative agent, pursuant to which Business Loan pledged the loans itholds to secure future advances by certain institutional lenders. The interestrate charged on the advances under the DB Facility is based on LIBOR, the PrimeRate or the Federal Funds Rate, depending on market conditions, and adjustsperiodically.  As of March 31, 2005,the outstanding principal balance under the DB Facility was approximately $45.1million at an interest rate of 2.81%.  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 as contractuallyrequired.  At March 31, 2005, theremaining borrowing capacity available under the DB Facility was approximately$41.6 million.

 

The DB Facility containscovenants that require Business Loan to maintain its status as a separateentity; prohibit certain significant corporate transactions (such as mergers,consolidations, liquidations or dissolutions); and restrict material changes tothe Company’s credit and collection policies. The DB Facility also restricts some of the terms and provisions(including interest rates, terms to maturity and payments schedules) and limitsthe borrower and industry concentrations of loans that are eligible to secureadvances.  As of March 31, 2005,Business Loan was in compliance with all of the facility covenants. 

 

The administrative agentalso 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 is alsothe trustee of the account and once a month remits the collected funds to theCompany. At March 31, 2005, the amount due from custodian was $14,472,037and at September 30, 2004, the amount due from custodian was $1,203,079.

 

Effective July 12,2004, Gladstone Management, the Company’s affiliated external adviser also servicesthe loans pledged under the DB Facility. As a condition to this servicing arrangement, the Company executed a performanceguaranty pursuant to which it guaranteed that Management would comply fullywith all of its obligations under the DB Facility.  The performance guaranty requires the Companyto maintain a minimum net worth of $100 million and to maintain “asset coverage”with respect to “senior securities representing indebtedness” of at least 200%,in accordance with Section 18 of the 1940 Act.  As of March 31, 2005, the Company was incompliance with all covenants under the performance guaranty.  Gladstone Management services these loans foran annual fee of 1.5% of the monthly aggregate outstanding loan balance of theloans pledged under the DB Facility.  Forthe three and six months ended March 31, 2005, the Company recorded loanservicing fees of $585,542 and $1,116,494, respectively.  At March 31, 2005, the Company owed$127,838 of unpaid loan servicing fees to Gladstone Management, which are recordedin fees due to affiliate.  At September 30,2004, the Company owed $113,511 in loan servicing fees to Gladstone Management,recorded in fees due to affiliate.  Therewere no loan servicing fees incurred for the three and six months ended March 31,2004, as prior to July 12, 2004, the loans pledged under the DB Facilitywere serviced by Gladstone Capital Advisers, Inc., wholly-owned subsidiaryof the Company.

 

While GladstoneManagement began receiving loan servicing fees as of July 12, 2004, suchloan servicing fees received by Gladstone Management are credited to theCompany’s advisory fee payable to Gladstone Management under the advisoryagreement between the Company and Gladstone Management.  Accordingly, the advisory fee payable by theCompany to Gladstone Management for the three and six months ended March 31,2005 was reduced by $585,542 and $1,116,494, respectively, in respect of thesefees received by Gladstone Management.

 

NOTE11. INTEREST RATE CAP AGREEMENT

 

Pursuant to the DeutscheBank AG line of credit, 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.

 

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In February 2004,the Company entered into an interest rate cap agreement with a notional amountof $35.0 million at a cost of $304,000 and a current fair value ofapproximately $80,778 which is recorded in other assets on the Company’sconsolidated balance sheet at March 31, 2005.  At September 30, 2004, the interest ratecap agreement had a fair value of $89,741. 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 expires inFebruary 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%.

 

NOTE12. FEE INCOME

 

The1940 Act requires that a business development company make available managerialassistance to its portfolio companies. The 1940 Act defines managerialassistance as the service made available to a portfolio company to provide “significantguidance and counsel concerning the management, operations, or businessobjectives and policies of a portfolio company.”  Prior to the start of fiscal year 2005, theCompany provided managerial assistance and other services to its portfoliocompanies through its wholly-owned subsidiary, Gladstone Capital Advisers, Inc.and therefore recorded managerial assistance and other fee revenue inconnection with these activities. Effective October 1, 2004, the Company offers managerial assistanceand other services to its portfolio companies through its external investmentadviser, Gladstone Management.  Neitherthe Company nor its external investment adviser, Gladstone Management, chargesa fee for managerial assistance. However, in the past the Company and since October 1, 2004,Gladstone Management have provided other services to portfolio companies inaddition to managerial assistance.  Theseother services include 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 is charging for these services and is crediting thefunds received from these other services to the Company as a credit against theinvestment advisory fee due from the Company under the investment advisoryagreement.  Such fees are normally paidin part at the time of signing a non-binding letter of intent, with theremainder paid upon completion of the services, and are generallynon-recurring.  For the three and six monthsended March 31, 2005, the Company recorded no revenue from fees since, asdescribed above, these fees were remitted by the borrower directly to GladstoneManagement.  For the three and six monthsended March 31, 2004, the Company recorded $356,231 and $611,231,respectively, of fee revenue.

 

WhileGladstone Management began receiving all fees in connection with the Company’sinvestments as of October 1, 2004, such fees received by GladstoneManagement are credited to the Company as a reduction of the advisory feepayable to Gladstone Management under the advisory agreement between theCompany and Gladstone Management.  Forthe three and six months ended March 31, 2005, Gladstone Managementreceived $450,000 and $736,500, respectively for fees for services rendered toportfolio companies. None of these fees were for managerial assistance eventhough Gladstone Management provided managerial assistance to many of theCompany’s portfolio companies. Accordingly, the advisory fee payable by the Company to GladstoneManagement for the three and six months ended March 31, 2005 was reducedby $450,000 and $736,500, respectively, in respect of these fees received byGladstone Management.

 

NOTE13. ADVISORY AGREEMENT WITH GLADSTONE MANAGEMENT CORPORATION

 

EffectiveOctober 1, 2004, the Company entered into an advisory agreement withGladstone Management, an unconsolidated affiliate of the Company, whereby GladstoneManagement would serve as an external adviser to the Company.  As compensation for the services of GladstoneManagement, the Company pays Gladstone Management an annual advisory fee of1.25% of 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 total assets (as reduced by cash and cashequivalents pledged to creditors), payable in quarterly computed increments of0.1875%, for a total annual fee of 2.0% (0.50% quarterly) of total assets (asreduced by cash and cash equivalents pledged to creditors). The Companycontinues to pay direct expenses including, but not limited to, directors’fees, legal and accounting fees, stockholder related expenses, and directorsand officers insurance.

 

GladstoneManagement services the loans held by Business Loan, in return for which,Gladstone Management receives a 1.5% annual fee based on the monthly aggregatebalance of loans held by Business Loan. Since the Company owns these loans, all loan servicing fees paid toGladstone Management are also credited directly against the 2% managementfee.  These credits reduce the amount ofthe investment advisory fee and are shown above the direct credits lineitem.  For the three months ended March 31,2005 and December 31, 2004, these loan servicing fees totaled $585,542 and$530,952, respectively, all of which were credited against the 2% managementfee, reflecting it as a reduction of operating expenses in the consolidatedstatement of operations.  Under theadvisory agreement, Gladstone Management also provides the managerialassistance and other services that the Company previously made available to itsportfolio companies through its wholly-owned subsidiary Gladstone CapitalAdvisers, Inc.  To the extent that GladstoneManagement receives any fees directly from a portfolio company for suchservices, Gladstone Management credits these fees directly against the 2%management fee and these amounts are shown in the table below as a credit tothe management fee.  For the three monthsended March 31, 2005 and the three months ended December 31, 2004,Gladstone Management recorded $450,000 

 

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and$286,500, respectively, of such fees and credited this amount against the 2%management fee received from the Company. Overall, the management fee due to Gladstone Management cannot exceed 2%of total assets (as reduced by cash and cash equivalents pledged to creditors)during any given fiscal year.  Becausethe Company was internally managed at all times prior to October 1, 2004,no management fee was recorded for the three months ended March 31, 2004or December 31, 2003.  

 

Thefollowing table sets forth the quarterly computation of the management fee forthe three months ended March 31, 2005 and December 31, 2004, based onthe quarterly increment of 0.50% (0.3125% quarterly advisory fee and 0.1875%quarterly administrative fee):

 
| ** **                                                 | ** ** | **March 31, 2005** | ** **  | **December 31, 2004** | ** ** |
|------------------------------------------------------------|------------|--------------------|-------------|-----------------------|------------|
| **Fee:**                                                   | ** ** | ** **         | ** **  | ** **            | ** ** |
| Total assets                                               |       | $                  | 213,753,998 |                  | $          | 194,085,591 |   |
| Less: Borrowings  under line of credit* (a)*          |       | (18,644,179        | )           | (22,435,000           | )          |
| Total assets  subject to fee                               |       | 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:            |       | $                  | (59,993     | )                     | $          | 40,802 |   |

 

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*(a) **This amount represents borrowings under one of the Company’s lines ofcredit that were held in cash and cash equivalents as of March 31, 2005and December 31, 2004, respectively of each quarterly computation, 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.*

 

NOTE14. 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 a RIC, the Company is not subject tofederal or state income tax on the portion of its taxable income and gainsdistributed to stockholders.  To qualifyas a RIC, the Company is required to distribute to its stockholders at least90% of investment company taxable income, as defined by the Code and as such noincome tax provisions have been recorded for the individual companies ofGladstone Capital Corporation and Gladstone Business Loan LLC.  

