**UNITED STATES**

**SECURITIES ANDEXCHANGE COMMISSION**

**WASHINGTON, D.C.20549**

 

**FORM 10-Q**

 

| **ý****QUARTERLY REPORT  PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934** |
|--------------------------------------------------------------------------------------------------------|
|                                                                                                   |
| **FOR THE QUARTER  ENDED DECEMBER 31, 2004**                                                           |
|                                                                                                   |
| **o****TRANSITION REPORT  PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**     |

 

**COMMISSION FILENUMBER: 814-00237**

 

**GLADSTONE CAPITALCORPORATION**

(Exact name of registrant as specified inits charter)

 
| **MARYLAND**                                                    | ** ** | **54-2040781**                       |
|-----------------------------------------------------------------|------------|--------------------------------------|
| (State or other jurisdiction of  incorporation or organization) |       | (I.R.S. Employer Identification No.) |
|                                                            |       |                                 |
| **1616 ANDERSON ROAD,  SUITE 208**                              |
| **MCLEAN, VIRGINIA 22102**                                      |
| (Address of principal executive office)                         |
|                                                            |       |                                 |
| **(703) 286-7000**                                              |
| (Registrant’s telephone number,  including area code)      |

 

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

 

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

Yes ý No o.

 

Indicate the number of shares outstanding of each of the issuer’sclasses of common stock, as of the latest practicable date.  The number of shares of the issuer’s CommonStock, $0.001 par value, outstanding as of February 7, 2005 was 11,288,510.

 

 

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**GLADSTONE CAPITALCORPORATION**

**TABLE OF CONTENTS**

 
| PART I.    | FINANCIAL INFORMATION                                                                                                    |
|------------|--------------------------------------------------------------------------------------------------------------------------|
|       |                                                                                                                     |
| Item 1.    | Financial Statements (Unaudited)                                                                                         |
|       |                                                                                                                     |
|       | Consolidated Balance Sheets  as of December 31, 2004 and September 30, 2004                                              |
|       | Schedules of Investments as of December  31, 2004 and September 30, 2004                                                 |
|       | Consolidated  Statements of Operations for the three months ended December 31, 2004 and December  31, 2003               |
|       | Consolidated  Statement of Stockholders’ Equity for the three months ended December 31, 2004  and December 31, 2003 |
|       | Consolidated  Statements of Cash Flows for the three months ended December 31, 2004 and December  31, 2003               |
|       | Financial Highlights for the three  months ended December 31, 2004 and December 31, 2003                                 |
|       | 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 |
|       |                                                                                                                     |
|            |                                                                                                                          |  |

 

 

1

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**GLADSTONE CAPITALCORPORATION**

 

**CONSOLIDATED BALANCE SHEETS**

**(Unaudited)**

 
| ** **                                                                                                 | ** ** | **December 31,**

**2004** | ** **  | **September 30,**

**2004** | ** ** |
|------------------------------------------------------------------------------------------------------------|------------|----------------------------|-------------|-----------------------------|------------|
| ** **                                                                                                 | ** ** | ** **                 | ** **  |
| ASSETS                                                                                                     |       |                       |        |                        |       |
| Investments at fair value (Cost 12/31/2004:  $170,302,735; 9/30/2004: $149,189,306)                        |       | $                          | 167,842,273 |                        | $          | 146,446,240 |   |
| Cash and cash equivalents                                                                                  |       | 23,383,544                 |        | 15,969,890                  |       |
| Cash and cash equivalents pledged to creditors                                                             |       | —                     |        | 49,984,950                  |       |
| Interest receivable – investments in debt securities                                                  |       | 979,666                    |        | 837,336                     |       |
| Interest receivable – employees                                                                       |       | 38,012                     |        | 112,960                     |       |
| Due from custodian                                                                                         |       | 1,171,809                  |        | 1,203,079                   |       |
| Due from affiliate                                                                                         |       | 79,238                     |        | 109,639                     |       |
| Deferred financing fees                                                                                    |       | 258,824                    |        | 350,737                     |       |
| Prepaid assets                                                                                             |       | 189,718                    |        | 191,676                     |       |
| Other assets                                                                                               |       | 142,507                    |        | 127,220                     |       |
|                                                                                                       |       |                       |        |                        |       |
| TOTAL ASSETS                                                                                               |       | $                          | 194,085,591 |                        | $          | 215,333,727 |   |
|                                                                                                       |       |                       |        |                        |       |
| LIABILITIES AND STOCKHOLDERS’ EQUITY                                                                  |       |                       |        |                        |       |
|                                                                                                       |       |                       |        |                        |       |
| LIABILITIES                                                                                                |       |                       |        |                        |       |
| Accounts payable                                                                                           |       | $                          | 220,844     |                        | $          | 105,921 |   |
| Fees due to affiliate                                                                                      |       | 149,911                    |        | 113,511                     |       |
| Borrowings under lines of credit                                                                           |       | 40,400,000                 |        | 40,743,547                  |       |
| Accrued expenses and deferred liabilities                                                                  |       | 164,729                    |        | 798,096                     |       |
| Repurchase agreement                                                                                       |       | —                     |        | 21,345,997                  |       |
|                                                                                                       |       |                       |        |                        |       |
| Total Liabilities                                                                                          |       | $                          | 40,935,484  |                        | $          | 63,107,072 |   |
|                                                                                                       |       |                       |        |                        |       |
| STOCKHOLDERS’ EQUITY                                                                                  |       |                       |        |                        |       |
| Common stock, $0.001 par value, 50,000,000 shares  authorized and 11,278,510 shares issued and outstanding |       | $                          | 11,279      |                        | $          | 11,279 |   |
| Capital in excess of par value                                                                             |       | 164,183,548                |        | 164,294,781                 |       |
| Notes receivable – employees                                                                          |       | (9,282,678                 | )           | (9,432,678                  | )          |
| Net unrealized depreciation on investments                                                                 |       | (2,460,461                 | )           | (2,743,066                  | )          |
| Unrealized depreciation on derivative                                                                      |       | (239,070                   | )           | (214,259                    | )          |
| Distributions less than net investment income                                                              |       | 937,489                    |        | 310,598                     |       |
|                                                                                                       |       |                       |        |                        |       |
| Total Stockholders’ Equity                                                                            |       | $                          | 153,150,107 |                        | $          | 152,226,655 |   |
|                                                                                                       |       |                       |        |                        |       |
| TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY                                                            |       | $                          | 194,085,591 |                        | $          | 215,333,727 |   |
|                                                                                                            |            |                            |             |                             |            |  |  |  |

 

SEE ACCOMPANYING NOTES.