 

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 in aggregatefederal and state income taxes of $138,678.

 

NOTE15. SUBSEQUENT EVENTS

 

In April 2005, the Company funded a $6.325 million loan toDefiance Stamping Company, a manufacturer of stamped fasteners used in heavy truckand automotive components and purchased an additional $3.0 million loanparticipation of Polar Corporation, a manufacturer of trailer parts, and alsopurchased a $7.0 million loan participation in Infor Global Solutions Ltd., aprovider of enterprise application solutions.

 

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**ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSISOF 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, asamended, and Section 21E of the Securities Exchange Act of 1934, asamended. These statements may relate to, among other things, future events orour future performance 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 maintainour credit facilities on terms reasonably acceptable to us, if at all; (5) ourinability to successfully securitize our loan portfolio on terms reasonablyacceptable to us, if at all; (6) the decision of our competitors toaggressively seek to make senior and subordinated loans to small andmedium-sized businesses on terms more favorable than we intend to provide; and (7) thosefactors listed under the caption “Risk Factors” of the Annual Report on Form 10-Kas filed with the Securities and Exchange Commission on December 14, 2004.We caution readers not to place undue reliance on any such forward-lookingstatements, which are made pursuant to the Private Securities Litigation ReformAct of 1995 and, as such, speak only as of the date made. We undertake noobligation to publicly update or revise any forward-looking statements, whetheras a result of new information, future events or otherwise, after the date ofthis Form 10-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 incorporatedunder the General Corporation Laws of the State of Maryland on May 30,2001. Our investment objectives are to achieve a high level of current incomeby investing in debt securities, consisting primarily of senior notes, secondlien notes, and senior subordinated notes of established private businessesthat are backed by leveraged buyout funds, venture capital funds or others,with a particular emphasis on second lien and senior subordinated notes.  In addition, we may acquire existing loans,which meet this profile, from leveraged buyout funds, venture capital funds andothers. We also seek to provide our stockholders with long-term capital growththrough the appreciation in the value of warrants, or other equity instrumentsthat we may receive when we extend loans. We operate as a closed-end,non-diversified management investment company, and have elected to be treatedas a business development company under the 1940 Act.

 

We seek out small andmedium-sized businesses that meet certain criteria, including (1) thepotential for growth in cash flow, (2) adequate assets for loancollateral, (3) experienced management teams with a significant ownershipinterest in the borrower, (4) profitable operations based on the borrower’scash flow, (5) reasonable capitalization of the borrower (usually bybuyout funds or venture capital funds) and (6) the potential to realizeappreciation and gain liquidity in our equity position, if any. We anticipatethat liquidity in our equity position will be achieved through a merger oracquisition of the borrower, a public offering by the borrower or by exerciseof our right to require the borrower to buy back its warrants. We lend toborrowers that need funds to finance growth, restructure their balance sheetsor effect a change of control.

 

Our loans typically rangefrom $5 million to $15 million, mature in no more than seven years and accrueinterest at a fixed or variable rate that exceeds the prime rate. A number ofour loans have a provision that calls for some portion of the interest paymentsto be deferred and added to the principal balance so that the interest is paid,together with the principal, at maturity. This form of deferred interest isoften called “payment in kind” or “PIK” interest, and, when earned, we recordPIK interest as interest income and add the PIK interest to the principalbalance of the loans. We seek to avoid PIK interest with all potentialinvestments under review. The amount of cost basis PIK interest accrued on ourbalance sheet as of March 31, 2005 was approximately $1,197,000.

 

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Because our loans willgenerally be subordinated debt of private companies who typically cannot orwill not expend the resources to have their debt securities rated by a creditrating agency, we expect that most, if not all, of the debt securities weacquire will be unrated. We cannot accurately predict what ratings these loansmight receive if they were in fact rated, and therefore we cannot determinewhether or not they could be considered to be “investment grade” quality.

 

To the extent possible,our loans generally are collateralized by a security interest in the borrower’sassets. Interest payments are generally made monthly or quarterly (except tothe extent of any PIK interest) with amortization of principal generally beingdeferred for several years. The principal amount of the loans and any accruedbut unpaid interest generally become due at maturity at five to seven years.When we receive a warrant to purchase stock in a borrower in connection with aloan, the warrant will typically have an exercise price equal to the fair valueof the portfolio company’s common stock at the time of the loan and entitle usto purchase a modest percentage of the borrower’s stock.

 

Original issue discounts(“OID”) arise when we extend a loan and receive an equity interest in theborrower at the same time.  To the extentthat the price paid for the equity is not at market value, the Company mustallocate part of the price paid for the loan, to the value of the equity.  Then the amount allocated to the equity, theOID, must be amortized over the life of the loan.  As with PIK interest, the amortization of OIDalso produces income that must be recognized for purposes of satisfying the regulatedinvestment company (“RIC”) distribution requirements, whereas the cash isreceived, if at all, when the equity instrument is sold.

 

In addition, as a business development company underthe 1940 Act, we are required to make available significant managerialassistance to our portfolio companies. Prior to the externalization of ourmanagement on October 1, 2004, the start of the 2005 fiscal year, weprovided these services through our wholly-owned subsidiary, Gladstone CapitalAdvisers, Inc.  Since theexternalization of our management on October 1, 2004, our investmentadviser, Gladstone Management Corporation (“Gladstone Management”), began toprovide these services on our behalf through its officers who are also ourofficers.  In addition, GladstoneManagement provides other services to our portfolio companies, for which itreceives fees, in connection with our investments.  The fees for these services are generally paidto Gladstone Management in part at the time a prospective portfolio companysigns a non-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 fees received, with the exception ofthe recurring fee, by Gladstone Management are credited against the managementadvisory fee payable to Gladstone Management pursuant to the terms of ouradvisory agreement, which has the effect of reducing our expenses to the extentof any such fees received by Gladstone Management.  The specific services Gladstone Managementprovides vary by portfolio company, but generally include a wide variety ofservices to the portfolio companies such as investment banking services,arranging bank financing, arranging equity financing structuring financing frommultiple lenders and investors, reviewing existing credit facilities,restructuring existing loans, raising equity and debt capital, turnaroundmanagement, merger and acquisition services and recruiting new managementpersonnel.  Prior to the start of fiscalyear 2005, Gladstone Capital Advisers, Inc. provided these services andreceived these fees and we have recorded fees for these services as fee incomefor the periods in which these fees were earned by us.

 

Prior to making an investment, we ordinarily enterinto a non-binding term sheet with the potential borrower. These non-bindingterm sheets are generally subject to a number of conditions, including but notlimited to the satisfactory completion of our due diligence investigations of thepotential borrower’s business and reaching agreement on the legal documentationfor the loan. Upon execution of the non-binding term sheet, the potentialborrower generally pays Gladstone Management a non-refundable fee for itsservices rendered through the date of the non-binding term sheet. Prior to theexternalization of our management on October 1, 2004, we recognized thisas fee revenue 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 weexpend significant effort in considering and negotiating a potential investmentthat ultimately is not consummated, we generally will seek reimbursement fromthe proposed borrower for our reasonable expenses incurred in connection withthe 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 wehave incurred significant legal fees in connection with the transaction, wewill typically seek reimbursement for these expenses from the proposedborrower.  However, there can be noguarantee that we will be successful in collecting any such reimbursements.

 

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The only significantcontinuing revenue associated with the investments we have already closed isinterest income and, potentially, capital gains realized in connection with theliquidation of any associated equity interest (e.g., warrants).

 

During the six monthsended March 31, 2005, we extended approximately $91.5 million of new loansto, and loan participations in, a total of 14 companies.  Also, during the six months ended March 31,2005, six borrowers repaid their loans ahead of contractual maturity and wesold two loan investments for an aggregate return of capital of approximately $50.5million and we received scheduled contractual principal repayments ofapproximately $9.3 million, for total principal repayments of approximately$59.8 million.  Since our initial publicoffering in August 2001, we have made 61****different loans to, or investments in, 37****companies for a total of approximately $310.5****million, before giving effect to principalrepayments on investments and divestitures.

 

We are earnestly workingtoward the consummation of more investments. These prospective loans aresubject to, among other things, the satisfactory completion of our duediligence investigation of each borrower, acceptance of terms and structure andnecessary consents. With respect to each prospective loan, we will only agreeto provide the loan if, among other things, the results of our due diligenceinvestigations are satisfactory, the terms and conditions of the loan areacceptable and all necessary consents are received. Our management hasinitiated its due diligence investigations of the potential borrowers, howeverwe cannot assure you that we will not discover facts in the course ofcompleting our due diligence that would render a particular investmentimprudent or that any of these loans will actually be made.

 

**ExternalAdviser**

 

Effective October 1,2004, pursuant to our advisory agreement with Gladstone Management, we payGladstone Management an annual advisory fee of 1.25% of our 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 our total assets (as reduced by cash and cash equivalents pledged tocreditors), payable in quarterly computed increments of 0.1875%. This fee isthen directly reduced by the amount of loan servicing fees paid to GladstoneManagement and any other fees received by Gladstone Management from ourborrowers and potential borrowers.  Wecontinue to pay direct expenses including, but not limited to, directors fees,legal and accounting fees, stockholder related expenses, and directors andofficers insurance.

 

EffectiveJuly 12, 2004, Gladstone Management assumed the responsibility forservicing our loan portfolio pursuant to a loan servicing agreement withGladstone Business Loan LLC (“Business Loan”). Gladstone Management servicesthese loans in return for a 1.5% annual fee, based on the monthly aggregateoutstanding loan balance of the loans pledged under the facility.  For the three and six months ended March 31,2005, we incurred approximately $586,000 and $1,116,000, respectively, in loanservicing fees.  Prior to July 12,2004, our loans were serviced under a similar agreement between Business Loanand Gladstone Capital Advisers Inc., our wholly-owned subsidiary, although thefees from these intercompany transactions were eliminated through theconsolidation of our financial results with those of Business Loan andGladstone Capital Advisers.

 

For the three monthsended March 31, 2005, the gross management fee, before reductions for loanservicing fees and other fees was approximately $976,000.  After being reduced by loan servicing fees ofapproximately $586,000 and other fees received by Gladstone Management of$450,000, our net management fee for the three months ended March 31, 2005was a credit of approximately $60,000.  Forthe three months ended December 31, 2004, the gross management fee, beforereductions for loan servicing fees and other fees was approximately$858,000.  After being reduced by loanservicing fees of approximately $531,000 and other fees received by GladstoneManagement of approximately $286,500, our net management fee for the threemonths ended December 31, 2004 was $40,802.  Since the fees are computed quarterly it isnecessary to sum the two quarters in order to derive the year to datemanagement fee, therefore the six months ended March 31, 2005 grossmanagement fee before reductions was approximately $717,000 and the aggregate netmanagement fee after reductions was a credit of approximately $19,200 for thesix months ended March 31, 2005.  There was no fee for the three months ended March 31,2004 or December 31, 2003 because we were internally managed at all timesuntil October 1, 2004.

 

Prior to theexternalization of our management, we were party to an expense sharingarrangement with Gladstone Management, which during such time served as theexternal adviser to Gladstone Commercial Corporation (“Gladstone Commercial”),a real estate investment trust affiliated with us. Under this expense sharingarrangement, Gladstone Management reimbursed Gladstone Capital Advisers for aportion of our total payroll and benefits expenses (based on the percentage oftotal hours worked by each of our employees on Gladstone Commercial matters).Gladstone Management also reimbursed Gladstone Capital Advisers for its prorata portion of all other general expenses (based on the percentage of totalhours worked by all of our employees

 

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on Gladstone Commercialmatters). Gladstone Management further passed its share of these expenses alongto Gladstone Commercial under a separate advisory agreement.  At September 30, 2004, GladstoneManagement owed us $109,639 of reimbursements recorded in fees due fromaffiliate, all of which was subsequently paid. Following our engagement of Gladstone Management on October 1,2004, the first day of our 2005 fiscal year, Gladstone Management nowdirectly employs all of our personnel and pays its payroll, benefits, andgeneral expenses directly.  Thus, theexpense sharing arrangement between Gladstone Capital Advisers and GladstoneManagement terminated upon the externalization of our management on October 1,2004.

 

**CriticalAccounting Policies**

 

The preparation offinancial statements and related disclosures in conformity with accountingprinciples generally accepted in the United States requires management to makeestimates and assumptions that affect the reported consolidated amounts ofassets and liabilities, and disclosure of contingent assets and liabilities atthe date of the financial statements, and revenues and expenses during theperiod reported. Actual results could differ materially from those estimates.  Our accounting policies are more fullydescribed in the “Notes to Consolidated Financial Statements” containedelsewhere in this report.  We haveidentified our investment valuation process as our most critical accountingpolicy.

 

**InvestmentValuation**

 

The most significantestimate inherent in the preparation of our consolidated financial statementsis the valuation of investments and the related amounts of unrealized appreciationand depreciation of investments recorded.

 

*GeneralValuation Policy*: We value our investment portfolio eachquarter. We carry our investments at fair value, as determined in good faith byour board of directors.  Securities thatare publicly traded, if any, are valued at the closing price of the exchange orsecurities market on which they are listed on the valuation date. Securitieswhich are not traded on a public exchange or securities market, but for which alimited market exists and that have been rated by a NRSRO (as defined below),such as certain participations in syndicated loans, are valued at theindicative bid price offered by the syndication agent on the valuation date.

 

Debt and equitysecurities that are not publicly traded, for which a limited market does notexist, or for which a limited market exists but that have not been rated by aNRSRO (or for which we have various degrees of trading restrictions) are valuedat fair value as determined in good faith by our board of directors.  In making the good faith determination of thevalue of these securities, we start with the cost basis of the security, whichincludes the amortized original issue discount, and PIK interest, if any.  We then apply the methods set out below in “ValuationMethods.”  Members of our portfoliomanagement team prepare the valuations of our investments in portfoliocompanies using the most recent portfolio company financial statements andforecasts.  These individuals alsoconsult with portfolio company senior management and ownership to obtainfurther updates on the portfolio company’s performance, including informationsuch as industry trends, new product development, and other operationalissues.  Due to the uncertainty inherentin the valuation process, such estimates of fair value may differ significantlyfrom the values that would have been obtained had a ready market for thesecurities existed, and the differences could be material.  Additionally, changes in the market environmentand other events that may occur over the life of the investments may cause thegains or losses ultimately realized on these investments to be different thanthe valuations currently assigned.  Nosingle standard for determining fair value in good faith exists since fairvalue depends upon circumstances of each individual case.  In general, fair value is the amount that wemight reasonably expect to receive upon the current sale of the security.

 

We currently engageStandard & Poor’s Loan Evaluation Service (S&P) to help evaluatethe value of the majority of our loan securities (other than those which arepublicly traded or for which a limited market exists, as described above), aswell as for evaluations on success fees (conditional interest included in someloan securities).  We and S&P onlyevaluate the value of a success fee if the probability of receiving the successfee on a given loan is above 6-8%, a threshold of significance, in which case avalue is assigned.  Upon completing ourcollection of data with respect to the investments (including the informationdescribed under “Credit Information,” the risk ratings of the loans describedunder “Loan Grading and Risk Rating” and the factors described under “ValuationMethods”), this valuation data is presented to S&P.  S&P makes its independent assessment ofthe data that we have assembled and assesses its own data to determine marketvalues for the securities.  With regardto its work, S&P has issued the following paragraph:

 

S&P providesevaluated price opinions which are reflective of what S&P believes the bidside of the market would be for each loan after careful review and analysis ofdescriptive, market and credit information. Each price reflects S&P’s best judgment based upon carefulexamination of a variety of market factors. Because of fluctuation in the market and in other factors beyond itscontrol, S&P cannot guarantee these evaluations.  The evaluations reflect the market prices, orestimates thereof, on the date specified. The prices are based on comparable market prices for similarsecurities.  Market information has beenobtained from reputable secondary market sources.  Although these sources are consideredreliable, S&P cannot guarantee their accuracy.

 

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With our assessment andS&P value estimates as a backdrop, our board of directors votes to acceptor not accept the analyses and values recommended by management andS&P.  At March 31, 2005 and September 30,2004, the board of directors elected to accept the valuations recommended byS&P on those loans as denoted on the Schedules of Investments as of March 31,2005 and September 30, 2004 in our consolidated financial statements.

 

Because there is a delaybetween when we close a loan and when the loan can be evaluated by S&P, somenew loans are not valued immediately by S&P; rather, the board of directorsmakes its own determination about the value of these loans in accordance withour valuation policy.  Because S&Pdoes not provide values for mortgage loans or equity securities, our board ofdirectors also determines the fair value of these investments using ourvaluation policy without the input of S&P.

 

*CreditInformation:*****Wemonitor a wide variety of key credit statistics that provide informationregarding our portfolio companies to help us assess credit quality andportfolio performance.  We require ourportfolio companies to provide annual audited and either monthly or quarterlyunaudited financial statements.  Usingthese statements, we calculate and evaluate the credit statistics.  For purposes of analyzing the financialperformance of our portfolio companies, we may make certain adjustments totheir cash flow statements to reflect the pro forma results of a companyconsistent with a change of control transaction, to reflect anticipated costsavings resulting from a merger or restructuring, costs related to new productdevelopment, compensation to previous owners, and other acquisition orrestructuring related items.  For thoseinvestments for which S&P prepares valuation recommendations, we providethis credit information to S&P for its use in preparing itsrecommendations.  For those investmentsfor which S&P does not prepare valuation recommendations, management usesthis credit information in connection with its preparation of valuationrecommendations.