 

2

----

 

 

**GLADSTONE CAPITALCORPORATION**

**SCHEDULEOF INVESTMENTS**

**AS OF DECEMBER 31,2004**

**(UNAUDITED)**

** **
| **Company (1)**                     | ** ** | **Industry**                                                          | ** ** | **Investment (2)**                                                  | ** ** | **Cost**   | ** ** | **Fair Value** |
|-------------------------------------|------------|-----------------------------------------------------------------------|------------|---------------------------------------------------------------------|------------|------------|------------|----------------|
| ** **                          | ** ** | ** **                                                            | ** ** | ** **                                                          | ** ** | ** ** | ** ** | ** **     |
| Advanced Homecare Management, Inc.  |       | Home health nursing services                                          |       | Senior Subordinated Term Debt (7)

(13.3%, Due 12/2010)             |       | $          | 7,500,000  |           | $ | 7,500,000 |
|                                |       |                                                                  |       |                                                                |       |       |       |           |   |   |
| 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 (6) (10.0%, Due 6/2008)                            |       | 1,190,141  |       | 1,184,190      |
|                                |       |                                                                  |       | Senior Subordinated Term Debt (5) (6)

(11.3%, PIK 4%, Due 12/2008) |       | 3,694,750  |       | 3,653,184      |
|                                |       |                                                                  |       |                                                                |       |       |       |           |
| Bear Creek Corporation              |       | Premium horticultural and food products                               |       | Senior Subordinated Term Debt (7)

(9.9%, Due 6/2010)               |       | 6,000,000  |       | 6,090,000      |
|                                |       |                                                                  |       |                                                                |       |       |       |           |
| Benetech, Inc.                      |       | Dust management systems for the coal and electric utility  industries |       | Senior Term Debt (6)

(8.5%, Due 5/2009)                            |       | 3,087,500  |       | 3,091,359      |
|                                |       |                                                                  |       | Senior Term Debt (3) (6)

(11.5%, Due 5/2009)                       |       | 3,250,000  |       | 3,262,188      |
|                                |       |                                                                  |       |                                                                |       |       |       |           |
| Coyne International Enterprises     |       | Industrial services                                                   |       | Senior Term Debt (3) (5) (6)

(13.0%, PIK 2%, Due 7/2007)           |       | 15,742,507 |       | 15,506,369     |
|                                |       |                                                                  |       |                                                                |       |       |       |           |
| 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     |       | 569,535        |
|                                |       |                                                                  |       |                                                                |       |       |       |           |
| Gammill, Inc.                       |       | Designer and assembler of quilting machines and accessories           |       | Senior Term Debt (6)

(9.5%, Due 12/2008)                           |       | 4,580,769  |       | 4,580,769      |
|                                |       |                                                                  |       | Senior Term Debt (3) (6)

(12.0%, Due 12/2008)                      |       | 4,750,000  |       | 4,750,000      |
|                                |       |                                                                  |       |                                                                |       |       |       |           |
| Global Materials Technologies, Inc. |       | Manufacturing-steel wool products and metal fibers                    |       | Senior Term Debt (3)

(13.0%, Due 11/2009)                          |       | 5,500,000  |       | 5,500,000      |
|                                |       |                                                                  |       |                                                                |       |       |       |           |
| Inca Metal Products Corporation     |       | Material handling and storage products                                |       | Senior Term Debt (3) (6)

(5.2%, Due 9/2006)                        |       | 2,316,525  |       | 2,108,038      |
| Kingway Acquisition, Inc.           |       |                                                                  |       |                                                                |       |       |       |           |
| Clymer  Acquisition, Inc.

    |       |                                                                  |       |                                                                |       |       |       |           |
|                                |       |                                                                  |       |                                                                |       |       |       |           |
| Maidenform, Inc.                    |       | Intimate apparel                                                      |       | Senior Subordinated Term Debt (7)

(10.2%, Due 5/2011)              |       | 10,003,437 |       | 10,200,000     |
|                                |       |                                                                  |       |                                                                |       |       |       |           |
| Marcal Paper Mills, Inc.            |       | Manufacturing-paper products                                          |       | Senior Subordinated Term Debt (6)

(13.0%, Due 12/2006)             |       | 6,800,000  |       | 6,494,000      |
|                                |       |                                                                  |       | First Mortgage Loan (5)

(16%, PIK 1%, Due 12/2006)                 |       | 9,277,839  |       | 9,277,839      |

 

3

----

 

 
| **Company (1)**                       | ** ** | **Industry**                                              | ** ** | **Investment (2)**                                      | ** ** | **Cost**   | ** **  | **Fair Value** |
|---------------------------------------|------------|-----------------------------------------------------------|------------|---------------------------------------------------------|------------|------------|-------------|----------------|
| ** **                            | ** ** | ** **                                                | ** ** | ** **                                              | ** ** | ** ** | ** **  | ** **     |
| Marietta Corporation                  |       | Manufacturing-personal care products                 |       | Senior Subordinated Term Debt (7)

(11.5%, Due 6/2010)  |       | 2,000,000  |        | 2,020,000      |
|                                  |       |                                                      |       |                                                    |       |       |        |           |
| MedAssets, Inc.                       |       | Pharmaceuticals and healthcare GPO                        |       | Senior Term Debt (7)

(6.7%, Due 3/2007)                |       | 1,636,973  |        | 1,645,488      |
|                                  |       |                                                      |       | Senior Subordinated Term Debt (7)

(12.6%, Due 3/2008)  |       | 6,503,047  |        | 6,597,500      |
|                                  |       |                                                      |       |                                                    |       |       |        |           |
| Mistras Holdings Corp.                |       | Nondestructive testing instruments, systems and  services |       | Senior Term Debt (3) (6)

(10.5%, Due 8/2008)           |       | 9,666,666  |        | 9,569,999      |
|                                  |       |                                                      |       | Senior Term Debt (3) (6)

(12.5%, Due 8/2008)           |       | 4,833,334  |        | 4,772,917      |
|                                  |       |                                                      |       | Senior Term Debt (3) (6)

(13.5%, Due 8/2008)           |       | 1,000,000  |        | 992,500        |
|                                  |       |                                                      |       |                                                    |       |       |        |           |
| Polar Corporation                     |       | Manufacturing-trailer parts                               |       | Senior Subordinated Term Debt (7)

(8.9%, Due 6/2010)   |       | 3,000,000  |        | 3,060,000      |
|                                  |       |                                                      |       |                                                    |       |       |        |           |
| Regency Gas Services LLC              |       | Midstream gas gathering and processing                    |       | Senior Subordinated Term Debt (7)