 

*LoanGrading and Risk Rating:*As part of our valuation procedureswe risk rate all of our loans.  Our riskrating system uses a scale of 0 to 10. This system is used to estimate the probability of default on our debtsecurities and the probability of loss if there is a default.  These types of systems are referred to asrisk rating systems and are used by banks and rating agencies.  The risk rating system covers bothqualitative and quantitative aspects of the business and the securities wehold.  For those investments for whichS&P prepares valuation recommendations, we compile this information andprovide it to S&P for its consideration in determining its valuationrecommendations.  For those investmentsfor which S&P does not prepare valuation recommendations, management usesthis information to develop valuation recommendations.

 

We seek to have our riskrating system mirror the risk rating systems of major risk rating organizationssuch as those provided by nationally recognized statistical ratingorganizations (“NRSRO”) as defined in Rule 2a-7 under the 1940 Act. Whilewe seek to mirror the NRSRO systems, we cannot provide any assurance that ourrisk rating system provides the same risk rating as a NRSRO. The followingchart is an estimate of the relationship of our risk rating system to thedesignations used by two NRSROs as they risk rate debt securities of majorcompanies.  Because we have establishedour system to rate debt securities of companies that are unrated by any NRSROthere can be no assurance that the correlation to the NRSRO set out below isaccurate. It is our understanding that most debt securities of middle marketcompanies do not exceed the grade of BBB on a NRSRO scale; so there would be nodebt securities in the middle market that would meet the definition of AAA, AAor A.  Therefore, our scale begins withthe designation BBB as the best 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 22.0% 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) thedefault rates set forth herein are for a ten year term debt, if the company’sdebt security is less than ten years then the probability of default isadjusted to a lower percentage for the shorter period which may move thesecurity higher on our risk rating scale.*

 

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The above scale gives anindication of the probability of default and the magnitude of the loss if thereis a default. The following table lists the risk ratings for all of the debtsecurities outstanding at March 31, 2005, December 31, 2004 and September 30,2004:

 

| **Rating**       | ** ** | **Mar. 31, 2005** | ** ** | **Dec. 31, 2004** | ** ** | **Sept. 30, 2004** | ** ** |
|------------------|------------|------------------------|------------|------------------------|------------|--------------------|------------|
| Average          | ** ** | **7.2**                | ** ** | **7.2**                | ** ** | **7.6**            | ** ** |
| Weighted Average | ** ** | **7.2**                | ** ** | **7.2**                | ** ** | **7.6**            | ** ** |
| Highest          | ** ** | **10.0**               | ** ** | **10.0**               | ** ** | **9.0**            | ** ** |
| Lowest           | ** ** | **5.0**                | ** ** | **5.0**                | ** ** | **5.0**            | ** ** |

 

Our policy is to stopaccruing interest on an investment if we determine that interest is no longercollectible. To date we have not placed any investments on non-accrual.  At March 31, 2005 and September 30,2004, no payments were past due on any of our debt securities.  We do not risk rate our equity securities.

 

*ValuationMethods:*  For debtsecurities, we first determine if the debt security is publicly traded (i.e.,if it is listed on an exchange or securities market).  If it is publicly traded, then we determinethe value based on the closing price for the security on the exchange orsecurities market on which it is listed on the valuation date.  If the security is not publicly traded, but alimited market for the security exists, such as for syndicated loans, and ifthe security has been rated by a NRSRO, then we value the loan at theindicative bid price offered by the syndication agent on the valuationdate.  At March 31, 2005, none ofthe debt securities in our portfolio were publicly traded and there was alimited market for eight debt securities in our portfolio.  At September 30, 2004, none of the debtsecurities in our portfolio were publicly traded and there was a limited marketfor five debt securities in our portfolio.

 

For debt securities that eitherare not publicly traded, for which there is no market, or for which there is amarket but have not been rated by a NRSRO, we begin with the risk ratingdesignation of the security described above. 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.  To determine the current sale price of thesecurity, we consider some or all of the following factors:

 

•      financialstanding of the issuer of the security;

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

•      thecost of the security;

•      thesize of the security held as it relates to the liquidity of the market for suchsecurities;

•      contractualrestrictions on the disposition of the security;

•      pendingpublic offering of the issuer of the security;

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

•      reportedprices of similar securities of the issuer or comparable issuers;

•      abilityof the issuer to obtain needed financing;

•      changesin the economy affecting the issuer;

•      recentpurchases or sale of a security of the issuer;

•      pricingby other buyers or sellers of similar securities;

•      financialstatements of the borrower;

•      reportsfrom portfolio company senior management and ownership;

•      thetype of security;

•      costat date of purchase;

•      sizeof holding;

•      discountfrom market value of unrestricted securities of the same class at the time ofpurchase;

•      specialreports prepared by analysts;

•      informationas to any transactions or offers with respect to the security;

•      existenceof merger proposals or tender offers affecting the securities;

•      thecollateral;

•      theissuer’s ability to make payments;

•      thecurrent and forecasted earnings of the issuer;

•      salesto third parties of similar securities;

•      statisticalratios compared to lending standards;

•      statisticalratios compared to other similar securities; and

•      otherpertinent factors.

 

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For those debt securitiesfor which S&P prepares valuation recommendations, we provide the foregoinginformation to S&P for its use in preparing its recommendations.

 

For convertible debt,equity, success fees or other equity-like securities, we first determine ifthere 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, 2005 and September 30,2004 there was no market for any of the equity securities we owned.  If there is no market for the equitysecurities, then we use the same information we would use for a debt securityvaluation described above, except risk-rating, as well as standard valuationtechniques used by major valuation firms to value the equity securities ofprivate 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, 2005 and September 30, 2004 we had $37,000invested, at cost, in equity securities compared to our debt portfolio with acost basis of $181,063,806 and $149,152,306, respectively.

 

At March 31, 2005,the value of our warrants of Finn Corporation had an unrealized appreciation of$562,176.  This aforementioned unrealizedappreciation plus unrealized appreciation of $531,439 on certain otherinvestments, primarily syndicated participation investments, most notablyMaidenform Inc., which had unrealized appreciation of $146,696, for overall unrealizedappreciation of $1,093,615, partially offsets total unrealized depreciation of$3,745,803, which was mainly composed of unrealized depreciation in our seniorsubordinated term debt investment in Finn Corporation (excluding the warrants)of $3,097,500 and our senior subordinated term debt investment in Marcal PaperMills, Inc. of $248,438.

 

**TaxStatus**

 

*FederalIncome Taxes*

 

Weintend to continue to qualify for treatment as a RIC under Subtitle A, Chapter1 of Subchapter M of the Code. As a RIC, we are not subject to federal incometax on the portion of our taxable income and gains distributed to stockholders.To qualify as a RIC, we are required to distribute to stockholders at least 90%of investment company taxable income, as defined by the Code.  We have a policy to pay out as a dividend upto 100% of that amount.

 

**RevenueRecognition**

 

*InterestIncome Recognition*

 

Interestincome is recorded on the accrual basis to the extent that such amounts areexpected to be collected. We will stop accruing interest on investments when itis determined that interest is no longer collectible. Conditional interest or asuccess fee is recorded when earned upon full repayment of a loan investment.

 

*Paymentin Kind Interest*

 

Wealso have some loans in our portfolio which contain a PIK interest provision.The PIK interest, computed at the contractual rate specified in each loanagreement, is added to the principal balance of the loan and recorded asinterest income. To maintain our status as a RIC, this non-cash source ofincome must be paid out to stockholders in the form of dividends, even thoughwe have not yet collected the cash.

 

**FeeIncome**

 

The1940 Act requires that a business development company make available managerialassistance to its portfolio companies by providing significant guidance andcounsel concerning the management, operations, or business objective andpolicies of the respective portfolio company. Prior to October 1, 2004, weprovided managerial assistance to our portfolio companies in connection withour investments through our wholly-owned subsidiary, Gladstone Capital Advisers, Inc.  Effective October 1, 2004, we beganproviding these and other services through our external adviser, GladstoneManagement.  Currently, neither we norGladstone Management receive fees in connection with managerial assistance.However, effective October 1, 2004 our adviser, Gladstone Management,receives the fees for the other services it provides, and those fees for otherservices are credited to the investment advisory fees due to GladstoneManagement.  These other fees aregenerally paid to Gladstone Management in part at the time a prospectiveportfolio company signs a non-binding term sheet with us, with the remainderpaid at the closing of the investment. These fees are generally non-recurring, are recognized as revenue whenearned and are paid directly to Gladstone Management by the borrower orpotential borrower, effective October 1, 2004 and for all futureperiods.  The services GladstoneManagement provides vary by investment, but generally include a wide variety ofservices to the portfolio companies such as investment banking services,arranging bank financing, arranging equity financing structuring financing frommultiple lenders and investors, reviewing existing

 

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credit facilities, restructuring existing loans, raising equity anddebt capital, turnaround management, merger and acquisition services andrecruiting new management personnel.  Anyservices of this nature subsequent to the closing would generally generate aseparate fee at the time of completion. From time to time, we are invited toparticipate as a co-lender in a transaction. In the event that we do not providesignificant services in connection with our investment, loan fees paid directlyto Gladstone Management in such situations are deferred and amortized over thelife of the loan.

 

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**RESULTSOF OPERATIONS**

 

*Comparisonof the three months ended March 31, 2005 to the three months ended March 31,2004*

 

**Investment Income**

 

Investment income for thethree months ended March 31, 2005 was approximately $5.9 million ascompared to approximately $4.4 million for the three months ended March 31,2004. This increase was primarily a result of increased interest income from anincreased number of investments during the three months ended March 31,2005, as compared to the same period of the prior year, partially offset by adecline in fee revenue resulting from the receipt of such fees by our externalinvestment adviser.

 

Interest income from ourinvestments in debt securities of private companies was approximately $5.2million, including approximately $130,000 of PIK interest, for the three monthsended March 31, 2005 as compared to approximately $3.9 million for thethree months ended March 31, 2004, which included approximately $138,000of PIK interest. This increase****was primarily a result of anincrease in investments of $141.7 million, partially offset by principalrepayments and the sale of an investment in the aggregate of approximately $101.8million, at March 31, 2005 as compared to investments at March 31,2004.

 

The annualized weightedaverage yield on our portfolio for the three months ended March 31, 2005was 11.6% (without giving effect to PIK interest) and 13.5% (after givingeffect to PIK interest). The annualized weighted average yield on our portfoliofor the three months ended March 31, 2004 was 11.8% (without giving effectto PIK interest) and 13.1% (after giving effect to PIK interest).

 

Interest income frominvested cash and cash equivalents for the three months ended March 31,2005 was approximately $5,000, as compared to approximately $17,000 for the threemonths ended March 31, 2004. This decrease****was primarily a result of a decrease in invested cash andcash equivalents resulting from an increase in investments of $141.7 million,partially offset by principal repayments and the sale of an investment in theaggregate of approximately $101.8 million, between March 31, 2004 and March 31,2005.

 

For the three monthsended March 31, 2005 and March 31, 2004, we recorded approximately $114,000and $110,000, respectively, in interest income from loans to our employees inconnection with the exercise of employee stock options.

 

No fee income wasrecorded for the three months ended March 31, 2005, as compared to $356,000for the three months ended March 31, 2004. This decrease was the result ofthe externalization of our management, effective October 1, 2004, throughthe engagement of our affiliate Gladstone Management to serve as our externalinvestment adviser.  As noted above,Gladstone Management receives all fees in connection with our investments andprospective investments, which fees are offset against the advisory fee payableto Gladstone Management.  During thethree months ended March 31, 2005, Gladstone Management received anaggregate of $450,000 in such fees.

 

For the three monthsended March 31, 2005, we recorded approximately $570,000 of other incomeas compared to $6,000 of other income for the three months ended March 31,2004.  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.

 

**OperatingExpenses**

 

Operating expenses forthe three months ended March 31, 2005 were approximately $1.5 million, ascompared to approximately $1.2 million for the three months ended March 31,2004. This increase****was mainly aresult of an increase in interest expense and stockholder related costs,partially offset by a decline in professional fees.  Additionally, operating expenses for thethree months ended March 31, 2005 reflected a significant reduction indirect operating expenses as a result of the externalization of our managementeffective October 1, 2004, offset by the loan servicing fees andmanagement fee incurred as a result of this externalization..

 

Loanservicing fees of approximately $586,000 were incurred for the three monthsended March 31, 2005.  These feeswere incurred in connection with a loan servicing agreement between GladstoneBusiness Loan LLC (“Business Loan”) and Gladstone Management, which becameeffective July 12, 2004.  These feeswere directly credited against the amount of the management fee due toGladstone Management.  During the threemonths ended March 31, 2004, our loan portfolio was serviced under asimilar agreement with Gladstone Capital Advisers Inc., our wholly-ownedsubsidiary, and the fees Business Loan paid to Gladstone Capital Advisers, Inc.were eliminated upon consolidation of our financial results.

 

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EffectiveOctober 1, 2004, we entered into an advisory agreement with GladstoneManagement whereby Gladstone Management serves as our external adviser.  As compensation for the services of GladstoneManagement, we pay Gladstone Management an annual advisory fee of 1.25% oftotal assets (as reduced by cash and cash equivalents pledged to creditors), payablein quarterly computed increments of 0.3125%, and an annual administrative feeof 0.75% of total assets (as reduced by cash and cash equivalents pledged tocreditors), payable in quarterly computed increments of 0.1875%, for a totalfee of 2% of total assets (as reduced by cash and cash equivalents pledged tocreditors). We continue to pay direct expenses including, but not limited to,directors’ fees, legal and accounting fees, stockholder related expenses, anddirectors and officers insurance.  Underthe advisory agreement, Gladstone Management provides the managerial assistanceand other services to our portfolio companies that we previously providedthrough our wholly-owned subsidiary Gladstone Capital Advisers, and likewiseGladstone Management directly receives any fees for such services.  Any such fees are credited directly againstthe 2% management fee payable to Gladstone Management.  The 2% management fee is also directlyreduced by the amount of the monthly loan servicing fees we pay to GladstoneManagement. Overall, the management fee due to Gladstone Management cannotexceed 2% of total assets (as reduced by cash and cash equivalents pledged tocreditors) during any given fiscal year. Because we were internally managed at all times prior to October 1,2004, no management fee was recorded for the three months ended March 31,2004.

 

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

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

 

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*(a) **This amount represents borrowings under one of ourlines of credit that were held in cash and cash equivalents as of March 31,2005 for the purpose of satisfying our asset diversification requirements underthe Internal Revenue 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 GladstoneManagement.  As a result, such amountsare deducted from our total assets for purposes of computing the asset baseupon which the management fee is determined.*

 

Professional fees, consisting primarily of legal andaudit fees, for the three months ended March 31, 2005 were approximately $156,000,as compared to approximately $271,000 for the three months ended March 31,2004.  The decrease is due primarily to adecrease in non-reimbursable legal fees.

 

Amortization of deferred financing costs, inconnection with our lines of credit, were approximately $92,000 for the threemonths ended March 31, 2005 and approximately $70,000 for the three monthsended March 31, 2004.  The increaseis due to the amortization of deferred financing costs for both of our lines ofcredit during the three months ended March 31, 2005 as compared to theamortization of deferred financing costs for only one line of credit which wasin place during the three months ended March 31, 2004.

 

Interest expense for the three months ended March 31,2005 was approximately $440,000 as compared to approximately $102,000 for thethree months ended March 31, 2004.   This increase is primarily a result ofincreased borrowings under our lines of credit during the three months ended March 31,2005, which borrowings were used, in part, to finance our increased investmentsand to a lesser extent, an increase in the interest rates on our borrowings.

 

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Stockholder related costs for the three months ended March 31,2005 were approximately $105,000, as compared to approximately $67,000 for thethree months ended March 31, 2004. Stockholder related costs include such recurring items as transfer agentfees, securities fees, electronic filing fees and printing and mailing of proxyreports to stockholders.

 

Directors’ fees for the three months ended March 31,2005 were $24,000, as compared to approximately $33,000 for the three monthsended March 31, 2004. This is the result of fewer board meetings heldduring the three months ended March 31, 2005 as compared to the threemonths ended March 31, 2004.

 

Insurance expense for the three months ended March 31,2005 was approximately $44,000, as compared to approximately $63,000 for thethree months ended March 31, 2004. The decrease is primarily the result ofthe externalization of our management. Effective October 1, 2004, Gladstone Management pays generalinsurance expenses directly and such insurance coverage is included in theservices we receive in consideration for the 2% management fee we pay toGladstone Management.  Insurance expenseincurred during the three months ended March 31, 2005 represents theamortization of our directors and officers insurance premiums, which areexpenses for which we continue to be responsible for following theexternalization of our management.

 

Effective October 1, 2004, all of our employeesbecame employees of Gladstone Management and therefore no salaries or benefitexpenses were incurred by us for the three months ended March 31, 2005 ascompared to approximately $420,000 for the three months ended March 31,2004.  We reimburse Gladstone Managementfor its employee services as part of the 2% of total assets (excluding cash andcash equivalents pledged to creditors) management fee.

 

Effective October 1, 2004, our external adviser,Gladstone Management, began to pay rent directly and therefore for the threemonths ended March 31, 2005 no rent expense was incurred by us as comparedto approximately $34,000 for the three months ended March 31, 2004.  General overhead expenses such as rent arealso included as part of the management fee to Gladstone Management.

 

General and administrative expenses were approximately$69,000 for the three months ended March 31, 2005, as compared toapproximately $181,000 for the three months ended March 31, 2004. This decrease****is primarily a result of GladstoneManagement handling general overhead type expenses.  The expenses for the three months ended March 31,2005 primarily represent direct expenses such as travel related specifically toour portfolio companies, loan evaluation services for our portfolio companies,press releases and backup servicer expenses.

 

**Realized Gain on Sale ofInvestment**

 

During the three months ended March 31, 2005, wesold our $2.0 million syndicated participation in Marietta Corp. for a gain of$20,000, as compared to the three months ended March 31, 2004 in which webought and sold our $1.0 million investment in Metokote Corporation for a gainof $12,500.

 

**Net Unrealized Appreciation (Depreciation)on Derivative**

 

During the three months ended March 31, 2005, werecorded net unrealized appreciation of approximately $16,000 due to anincrease in the fair market value of our interest rate cap agreement, ascompared to unrealized depreciation of approximately $5,000 during the twomonths that the investment was held during the three months ended March 31,2004.