(8.3%, Due 12/2010)  |       | 2,000,000  |        | 2,040,000      |
|                                  |       |                                                      |       |                                                    |       |       |        |           |
| Santana Plastics                      |       | Manufacturing-polyethylene bathroom partitions       |       | Senior Term Debt (3)

(10.5%, Due 11/2009)              |       | 6,000,000  |        | 6,000,000      |
|                                  |       |                                                      |       | Senior Term Debt (4)

(13.0%, Due 11/2009)              |       | 1,950,000  |        | 1,950,000      |
|                                  |       |                                                      |       |                                                    |       |       |        |           |
| Tech Lighting LLC                     |       | Manufacturing-low voltage lighting systems                |       | Senior Subordinated Term Debt (7)

(9.3%, Due 10/2010)  |       | 9,014,295  |        | 9,045,000      |
|                                  |       |                                                      |       |                                                    |       |       |        |           |
| Valor Telcommunications, Inc.         |       | Rural telecommunications                                  |       | Senior Subordinated Term Debt (7)

(10.1%, Due 11/2011) |       | 9,985,952  |        | 10,300,000     |
|                                  |       |                                                      |       |                                                    |       |       |        |           |
| Woven Electronics Corporation

  |       | Custom electrical cable assemblies                        |       | Senior Term Debt (3) (6)

(7.3%, Due 3/2009)            |       | 2,482,000  |        | 2,478,898      |
|                                  |       |                                                      |       | Senior Term Debt (4) (6)

(11.5%, Due 3/2009)           |       | 12,000,000 |        | 11,985,000     |
|                                  |       |                                                      |       |                                                    |       |       |        |           |
| **Total:**                            |       |                                                      |       |                                                    |       | $          | 170,302,735 |           | $ | 167,842,273 |
|                                       |            |                                                           |            |                                                         |            |            |             |                |  |  |

 

----

 

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

(2) Percentage represents interest rates in effect at December 31,2004 and due date represents the contractual maturity date.

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

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

(5) Has some paid in kind (PIK) interest.  Refer to Note 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 provided byStandard & Poor’s Loan Evaluation Services.

(7) Marketable securities are valued based on the bid price, as ofDecember 28, 2004, from the respective originating syndication agent’s tradingdesk.

 

SEE ACCOMPANYING NOTES.

 

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. (d/b/a Alstyle)   |       | Activewear products                                                   |       | Senior Term Debt (3) (6)

(11.0%, Due 6/2008)                     |       | $          | 12,250,000 |           | $ | 12,250,000 |
|                            |       |                                                                  |       |                                                              |       |       |       |           |
| 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)

(9.75%, Due 6/2008)                         |       | 1,190,141  |       | 1,188,653      |
|                            |       |                                                                  |       | Senior Subordinated Term Debt (5) (6)

(11%, PIK 4%, Due 12/2008) |       | 3,657,164  |       | 3,634,306      |
|                            |       |                                                                  |       |                                                              |       |       |       |           |
| 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  utility industries |       | Senior Term Debt (6)

(8.5%, Due 5/2009)                          |       | 3,168,750  |       | 3,160,828      |
|                            |       |                                                                  |       | Senior Term Debt (3) (6)

(11.5%, Due 5/2009)                     |       | 3,250,000  |       | 3,241,875      |
|                            |       |                                                                  |       |                                                              |       |       |       |           |
| 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  accessories          |       | Senior Term Debt (6)

(9.5%, Due 12/2008)                         |       | 4,708,013  |       | 4,731,553      |
|                            |       |                                                                  |       | Senior Term Debt (3) (6)

(12.0%, Due 12/2008)                    |       | 4,750,000  |       | 4,767,813      |
|                            |       |                                                                  |       |                                                              |       |       |       |           |
| 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)

(9.4%, Due 5/2011)             |       | 10,003,571 |       | 10,175,000     |
|                            |       |                                                                  |       |                                                              |       |       |       |           |
| 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)

(16%, Due 12/2006)                       |       | 9,254,715  |       | 9,254,715      |
|                            |       |                                                                  |       |                                                              |       |       |       |           |
| 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)

(11.2%, Due 3/2008)            |       | 6,503,282  |       | 6,500,000      |
|                                 |            |                                                                       |            |                                                                   |            |            |            |                |  |  |

 

5

----

 
| Mistras Holdings Corp.        |   | Nondestructive testing instruments, systems and  services |   | Senior Term Debt (3) (6)

(10.5%, Due 8/2008) |   | 9,833,333  |        | 9,759,583  |
|-------------------------------|--------|-----------------------------------------------------------|--------|-----------------------------------------------|--------|------------|-------------|------------|
|                          |   |                                                      |   | Senior Term Debt (3) (6)

(12.5%, Due 8/2008) |   | 4,916,667  |        | 4,867,500  |
|                          |   |                                                      |   | Senior Term Debt (3) (6)

(13.5%, Due 8/2008) |   | 1,000,000  |        | 1,000,000  |
|                          |   |                                                      |   |                                          |   |       |        |       |
| 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)

(11.5%, Due 3/2009) |   | 12,000,000 |        | 11,985,000 |
|                          |   |                                                      |   |                                          |   |       |        |       |
| **Total:**                    |   |                                                      |   |                                          |   | $          | 149,189,306 |       | $ | 146,446,240 |
|                               |        |                                                           |        |                                               |        |            |             |            |  |  |

 

----

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

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

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

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

(5) Has some paid in kind (PIK) interest.  Refer to Note 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 provided byStandard & Poor’s Loan Evaluation Services.

(7) Marketable securities are valued based on the bid price, as ofSeptember 30, 2004, from the respective originating syndication agent’s tradingdesk.

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

 

SEE ACCOMPANYING NOTES.