 

**Net Unrealized Depreciation onInvestments**

 

For the three months ended March 31, 2005, werecorded net unrealized depreciation on investments of approximately $192,000as compared to net unrealized depreciation of approximately $305,000, for thethree months ended March 31, 2004. The unrealized depreciation is mainly attributable to the decrease inthe value of our senior subordinated term debt investment in Finn Corporation,partially offset by unrealized appreciation on certain of our syndicated loanparticipations.

 

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**Net Increase in Stockholders’ Equity fromOperations**

 

Overall, werealized a net increase in stockholders’ equity resulting from operations of approximately$4.3 million for the three months ended March 31, 2005.  Based on a weighted-average of 11,288,833(basic) and 11,620,603 (diluted) shares outstanding, our net increase instockholders’ equity from operations per weighted average common share for thethree months ended March 31, 2005 was $0.38 (basic) and $0.37 (diluted).

 

For the three months ended March 31,2004, we realizeda net increase in stockholders’ equity resulting from operations ofapproximately $2.8 million.  Based on aweighted-average of 10,087,615 (basic) and 10,375,281 (diluted) shares outstanding,our net increase in stockholders’ equity resulting from operations per weightedaverage common share for the three months ended March 31, 2004 was $0.28 (basic)and $0.27 (diluted).

 

*Comparisonof the six months ended March 31, 2005 to the six months ended March 31,2004*

 

**Investment Income**

 

Investment income for thesix months ended March 31, 2005 was approximately $12.0 million ascompared to approximately $8.3 million for the six months ended March 31,2004. This increase was primarily a result of increased interest income from anincreased number of investments during the six months ended March 31,2005, as compared to the same period of the prior year, partially offset by adecline in fee revenue resulting from the receipt of such fees by our externalinvestment adviser.

 

Interest income from ourinvestments in debt securities of private companies was approximately $10.9million, including approximately $271,000 of PIK interest, for the six monthsended March 31, 2005 as compared to approximately $7.4 million for the sixmonths ended March 31, 2004, which included approximately $276,000 of PIKinterest. This increase****was primarily a result of anincrease in investments of $141.7 million, partially offset by principalrepayments and sale of investments for an aggregate return of approximately$101.8 million, at March 31, 2005 as compared to investments at March 31,2004.

 

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 annualized weighted average yield on our portfolio for the sixmonths ended March 31, 2004 was 12.1% (without giving effect to PIKinterest) and 12.9% (after giving effect to PIK interest).

 

Interest income frominvested cash and cash equivalents for the six months ended March 31, 2005was approximately $21,000, as compared to approximately $66,000 for the sixmonths ended March 31, 2004. This decrease****was primarily a result of a decrease in invested cash andcash equivalents resulting from an increase in investments of $141.7 million,partially offset by principal repayments and sale of investments for anaggregate return of approximately $101.8 million, between March 31, 2004and March 31, 2005.

 

For the six months ended March 31,2005 and March 31, 2004, we recorded approximately $228,000 and $218,000,respectively, in interest income from loans to our employees in connection withthe exercise of employee stock options.

 

No fee income wasrecorded for the six months ended March 31, 2005, as compared to approximately$611,000 for the six months ended March 31, 2004. This decrease was theresult of the externalization of our management, effective October 1,2004, through the engagement of our affiliate Gladstone Management to serve asour external investment adviser.  Asnoted above, Gladstone Management receives all fees in connection with ourinvestments and prospective investments, which fees are offset against theadvisory fee payable to Gladstone Management. During the six months ended March 31, 2005, Gladstone Managementreceived an aggregate of $736,500 in such fees.

 

For the six months ended March 31,2005, we recorded approximately $810,000 of other income as compared to $22,000of other income for the six months ended March 31, 2004.  The income for both periods consisted ofprepayment penalty fees received upon the full repayment of certain loaninvestments ahead of contractual maturity and prepayment fees received upon theearly unscheduled principal repayments ahead of scheduled payment dates which,in both instances were based on a percentage of the outstanding principalamount of the loan at the date of prepayment.

 

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**OperatingExpenses**

 

Operating expenses forthe six months ended March 31, 2005 were approximately $2.7 million, ascompared to approximately $2.3 million for the six months ended March 31,2004. This increase****was mainly aresult of an increase in interest expense and stockholder related costs.  Additionally, operating expenses for the sixmonths ended March 31, 2005 reflected a significant reduction in directoperating expenses, as a result of the externalization of our managementeffective October 1, 2004, offset by an increase in loan servicing feesand management fee incurred as a result of this externalization.

 

Loanservicing fees of approximately $1.1 million were incurred for the six monthsended March 31, 2005.  These feeswere incurred in connection with a loan servicing agreement between GladstoneBusiness Loan LLC (“Business Loan”) and Gladstone Management, which becameeffective July 12, 2004.  These feeswere directly credited against the amount of the management fee due toGladstone Management.  During the sixmonths ended March 31, 2004, our loan portfolio was serviced under asimilar agreement with Gladstone Capital Advisers Inc., our wholly-ownedsubsidiary, and the fees Business Loan paid to Gladstone Capital Advisers, Inc.were eliminated upon consolidation of our financial results.

 

EffectiveOctober 1, 2004, we entered into an advisory agreement with GladstoneManagement whereby Gladstone Management serves as our external adviser.  As compensation for the services of GladstoneManagement, we pay Gladstone Management an annual advisory fee of 1.25% oftotal assets (as reduced by cash and cash equivalents pledged to creditors),payable in quarterly computed increments of 0.3125%, and an annualadministrative fee of 0.75% of total assets (as reduced by cash and cashequivalents pledged to creditors), payable in quarterly computed increments of0.1875%, for a total fee of 2% of total assets (as reduced by cash and cashequivalents pledged to creditors). We continue to pay direct expenses including,but not limited to, directors’ fees, legal and accounting fees, stockholderrelated expenses, and directors and officers insurance.  Under the advisory agreement, GladstoneManagement provides the managerial assistance and other services to our portfoliocompanies that we previously provided through our wholly-owned subsidiaryGladstone Capital Advisers, and likewise Gladstone Management directly receivesany fees for such services.  Any suchfees are credited directly against the 2% management fee payable to GladstoneManagement.  The 2% management fee isalso directly reduced by the amount of the monthly loan servicing fees we payto 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.  Because we were internally managed at alltimes prior to October 1, 2004, no management fee was recorded for thethree months ended March 31, 2004 or December 31, 2003.

 

Thefollowing table sets forth the quarterly computations of the management fee forthe three months ended March 31, 2005 and December 31, 2004, based onthe quarterly increment of 0.50% (0.3125% quarterly advisory fee plus 0.1875%quarterly administrative fee):

 
| ** **                                                 | ** ** | **March 31, 2005** | ** **  | **December 31, 2004** | ** ** |
|------------------------------------------------------------|------------|--------------------|-------------|-----------------------|------------|
| **Fee:**                                                   |       |               |        |                  |       |
| Total assets                                               |       | $                  | 213,753,998 |                  | $          | 194,085,591 |   |
| Less: Borrowings  under line of credit* (a)*          |       | (18,644,179        | )           | (22,435,000           | )          |
| Total assets  subject to fee                               |       | 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:            |       | $                  | (59,993     | )                     | $          | 40,802 |   |

 

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*(a) **This amount represents borrowings under one of ourlines of credit that were held in cash and cash equivalents as of March 31,2005 and December 31, 2004, for each respective quarter, for the purposeof satisfying our asset diversification requirements under the Internal RevenueCode.  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 a result, such amounts are deducted fromour total assets for purposes of computing the asset base upon which themanagement fee is determined.*

 

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Professional fees, consisting primarily of legal andaudit fees, for the six months ended March 31, 2005 were approximately $395,000,as compared to approximately $424,000 for the six months ended March 31,2004.  The decrease is due primarily to adecrease in non-reimbursable legal fees.

 

Amortization of deferred financing costs, inconnection with our lines of credit, were approximately $184,000 for the sixmonths ended March 31, 2005 and approximately $153,000 for the six monthsended March 31, 2004.  The increaseis due to the amortization of deferred financing costs for both lines of creditduring the six months ended March 31, 2005 as compared to the amortizationof deferred financing costs for only one line of credit which was in placeduring the six months ended March 31, 2004.

 

Interest expense for the six months ended March 31,2005 was approximately $611,000 as compared to approximately $180,000 for the sixmonths ended March 31, 2004.   Thisincrease is a result of increased borrowings under our lines of credit duringthe six months ended March 31, 2005, which borrowings were used, in part,to finance our increased investments, and to a lesser extent, an increase inthe interest rate.

 

Stockholder related costs for the six months ended March 31,2005 were approximately $176,000, as compared to approximately $120,000 for thesix months ended March 31, 2004. Stockholder related costs include such recurring items as transfer agentfees, securities fees, electronic filing fees and printing and mailing ofannual reports and proxy statements to stockholders.

 

Directors’ fees for the six months ended March 31,2005 were $51,000, as compared to approximately $57,000 for the six monthsended March 31, 2004. This is the result of fewer board meetings heldduring the six months ended March 31, 2005 as compared to the six monthsended March 31, 2004.