 

6

----

 

 

**GLADSTONE CAPITALCORPORATION**

**CONSOLIDATED STATEMENT OF OPERATIONS**

**(UNAUDITED)**

 
| ** **                                                                              | ** ** | **Three Months**

**Ended**

**December 31,** | ** ** | **Three Months**

**Ended**

**December 31,** | ** ** |
|-----------------------------------------------------------------------------------------|------------|-----------------------------------------------|------------|-----------------------------------------------|------------|
| ** **                                                                              | ** ** | **2004**                                      | ** ** | **2003**                                      | ** ** |
| INVESTMENT INCOME                                                                       |       |                                          |       |                                          |       |
| Interest income – investments                                                      |       | $                                             | 5,707,343  |                                          | $          | 3,539,696 |   |
| Interest income – cash and cash equivalents                                        |       | 16,340                                        |       | 48,621                                        |       |
| Interest income – notes receivable from employees                                  |       | 114,718                                       |       | 108,632                                       |       |
| Fee income(Refer to Note 12)                                                            |       | —                                        |       | 255,000                                       |       |
| Other income                                                                            |       | 240,000                                       |       | 16,000                                        |       |
| Total investment income                                                                 |       | 6,078,401                                     |       | 3,967,949                                     |       |
|                                                                                    |       |                                          |       |                                          |       |
| EXPENSES                                                                                |       |                                          |       |                                          |       |
| Loan servicing                                                                          |       | 530,952                                       |       | —                                        |       |
| Management fee (Refer to Notes 10 and 13)                                               |       | 327,302                                       |       | —                                        |       |
| Professional fees                                                                       |       | 238,722                                       |       | 152,771                                       |       |
| Amortization of deferred financing fees                                                 |       | 91,912                                        |       | 83,551                                        |       |
| Interest                                                                                |       | 171,730                                       |       | 78,200                                        |       |
| Stockholder related costs                                                               |       | 71,769                                        |       | 52,660                                        |       |
| Directors fees                                                                          |       | 27,000                                        |       | 24,333                                        |       |
| Insurance                                                                               |       | 46,272                                        |       | 74,011                                        |       |
| Salaries and benefits                                                                   |       | —                                        |       | 390,707                                       |       |
| Rent                                                                                    |       | —                                        |       | 37,760                                        |       |
| General and administrative                                                              |       | 43,160                                        |       | 135,320                                       |       |
| Expenses before credit from Gladstone Management                                        |       | 1,548,819                                     |       | 1,029,313                                     |       |
| Credit to management fee for fees collected by  Gladstone Management (Refer to Note 13) |       | (286,500                                      | )          | —                                        |       |
| Total expenses net of credit to management fee                                          |       | 1,262,319                                     |       | 1,029,313                                     |       |
|                                                                                    |       |                                          |       |                                          |       |
| NET INVESTMENT INCOME BEFORE INCOME TAXES                                               |       | 4,816,082                                     |       | 2,938,636                                     |       |
| Income tax expense                                                                      |       | 138,678                                       |       | —                                        |       |
| NET INVESTMENT INCOME                                                                   |       | 4,677,404                                     |       | 2,938,636                                     |       |
|                                                                                    |       |                                          |       |                                          |       |
| REALIZED AND UNREALIZED GAIN (LOSS) ON INVESTMENTS:                                     |       |                                          |       |                                          |       |
| Realized gain on sale of investment                                                     |       | 9,750                                         |       | —                                        |       |
| Unrealized depreciation on derivative                                                   |       | (24,811                                       | )          | —                                        |       |
| Net unrealized appreciation (depreciation) on  investments                              |       | 282,605                                       |       | (1,557,562                                    | )          |
| Net gain (loss) on investments                                                          |       | 267,544                                       |       | (1,557,562                                    | )          |
|                                                                                    |       |                                          |       |                                          |       |
| NET INCREASE IN STOCKHOLDERS’ EQUITY RESULTING FROM  OPERATIONS                    |       | $                                             | 4,944,948  |                                          | $          | 1,381,074 |   |
|                                                                                    |       |                                          |       |                                          |       |
| NET INCREASE IN STOCKHOLDERS’ EQUITY RESULTING FROM  OPERATIONS PER COMMON SHARE:  |       |                                          |       |                                          |       |
| Basic                                                                                   |       | $                                             | 0.44       |                                          | $          | 0.14 |   |
| Diluted                                                                                 |       | $                                             | 0.43       |                                          | $          | 0.13 |   |
|                                                                                    |       |                                          |       |                                          |       |
| WEIGHTED AVERAGE SHARES OF COMMON STOCK OUTSTANDING:                                    |       |                                          |       |                                          |       |
| Basic                                                                                   |       | 11,278,510                                    |       | 10,081,844                                    |       |
| Diluted                                                                                 |       | 11,615,796                                    |       | 10,333,529                                    |       |

 

SEE ACCOMPANYING NOTES.

 

7

----

 

 

**GLADSTONE CAPITALCORPORATION**

**CONSOLIDATED STATEMENT OF STOCKHOLDERS’EQUITY**

 

**(UNAUDITED)**

 