 

Insurance expense for the six months ended March 31,2005 was approximately $90,000, as compared to approximately $137,000 for the sixmonths ended March 31, 2004. The decrease is primarily the result of theexternalization of our management. Effective October 1, 2004, Gladstone Management pays generalinsurance expenses directly and such insurance coverage is included in theservices we receive in consideration for the 2% management fee we pay toGladstone Management.  Insurance expenseincurred during the six months ended March 31, 2005 represents theamortization of our directors and officers insurance premiums, which areexpenses for which we continue to be responsible for following theexternalization of our management.

 

Effective October 1, 2004, all of our employeesbecame employees of Gladstone Management and therefore no salaries or benefitexpenses were incurred by us for the six months ended March 31, 2005 ascompared to approximately $810,000 for the six months ended March 31,2004.  We reimburse Gladstone Managementfor its employee services as part of the 2% of total assets (excluding cash andcash equivalents pledged to creditors) management fee.

 

Effective October 1, 2004, our external adviser,Gladstone Management, began to pay rent directly and therefore for the sixmonths ended March 31, 2005 no rent expense was incurred by us as comparedto approximately $72,000 for the six months ended March 31, 2004.  General overhead expenses such as rent arealso included as part of the management fee to Gladstone Management.

 

General and administrative expenses were approximately$113,000 for the six months ended March 31, 2005, as compared toapproximately $317,000 for the six months ended March 31, 2004. Thisdecrease****is primarily a result ofGladstone Management handling general overhead type expenses.  The expenses for the six months ended March 31,2005 primarily represent direct expenses such as travel related specifically toour portfolio companies, loan evaluation services for our portfolio companies,press releases and backup servicer expenses.

 

**Income Tax Expense**

 

Gladstone Capital Advisers, Inc., a wholly-ownedsubsidiary of Gladstone Capital Corporation, is subject to federal and stateincome taxation on the income it has recorded such as managerial assistance andother fees.  During the six months ended March 31,2005, Gladstone Capital Advisers incurred aggregate federal and state incometaxes of $138,678 resulting from taxable income it received during the 2004fiscal year.  Following theexternalization of our management effective October 1, 2004 substantiallyall revenues previously received by Gladstone Capital Advisers are now receivedby Gladstone Management.  As a result, wedo not anticipate incurring significant tax expense as a result of the activitiesof Gladstone Capital Advisers in the future.

 

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**Realized Gain on Sale ofInvestment**

 

During the six months ended December 31, 2004, wesold our $975,000 syndicated participation in Burt’s Bees, Inc. for a gainof $9,750 and we sold our $2.0 million syndicated participation in MariettaCorp. for a gain of $20,000, as compared to the three months ended March 31,2004 in which we bought and sold our $1.0 million investment in MetokoteCorporation for a gain of $12,500.

 

**Net Unrealized Depreciation onDerivative**

 

As a result of the decline in fair market value of ourinterest rate cap agreement, we recorded net unrealized depreciation onderivative of approximately $9,000 for the six months ended March 31, 2005,as compared to net unrealized depreciation of approximately $5,000 for the twomonths the investment was held during the six months ended March 31, 2004.

 

**Net Unrealized Appreciation(Depreciation) on Investments**

 

For the six months ended March 31, 2005, werecorded net unrealized appreciation on investments of approximately $91,000 ascompared to net unrealized depreciation of approximately $1.9 million, for the sixmonths ended March 31, 2004.  Theunrealized appreciation is mainly attributable to the increase in the value ofthe Finn warrant as well as the unrealized appreciation on certain of oursyndicated loan participations, partially offset by unrealized depreciation oursenior subordinated term debt investment in Finn Corporation.

 

**Net Increase in Stockholders’ Equity fromOperations**

 

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

 

For the six months ended March 31, 2004, we realized a net increase instockholders’ equity resulting from operations of approximately $4.2million.  Based on a weighted-average of10,084,729 (basic) and 10,354,405 (diluted) shares outstanding, our netincrease in stockholders’ equity resulting from operations per weighted averagecommon share for the six months ended March 31, 2004 was $0.42 (basic) and$0.41 (diluted).

 

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**LIQUIDITY AND CAPITALRESOURCES**

 

At March 31, 2005, we had investments in debtsecurities of, or loans to 22 private companies, totaling approximately $181.1million (cost basis) of total assets. This number includes approximately $200,000in accrued PIK interest income for the six months ended March 31, 2005,which as described in “Overview,” is added to the carrying value of ourinvestments.

 

In October 2004, wesold our $975,000 participation in Burt’s Bees, Inc. for a gain of $9,750.

 

During November 2004, we extended a $5.5 million loan toGlobal Materials Technologies, Inc. a manufacturer of steel wool productsand metal fibers and also extended a $7.95 million loan to Santana Plastics, Inc.,a manufacturer of polyethylene bathroom partitions. We also purchasedsyndicated loan participations in Valor Telecommunications, a ruraltelecommunications company, in the amount of $8.0 million and Tech Lighting LLC,a manufacturer of low voltage lighting systems in the amount of $7.0 million.We also received full principal repayments ahead of contractual maturity of$12.25 million from A & G, Inc. and $12.0 million from America’sWater Heater Rentals, Inc., which also remitted $1.4 million of prepaymentand success fees with its final payment.

 

In December 2004we purchased an additional $2.0 million loan participation of Tech Lighting andan additional $2.0 million loan participation of Valor Telecommunications.  We also purchased loan participations of $3.0million of Polar Corporation, a manufacturer of trailer parts, $2.0 million ofRegency Gas Services LLC, a company specializing in midstream gas gathering andprocessing, $2.0 million of Marietta Corporation, a manufacturer of personalcare products, and $7.5 million of Advanced Homecare Management, Inc., aprovider home health nursing services.

 

In January 2005,we sold our entire $2.0 million loan participation in Marietta Corporation fora gain of $20,000.  In January 2005,we also purchased an additional $2.5 million loan participation in PolarCorporation, an additional $1.0 million loan participation in Regency GasServices LLC and a $5.5 million loan participation in John Henry Holdings Inc.,an envelope manufacturer.

 

In February 2005,Inca Metal Products Corporation/Kingway Acquisition, Inc./ClymerAcquisition, Inc. repaid its entire $2.3 million investment, Bear CreekCorporation repaid its entire $6.0 million investment, and ValorTelecommunications repaid its entire $10.0 million investment, along withprepayment fees in the aggregate of approximately $0.5 million.

 

In March 2005,ARI Holdings, Inc. repaid its entire $1.2 million senior term debt and itsentire $3.7 million senior subordinated term debt, and we participated in a newsenior loan to ARI Holdings, Inc. in the amount of $3.9 million.

 

The following table summarizes the contractualprincipal amortization and maturity of our investment portfolio by fiscal year:

 

| **Year**   | ** ** | **Amount** | ** **  |
|------------|------------|------------|-------------|
| 2005       |       | $          | 3,518,190   |   |
| 2006       |       | $          | 21,061,898  |   |
| 2007       |       | $          | 32,893,712  |   |
| 2008       |       | $          | 27,499,178  |   |
| 2009       |       | $          | 33,315,994  |   |
| Thereafter |       | $          | 62,811,835  |   |
| Total      |       | $          | 181,100,807 |   |

 

Net cash used in operating activities for the sixmonths ended March 31, 2005, consisting primarily of the items describedin “Results of Operations,” was approximately $4.9 million.  Net cash used in investing activities wasapproximately $52.2 million during the six months ended March 31, 2005 andprimarily consisted of new investments in the aggregate amount of approximately$91.5 million and the repayment of the repurchase agreement of approximately$21.3 million, partially offset by principal repayments of approximately $59.8million from our portfolio companies. ** **Net cash provided by financingactivities was approximately $10.3 million for the six months ended March 31,2005 and consisted primarily of cash provided from borrowings on our lines ofcredit, net of repayments, of approximately $18.4 million and the exercise ofstock options 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.

 

As a result of the above factors, during the sixmonths ended March 31, 2005, cash and cash equivalents decreased fromapproximately $66.0 million at the beginning of the period to approximately $19.2million at the end of the period.

 

On October 1, 2004, we settled an outstandingrepurchase agreement (the “Repurchase Agreement”) with Ferris Baker WattsIncorporated for $21,345,997. The interest rate on the Repurchase Agreement was4.25% for a cost of $7,831. In the future, we may or may not use a similar formof repurchase agreement as an investment option or in order to satisfy certainasset diversification

 

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requirements and maintain our status as a RIC under Subchapter M of theInternal Revenue Code.  At March 31,2005, we did not use a repurchase agreement as an investment option in order tosatisfy our asset diversification requirement; however, of the $59.1 million ofborrowings outstanding under our lines of credit at March 31, 2005,approximately $18.6 million were invested in cash and cash equivalents in orderto satisfy our asset diversification requirement.

 

In order to qualify as a RICand to avoid corporate level tax on the income we distribute to ourstockholders, we are required, under Subchapter M of the 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 a monthly cash dividend of $0.12 per common share for each ofOctober, November and December 2004 and January, February, and March 2005.  We also declared a monthly cash dividend of$0.13 per common share for each April, May, and June 2005.