| ** **                                                           | ** ** | ** ** | ** ** | ** ** | ** ** | ** **                         | ** ** | ** **                                     | ** ** | ** **                                                       | ** ** | ** **                              | ** ** | ** **                                                 | ** ** | ** **                                                 | ** ** |
|----------------------------------------------------------------------|------------|------------|------------|------------|------------|------------------------------------|------------|------------------------------------------------|------------|------------------------------------------------------------------|------------|-----------------------------------------|------------|------------------------------------------------------------|------------|------------------------------------------------------------|------------|
| ** **                                                           | ** ** | ** ** | ** ** | ** ** | ** ** | **Capital in Excess of Par Value** | ** ** | **Notes Receivable From Sale of Common Stock** | ** ** | **Distributions (Less Than)/in Excess of Net Investment Income** | ** ** | **Realized Gain on Sale of Investment** | ** ** | **Unrealized Appreciation/ (Depreciation) of Investments** | ** ** | **Unrealized Appreciation/ (Depreciation) of Derivatives** | ** ** | **Total Stockholders' Equity** | ** ** |
| ** **                                                           | ** ** | ** ** |
| **Common  Stock**                                                    |
| **Shares**                                                           | ** ** | **Amount** |
| ** **                                                           | ** ** | ** ** | ** ** | ** ** | ** ** | ** **                         | ** ** | ** **                                     | ** ** | ** **                                                       | ** ** | ** **                              | ** ** | ** **                                                 | ** ** | ** **                                                 | ** ** | ** ** | ** ** |
| Balance at September 30, 2003                                        |       | 10,081,844 |       | $          | 10,082     |                               | $          | 140,416,674                                    |       | $                                                                | (8,985,940 | )                                       | $          | (416,094                                                   | )          | $                                                          | —     |   | $ | (222,340 | ) | $ | — |   | $ | 130,802,382 |   |
| Repayment of Principal on Notes Receivable                           |       | —     |       | —     |       | —                             |       | 103,252                                        |       | —                                                           |       | —                                  |       | —                                                     |       | —                                                     |       | 103,252 |   |
| Net Increase in Stockholders’ Equity Resulting from  Operations |       | —     |       | —     |       | —                             |       | —                                         |       | 2,938,636                                                        |       | —                                  |       | (1,557,562                                                 | )          | —                                                     |       | 1,381,074 |   |
| Distributions Declared ($0.33 per common share)                      |       | —     |       | —     |       | —                             |       | —                                         |       | (3,327,009                                                       | )          | —                                  |       | —                                                     |       | —                                                     |       | (3,327,009 | ) |
| Balance at December 31, 2003                                         |       | 10,081,844 |       | $          | 10,082     |                               | $          | 140,416,674                                    |       | $                                                                | (8,882,688 | )                                       | $          | (804,467                                                   | )          | —                                                     |       | $ | (1,779,902 | ) | — |   | $ | 128,959,699 |   |
|                                                                 |       |       |       |       |       |                               |       |                                           |       |                                                             |       |                                    |       |                                                       |       |                                                       |       |   |   |   |   |   |   |   |   |
|                                                                 |       |       |       |       |       |                               |       |                                           |       |                                                             |       |                                    |       |                                                       |       |                                                       |       |   |   |   |   |   |   |   |   |
| 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 |   |
| Shelf Offering Costs                                                 |       | —     |       | —     |       | (111,233                           | )          | —                                         |       | —                                                           |       | —                                  |       | —                                                     |       | —                                                     |       | (111,233 | ) |
| Repayment of Principal on Notes Receivable                           |       | —     |       | —     |       | —                             |       | 150,000                                        |       |                                                             |       | —                                  |       | —                                                     |       | —                                                     |       | 150,000 |   |
| Net Increase in Stockholders’ Equity Resulting from  Operations |       | —     |       | —     |       | —                             |       | —                                         |       | 4,677,404                                                        |       | 9,750                                   |       | 282,605                                                    |       | (24,811                                                    | )          | 4,944,948 |   |
| Distributions Declared ($0.36 per common share)                      |       | —     |       | —     |       | —                             |       | —                                         |       | (4,060,263                                                       | )          | —                                  |       | —                                                     |       | —                                                     |       | (4,060,263 | ) |
| Balance at December 31, 2004                                         |       | 11,278,510 |       | $          | 11,279     |                               | $          | 164,183,548                                    |       | $                                                                | (9,282,678 | )                                       | $          | 915,239                                                    |       | $                                                          | 22,250     |   | $ | (2,460,461 | ) | $ | (239,070 | ) | $ | 153,150,107 |   |
|                                                                      |            |            |            |            |            |                                    |            |                                                |            |                                                                  |            |                                         |            |                                                            |            |                                                            |            |  |  |  |  |  |  |  |  |  |  |  |

 

 

SEE ACCOMPANYING NOTES.

 

8

----

 

 

**GLADSTONE CAPITALCORPORATION**

**CONSOLIDATED STATEMENT OF CASH FLOWS**

**(UNAUDITED)**

 
| ** **                                                                                                                                | ** ** | **Three Months**

**Ended**

**December 31,** | ** ** | **Three Months**

**Ended**

**December 31,** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------------------------|------------|-----------------------------------------------|------------|
| ** **                                                                                                                                | ** ** | **2004**                                      | ** ** | **2003**                                      | ** ** |
| **CASH FLOWS FROM OPERATING ACTIVITIES**                                                                                                  |       |                                          |       |                                          |       |
| Net increase in stockholders' equity resulting from  operations                                                                           |       | $                                             | 4,944,948  |                                          | $          | 1,381,074 |   |
| Adjustments to reconcile net increase in  stockholders' equity

resulting from operations to net cash provided by  operating

activities: |       |                                          |       |                                          |       |
| Depreciation                                                                                                                              |       | —                                        |       | 7,091                                         |       |
| Net amortization of premiums and discounts                                                                                                |       | 455                                           |       | —                                        |       |
| Amortization of deferred financing fees                                                                                                   |       | 91,912                                        |       | —                                        |       |
| Unrealized depreciation on derivative                                                                                                     |       | 24,811                                        |       | —                                        |       |
| Change in net unrealized depreciation                                                                                                     |       | (282,605                                      | )          | 1,557,562                                     |       |
| Decrease (increase) in interest receivable                                                                                                |       | (67,382                                       | )          | 87,615                                        |       |
| Decrease in funds due from custodian                                                                                                      |       | 31,270                                        |       | 1,169,500                                     |       |
| Decrease (increase) in prepaid assets                                                                                                     |       | 1,958                                         |       | (52,204                                       | )          |
| Decrease in due from affiliate                                                                                                            |       | 30,401                                        |       | —                                        |       |
| Increase in other assets                                                                                                                  |       | (40,097                                       | )          | (250,476                                      | )          |
| Increase in accounts payable                                                                                                              |       | 114,923                                       |       | 67,805                                        |       |
| (Decrease) increase in accrued expenses and deferred  liabilities                                                                         |       | (633,367                                      | )          | 94,525                                        |       |
| Increase in fees due to affiliate                                                                                                         |       | 36,400                                        |       | —                                        |       |
| Increase in investment balance due to payment in  kind interest                                                                           |       | (140,090                                      | )          | (137,551                                      | )          |
| Net cash provided by operating activities                                                                                                 |       | 4,113,537                                     |       | 3,924,941                                     |       |
|                                                                                                                                      |       |                                          |       |                                          |       |
| **CASH FLOWS FROM INVESTING ACTIVITIES:**                                                                                                 |       |                                          |       |                                          |       |
|                                                                                                                                      |       |                                          |       |                                          |       |
| Purchase of investments                                                                                                                   |       | (46,949,500                                   | )          | (15,500,000                                   | )          |
| Principal repayments on investments                                                                                                       |       | 25,975,707                                    |       | 4,504,167                                     |       |
| Proceeds from repurchase agreements                                                                                                       |       | —                                        |       | 93,101,000                                    |       |
| Repayment of repurchase agreements                                                                                                        |       | (21,345,997                                   | )          | (78,449,000                                   | )          |
| Receipt of principal on notes receivable - employees                                                                                      |       | 150,000                                       |       | 103,252                                       |       |
| Purchase of furniture & equipment                                                                                                     |       | —                                        |       | (1,567                                        | )          |
| Net cash (used in) provided by investing activities                                                                                       |       | (42,169,790                                   | )          | 3,757,852                                     |       |
|                                                                                                                                      |       |                                          |       |                                          |       |
| **CASH FLOWS FROM FINANCING ACTIVITIES:**                                                                                                 |       |                                          |       |                                          |       |
|                                                                                                                                      |       |                                          |       |                                          |       |
| Borrowings from the lines of credit                                                                                                       |       | 50,400,000                                    |       | —                                        |       |
| Repayments on the lines of credit                                                                                                         |       | (50,743,547                                   | )          | —                                        |       |
| Distributions paid                                                                                                                        |       | (4,060,263                                    | )          | (6,654,018                                    | )          |
| Shelf offering costs                                                                                                                      |       | (111,233                                      | )          | —                                        |       |
| Deferred financing fees                                                                                                                   |       | —                                        |       | 58,664                                        |       |
| Net cash used in financing activities                                                                                                     |       | (4,515,043                                    | )          | (6,595,354                                    | )          |
|                                                                                                                                      |       |                                          |       |                                          |       |
| **NET (DECREASE) INCREASE IN CASH AND CASH  EQUIVALENTS (1)**                                                                             |       | (42,571,296                                   | )          | 1,087,439                                     |       |
| **CASH AND CASH EQUIVALENTS, BEGINNING OF PERIOD**                                                                                        |       | 65,954,840                                    |       | 101,166,221                                   |       |
| **CASH AND CASH EQUIVALENTS, END OF PERIOD**                                                                                              |       | $                                             | 23,383,544 |                                          | $          | 102,253,660 |   |
|                                                                                                                                      |       |                                          |       |                                          |       |
| **CASH PAID DURING PERIOD FOR INTEREST**                                                                                                  |       | $                                             | 139,763    |                                          | $          | — |   |
| **CASH PAID DURING PERIOD FOR INCOME TAXES**                                                                                              |       | $                                             | 138,678    |                                          | $          | — |   |

 

SEE ACCOMPANYING NOTES.

 

9

----

 

 

**GLADSTONE CAPITALCORPORATION**

**FINANCIALHIGHLIGHTS**

**(UNAUDITED)**

 

| ** **                                                       | ** ** | **Three Months**

**Ended**

**December 31,** | ** **  | **Three Months**

**Ended**

**December 31,** | ** ** |
|------------------------------------------------------------------|------------|-----------------------------------------------|-------------|-----------------------------------------------|------------|
| ** **                                                       | ** ** | **2004**                                      | ** **  | **2003**                                      | ** ** |
| ** **                                                       | ** ** | ** **                                    | ** **  | ** **                                    | ** ** |
| Per Share Data (1)                                               |       |                                          |        |                                          |       |
| Net asset value at beginning of period                           |       | $                                             | 13.50       |                                          | $          | 12.97 |   |
| *Income from investment operations:*                             |       |                                          |        |                                          |       |
| Net investment income (2)                                        |       | 0.41                                          |        | 0.29                                          |       |
| Realized gain on sale of investment (2)                          |       | —                                        |        | —                                        |       |
| Net unrealized gain/(loss) on investments (2)                    |       | 0.03                                          |        | (0.15                                         | )          |
| Net unrealized (loss) on derivatives (2)                         |       | —                                        |        | —                                        |       |
| Total from investment operations                                 |       | 0.44                                          |        | 0.14                                          |       |
| Less distributions:                                              |       |                                          |        |                                          |       |
| Distributions from net investment income                         |       | (0.36                                         | )           | (0.33                                         | )          |
| Total distributions                                              |       | (0.36                                         | )           | (0.33                                         | )          |
| Offering costs                                                   |       | (0.01                                         | )           | —                                        |       |
| Repayment of principal on notes receivable                       |       | 0.01                                          |        | 0.01                                          |       |
| Net asset value at end of period                                 |       | $                                             | 13.58       |                                          | $          | 12.79 |   |
|                                                             |       |                                          |        |                                          |       |
| Per share market value at beginning of period                    |       | $                                             | 22.71       |                                          | $          | 19.45 |   |
| Per share market value at end of period                          |       | 23.70                                         |        | 22.35                                         |       |
| Total Return (3)(4)                                              |       | 5.94                                          | %           | 16.71                                         | %          |
| Shares outstanding at end of period                              |       | 11,278,510                                    |        | 10,081,844                                    |       |
|                                                             |       |                                          |        |                                          |       |
| Ratios/Supplemental Data                                         |       |                                          |        |                                          |       |
| Net assets at end of period                                      |       | $                                             | 153,150,107 |                                          | $          | 128,959,699 |   |
| Average net assets                                               |       | $                                             | 151,429,917 |                                          | $          | 129,002,039 |   |
| Ratio of expenses to average net assets-annualized (5)           |       | 4.46                                          | %           | 3.19                                          | %          |
| Ratio of net expenses to average net  assets-annualized (6)      |       | 3.70                                          | %           | 3.19                                          | %          |
| Ratio of net investment income to average net  assets-annualized |       | 12.36                                         | %           | 9.11                                          | %          |
|                                                                  |            |                                               |             |                                               |            |  |  |  |

 

----

(1)   Basicper share data.

(2)   Based on weightedaverage basic per share data.

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

(4)   Amountswere not annualized.

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

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

 

SEE ACCOMPANYING NOTES**.**

 

10

----

 

 

**GLADSTONE CAPITALCORPORATION**

 

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

 

**December 31, 2004**

 

**(UNAUDITED)**

 

NOTE 1. ORGANIZATION

 

Gladstone CapitalCorporation (the “Company”) was incorporated under the General Corporation Lawsof the State of Maryland on May 30, 2001 as a closed-end investment company.  The Company has elected to be treated as abusiness development company, or BDC, under the Investment Company Act of 1940,as amended (the “1940 Act”).  Inaddition, the Company has elected to be treated for tax purposes as a regulatedinvestment company, or RIC, under the Internal Revenue Code of 1986, as amended(the “Code”).  The Company’s investmentobjectives are to achieve a high level of current income by investing in debtand equity securities of established private businesses.

 

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

 

Gladstone Business LoanLLC, a wholly-owned subsidiary of the Company, was established on February 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.

 

 

NOTE 2. UNAUDITEDINTERIM FINANCIAL STATEMENTS

 

Interim financialstatements of the Company are prepared in accordance with generally acceptedaccounting principles (“GAAP”) for interim financial information and pursuantto the requirements for reporting on Form 10-Q and Article 10 of RegulationS-X.  Accordingly, certain disclosuresaccompanying annual financial statements prepared in accordance with GAAP areomitted.  In the opinion of management,all adjustments, consisting solely of normal recurring accruals, necessary forthe fair statement of financial statements for the interim periods have beenincluded.  The current period’s resultsof operations are not necessarily indicative of results that ultimately may beachieved for the year.  The interimfinancial statements and notes thereto should be read in conjunction with thefinancial statements and notes thereto included in the Company’s Form 10-K forthe fiscal year ended September 30, 2004, as filed with the Securities andExchange Commission.