 

We anticipate continuingto borrow funds and, from time to time issuing additional equity securities toobtain additional capital to make further investments. To this end, we have aneffective registration statement on file with the Securities and ExchangeCommission (“SEC”) that would permit us to issue, through one or moretransactions, up to an aggregate of $48.8 million in securities, which mayconsist of shares of our common stock, preferred stock, and/or debt securities.

 

**Revolving Credit Facilities**

 

Throughour wholly-owned subsidiary, Business Loan, we have a $100 million revolvingcredit facility (the “DB Facility”) with Deutsche Bank AG, as administrativeagent, which matures on May 30, 2005.  Pursuant to the DB Facility, Business Loan haspledged the loans it holds to secure future advances by certain institutionallenders.  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, 2005, our outstanding principal balance under this DBFacility was approximately $45.1 million at an interest rate of 2.81%.  Available borrowings are subject to variousconstraints imposed by Deutsche Bank AG, based on the aggregate loan balancepledged by Business Loan, which varies as loans or added and repaid, regardlessof whether such repayments are early prepayment or are made as contractuallyrequired.  At March 31, 2005, theremaining borrowing capacity available under the DB Facility was approximately$41.6 million.  We are in the process ofnegotiating a renewal of this DB Facility, however there can be no guaranteethat we will be able to renew the DB Facility on terms that are favorable tous, if at all.  In the event that we arenot able to renew the DB Facility this could have a material adverse impact onour liquidity and ability to fund new investments.

 

The DBFacility contains covenants that, among other things, require Business Loan tomaintain its status as a separate entity; prohibit certain significantcorporate transactions (such as mergers, consolidations, liquidations ordissolutions); and restrict material changes to our credit and collectionpolicies.  The DB Facility also restrictssome of the terms and provisions (including interest rates, terms to maturityand payments schedules) and limits the borrower and industry concentrations ofloans that are eligible to secure advances. As of March 31, 2005, Business Loan was in compliance with all ofthe DB Facility covenants.  We currentlyintend to securitize all of the loans held by Business Loan and to use theproceeds from the securitization to pay down any amounts then outstanding underthe 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.

 

Theadministrative agent also requires that any interest or principal payments onpledged loans be remitted directly by the borrower into a lockbox account withthe Bank of New York as custodian. Deutsche Bank AG is also the trustee of the account and once a monthremits the collected funds to the Company. For the six months ended March 31,2005, the amount due from custodian increased by approximately $13.3 million.

 

GladstoneManagement, our affiliated external adviser, services the loans pledged underthe DB Facility.  As a condition to thisservicing arrangement, we executed a performance guaranty pursuant to which weguaranteed that Gladstone Management would comply fully with all of itsobligations under the facility. The performance guaranty requires us tomaintain a minimum net worth of $100 million and to maintain “asset coverage”with respect to “senior securities representing indebtedness” of at least 200%,in accordance with Section 18 of the 1940 Act.  As of March 31, 2005, we were incompliance with our covenants under the performance guaranty.

 

Wealso have a $15.0 million line of credit agreement with Branch Banking andTrust Company (“BB&T Agreement”) which matures on June 1, 2005.  Interest on outstanding borrowings is basedon the one month LIBOR plus 2.5% per annum. The unused portion of the line of credit is subject to a fee of 0.2% perannum.  The BB&T Agreement requiresus to meet and maintain certain covenants and ratios with respect to leverageand liquidity. As of March 31, 2005, there was $14.0 million outstandingunder the BB&T line of credit at an interest rate of 5.22%.  At March 31, 2005, the remainingborrowing capacity available under the BB&T Agreement was $1.0 million.

 

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**ITEM 3. QUANTITATIVE AND QUALITATIVEDISCLOSURES ABOUT MARKET RISK.**

 

We are subject tofinancial market risks, including changes in interest rates.  We expectthat ultimately approximately 20% of the loans in our portfolio will be made atfixed rates, with approximately 80% made at variable rates.  Currently ourportfolio has approximately 19% of the total of the loan portfolio cost basisat fixed rates, approximately 45% of the total loan portfolio cost basis atvariable rates with a floor and the remaining 35% of the total loan portfoliocost basis at variable rates.

 

In addition, we have twovariable rate borrowing facilities.  Wehave a $100 million revolving credit facility with Deutsche Bank AG whichmatures in May 2005.  We also have a$15 million line of credit agreement with Branch Banking and Trust Companywhich matures in June 2005.

 

In February 2004, we entered into an interestrate cap agreement in order to fulfill an obligation under our line of creditto enter into certain hedging transactions in connection with our borrowingsunder the line of credit.  We purchased this interest rate cap agreementwith a notional amount of $35 million for a one-time, up-front payment of$304,000.  The interest rate cap agreement entitles us to receivepayments, if any, equal to the amount by which interest payments on $35 millionat the point which one month LIBORexceed the payments on $35 million at 5%.  The cap expires in February 2009. This interest rate cap agreement effectively caps our interest paymentson our line of credit borrowing, up to the notional amount of the interest ratecap, at five percent.  This mitigates our exposure to increases ininterest rates on our borrowings on our lines of credit, which are at variablerates.  At March 31, 2004, the capagreement had a fair market value of $80,778. At March 31,2005, the one month LIBOR rate was approximately 2.87%.

 

To illustrate the potential impact of changes ininterest rates on our net increase in stockholders’ equity resulting fromoperations, we have performed the following analysis, which assumes that ourbalance sheet remains constant and no further actions beyond the interest ratecap agreement are taken to alter our existing interest rate sensitivity.  Under this analysis, a hypothetical increasein the one month LIBOR by 1% would increase our net increase in stockholders’equity resulting from operations by approximately $889,000 or 6.0%, over thenext twelve months, compared to the net increase in stockholders’ equity resultingfrom operations for the twelve months ended March 31, 2005.  A hypothetical decrease in the one monthLIBOR by 1% would decrease net increase in stockholders’ equity resulting fromoperations by approximately $889,000, or 6.0%, over the next twelve months,compared to the net increase in stockholders’ equity resulting from operationsfor the twelve months ended March 31, 2005.  Although management believes that thisanalysis is indicative of our existing interest rate sensitivity, it does notadjust for potential changes in credit quality, size and composition of ourloan portfolio on the balance sheet and other business developments that couldaffect net increase in stockholders’ equity resulting from operations.  Accordingly, no assurances can be given thatactual results would not differ materially from the results under thishypothetical analysis.

 

In the event that wesecuritize a portion of our loan portfolio, we believe that we will likely berequired to enter into further hedging arrangements in the future with respectto 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, 2005, we, including our Chief ExecutiveOfficer and Chief Financial Officer, evaluated the effectiveness of the designand operation of our disclosure controls and procedures.  Based on that evaluation, our management,including the Chief Executive Officer and Chief Financial Officer, concluded thatour disclosure controls and procedures were effective in timely alertingmanagement, including the Chief Executive Officer and Chief Financial Officer,of material information about us required to be included in periodic Securitiesand Exchange Commission filings. However, in evaluating the disclosure controls and procedures,management recognized that any controls and procedures, no matter how welldesigned and operated can provide only reasonable assurance of achieving thedesired control objectives, and management necessarily was required to applyits judgment in evaluating the cost-benefit relationship of possible controlsand procedures.

 

There have been no changes in our internal control over financialreporting that occurred during the quarter ended March 31, 2005, that havematerially affected, or are reasonably likely to materially affect, ourinternal control over financial reporting.

 

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**PART II–OTHERINFORMATION**

 

**ITEM1. LEGAL PROCEEDINGS.**

 

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 2. UNREGISTEREDSALES OF 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 2005 Annual Meeting of Stockholderswas held on February 9, 2005.  Thestockholders voted and approved the following matters:

 

•      The election of three Class Idirectors to hold office until the 2008 Annual Meeting of Stockholders.

 
| **Nominee**         | ** ** | **Shares Voted For** | ** ** | **Authority Withheld** | ** ** |
|---------------------|------------|----------------------|------------|------------------------|------------|
| Michela English     |       | 10,869,823           |       | 114,275                |       |
| Anthony Parker      |       | 10,883,470           |       | 100,628                |       |
| George Stelljes III |       | 10,869,729           |       | 87,369                 |       |

 

•      To approve an amendment to the Company’sAmended and Restated 2001 Equity Incentive Plan to increase the aggregatenumber of shares of capital stock authorized for issuance under such plan by250,000 shares and to grant the board of directors the authority to reduce theoption price for each outstanding option by an amount equal to the per shareamount of any cash dividend paid to all holders of outstanding common stock.

 
| Shares voted for     |   | 3,364,277 |   |
|----------------------|--------|-----------|--------|
| Shares voted against |   | 2,533,157 |   |
| Shares abstained     |   | 97,014    |   |

 

**ITEM 5. OTHER INFORMATION.**

 

Not applicable

 

**ITEM6.  EXHIBITS**

 

See the exhibit index.

 

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**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 and Treasurer |

 

Date: May 9, 2005

 

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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.

 

41

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