 

 

11

----

 

NOTE 3. STOCK OPTIONS

 

The following tables setforth the pro-forma effect of fair value option accounting for the three monthsended December 31, 2004 and December 31, 2003 in accordance with Statement ofFinancial Accounting Standards (SFAS) Statement No. 148 “Accounting forStock-Based Compensation — Transition and Disclosure”.

 
| ** **                                                                                                  | ** ** | **Three Months**

**Ended**

**December 31,** | ** ** | **Three Months**

**Ended**

**December 31,** | ** ** |
|-------------------------------------------------------------------------------------------------------------|------------|-----------------------------------------------|------------|-----------------------------------------------|------------|
| ** **                                                                                                  | ** ** | **2004**                                      | ** ** | **2003**                                      | ** ** |
| ** **                                                                                                  | ** ** | ** **                                    | ** ** | ** **                                    | ** ** |
| Net increase in stockholders' equity resulting from  operations as reported:                                | ** ** | $                                             | 4,944,948  | ** **                                    | $          | 1,381,074 | ** ** |
| Deduct: Total stock-based compensation expense  determined using the fair value based method for all awards |       | (72,355                                       | )          | (403,619                                      | )          |
| Pro forma net increase in stockholders' equity  resulting from operations per share                         |       | $                                             | 4,872,593  |                                          | $          | 977,455 |   |
|                                                                                                        |       |                                          |       |                                          |       |
| As reported - basic                                                                                         |       | $                                             | 0.44       |                                          | $          | 0.14 |   |
| As reported - diluted                                                                                       |       | $                                             | 0.43       |                                          | $          | 0.13 |   |
|                                                                                                        |       |                                          |       |                                          |       |
| Pro forma-basic                                                                                             |       | $                                             | 0.43       |                                          | $          | 0.10 |   |
| Pro forma-diluted                                                                                           |       | $                                             | 0.42       |                                          | $          | 0.09 |   |

 

 

 

 

In December 2004, the Financial Accounting StandardsBoard (“FASB”) approved the revision of SFAS 123, “Accounting for Stock-BasedCompensation, and issued the revised SFAS Statement No. 123R, “Share-BasedPayment.”  SFAS 123R effectively replacesSFAS 123, and supersedes APB Opinion No. 25, “Accounting for Stock Issued toEmployees.”  The new standard iseffective for awards that are granted, modified, or settled in cash for interimor annual periods beginning after June 15, 2005.  The adoption of SFAS 123R will require theCompany to begin expensing unvested or newly granted stock options ascompensation cost.

 

The Company currentlyaccounts for the issuance of stock options through the Amended and Restated2001 Equity Incentive Plan (the “Plan”) in accordance with APB Opinion No. 25, “Accountingfor Stock Issued to Employees.”  Inconnection with the externalization of the Company’s management, all of itsofficers and employees became direct employees of Gladstone ManagementCorporation as of October 1, 2004, the start of fiscal year 2005.  However, these individuals continue to beeligible 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.”

 

 

12

----

 

NOTE 4. INCREASE INSTOCKHOLDERS’ EQUITY FROM OPERATIONS PER SHARE

 

The following table setsforth the computation of basic and diluted net increase in stockholders’ equityresulting from operations per share for the three months ended December 31, 2004and December 31, 2003:

 
| ** **                                                                                                | ** ** | **Three Months**

**Ended**

**December 31,** | ** ** | **Three Months**

**Ended**

**December 31,** | ** ** |
|-----------------------------------------------------------------------------------------------------------|------------|-----------------------------------------------|------------|-----------------------------------------------|------------|
| ** **                                                                                                | ** ** | **2004**                                      | ** ** | **2003**                                      | ** ** |
| Numerator for basic and diluted net increase in stockholders'  equity resulting from operations per share |       | $                                             | 4,944,948  |                                          | $          | 1,381,074 |   |
|                                                                                                      |       |                                          |       |                                          |       |   |   |
| Denominator for basic weighted average shares                                                             |       | 11,278,510                                    |       | 10,081,844                                    |       |
| Dilutive effect of stock options                                                                          |       | 337,286                                       |       | 251,685                                       |       |
| Denominator for diluted weighted average shares                                                           |       | 11,615,796                                    |       | 10,333,529                                    |       |
|                                                                                                      |       |                                          |       |                                          |       |
| Basic net increase in stockholers' equity resulting  from operations per share                            |       | $                                             | 0.44       |                                          | $          | 0.14 |   |
| Diluted net increase in stockholers' equity  resulting from operations per share                          |       | $                                             | 0.43       |                                          | $          | 0.13 |   |
|                                                                                                           |            |                                               |            |                                               |            |  |  |  |

 

 

NOTE 5. DIVIDENDS

 

The Company is requiredto pay out as a dividend 90% of its ordinary income and short-term capitalgains for each taxable year in order to maintain its status as a RIC underSubtitle A, Chapter 1 of Subchapter M of the Code.  It is the policy of the Company to pay out asa dividend up to 100% of those amounts. The amount to be paid out as a dividend is determined by the Board ofDirectors each quarter and is based on the annual earnings estimated by the managementof the Company.  Based on that estimate, threemonthly dividends are declared each quarter. At year-end the Company may pay a bonus dividend, in addition to thequarterly dividends, to ensure that it has paid out at least 90% of itsordinary income and short-term capital gains for the year.  The Company has a policy of retaininglong-term capital gains, if any, and not paying them out as dividends.  Effective October 31, 2003, the Company beganpaying a monthly dividend.  The followingtable illustrates the first quarter of the 2005 fiscal year monthly dividendsper share, 2004 fiscal year monthly dividends per share and the 2003 fiscalyear quarterly dividends per share:

 

| **Fiscal Year** | ** ** | **Record Date** | ** ** | **Payment Date** | ** ** | **Dividend per Share** | ** ** | **Monthly or Quarterly** |
|-----------------|------------|-----------------|------------|------------------|------------|------------------------|------------|--------------------------|
| 2005            |       | 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                |
|            |       | June  30, 2003  |       | July  7, 2003    |       | $0.29                  |       | Quarterly                |
|            |       | March  31, 2003 |       | April  7, 2003   |       | $0.29                  |       | Quarterly                |
|            |       | Dec.  31, 2002  |       | Jan  7, 2003     |       | $0.29                  |       | Quarterly                |

 

 

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NOTE 6. INVESTMENTVALUATION

 

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

 

NOTE7. PAYMENT IN KIND INTEREST

 

The Company has loans inits portfolio that contain a payment in kind (“PIK”) provision. The PIKinterest is added to the principal balance of the loan and recorded asincome.  To maintain the Company’s statusas a RIC (as discussed in Note 5, above), this non-cash source of income mustbe paid out to stockholders in the form of dividends, even though the Companyhas not yet collected the cash. For the three months ended December 31, 2004,the Company recorded PIK income of $140,963, and for the three months ended December31, 2003, the Company recorded PIK income of $138,543.  At December 31, 2004 and September 30, 2004the Company had accrued on its balance sheets, a total in PIK income of $1,278,745and $1,138,727 respectively.  The Companydoes not hold any investments issued at original issue discount andaccordingly, has not realized any original issue discount income for the threemonths ended December 31, 2004 or December 31, 2003.

 

NOTE 8. REPURCHASEAGREEMENT

 

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

 

The Company had nooutstanding repurchase agreement as of December 31, 2004.  On September 29, 2004, the Company enteredinto a repurchase agreement (the “Repurchase Agreement”) with Ferris BakerWatts for $44,984,950. On September 30, 2004, this amount was reduced to$21,345,997 with the application of the net proceeds from the Company’s publicoffering of common stock in September 2004. This remaining balance was settled on October 1, 2004.  The Repurchase Agreement was recorded at costand was fully collateralized by a United States Treasury Bill with a fair valueof $50,000,000, a carrying value of $49,984,950 that matured on October 7, 2004and earned interest of $2,133.  Theinterest rate charged on the Repurchase Agreement was 4.25% for a cost of$7,831.

 

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NOTE 9. CONTRACTUALOBLIGATIONS

 

As of December 31, 2004,the Company was a party to signed and non-binding term sheets for threepotential investments for the Company’s portfolio.  The future scheduled investments are expectedto fund as follows:

 
| ** **                  | ** ** | **Payment Due by Period** | ** ** |
|-----------------------------|------------|---------------------------|------------|
| **Contractual Obligations** | ** ** | **Total**                 | ** ** | **Less than 1 Year** | ** ** | **1-3 Years** | ** ** | **3-5 Years** | ** ** | **More than**

**5 Years** | ** ** |
|                        |       |                      |       |   |   |   |   |   |   |   |   |
| Investments                 |       | 28,000,000                |       | 28,000,000 |   |   |   |   |   |   |   |
| Total                       |       | $                         | 28,000,000 |   | $ | 28,000,000 |   | $ | — |   | $ | — |   | $ | — |   |
|                             |            |                           |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

 

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

 

NOTE 10. LINES OF CREDIT

 

In June 2004, theCompany entered into a $15.0 million line of credit agreement with BranchBanking and Trust Company (“BB&T Agreement”) which matures on June 1,2005.  Interest on outstanding borrowingsis based upon the one month London Interbank Offered Rate (“LIBOR”) plus 2.5% perannum.  The unused portion of the line ofcredit is subject to a fee of 0.2% per annum. The BB&T Agreement requires the Company to meet and maintain certaincovenants and ratios with respect to leverage and liquidity. As of December 31,2004, there was $15.0 million outstanding under the BB&T line of credit atan interest rate of 4.9% and no available borrowings.  At December 31, 2004 the Company was incompliance with all covenants under the BB&T Agreement.

 

Through itswholly-owned subsidiary Gladstone Business Loan LLC (“Business Loan”), theCompany has a $100 million revolving credit facility with Deutsche Bank AG, asadministrative 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 facility is based on LIBOR, the PrimeRate or the Federal Funds Rate, depending on market conditions, and adjustsperiodically.  As of December 31, 2004,the outstanding principal balance under this credit facility was approximately$25.4 million at an interest rate of 2.28%.  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 December 31, 2004, theremaining borrowing capacity available under this line of credit wasapproximately $23.0 million.

 

The facilitycontains covenants that require Business Loan to maintain its status as aseparate entity; prohibit certain significant corporate transactions (such asmergers, consolidations, liquidations or dissolutions); and restrict materialchanges to the Company’s credit and collection policies.  The facility also restricts some of the termsand provisions (including interest rates, terms to maturity and paymentsschedules) and limits the borrower and industry concentrations of loans thatare eligible to secure advances.  As of December 31,2004, Business Loan was in compliance with all of the facility covenants.

 

Effective July 12,2004, Gladstone Management, the Company’s affiliated external adviser also servicesthe loans pledged under the facility.  Asa 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 facility. The Performance Guaranty requires the Company to maintain a minimum networth of $100 million and to maintain “asset coverage” with respect to “seniorsecurities representing indebtedness” of at least 200%, in accordance withSection 18 of the 1940 Act.  As ofDecember 31, 2004, the Company was in compliance with all covenants under thePerformance Guaranty.  GladstoneManagement services these loans for an annual fee of 1.5% of the monthlyaggregate outstanding loan balance of the loans pledged under thefacility.  For the three months endedDecember 31, 2004, the Company recorded loan servicing fees of $530,952.  There were no loan servicing fees incurredfor the three months ended December 31, 2003, as prior to July 12, 2004, theloans pledged under the facility were serviced by Gladstone Capital Advisers,Inc., wholly-owned subsidiary of the Company.

 

15

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While GladstoneManagement began receiving loan servicing fees as of July 12, 2004, such loanservicing fees received by Gladstone Management are credited to the Company’sadvisory fee payable to Gladstone Management under the advisory agreementbetween the Company and Gladstone Management. Accordingly, the advisory fee payable by the Company to GladstoneManagement for the three months ended December 31, 2004 was reduced by $530,952in respect of these fees received by Gladstone Management.

 

NOTE 11. INTEREST RATECAP 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 it believesthat the other party to the transaction is creditworthy, the Company does bearthe risk of loss of the amount expected to be received under such agreements inthe event of default or bankruptcy of the agreement counterparty.

 

In February 2004, theCompany entered into an interest rate cap agreement with a notional amount of$35.0 million at a cost of $304,000 and a current fair value of approximately$64,930 which is recorded in other assets on the Company’s consolidated balancesheet at December 31, 2004.  At September30, 2004, the interest rate cap agreement had a fair value of $89,741.  The Company records changes in the fair valueof the interest rate cap agreement monthly based on the current marketvaluation at month end as unrealized depreciation or appreciation on derivativeon the Company’s consolidated statement of operations. The interest rate capagreement expires in February 2009. The agreement provides that the Company’sfloating interest rate or cost of funds on a portion of the portfolio’sborrowings will be capped at 5% when the LIBOR rate is in excess of 5%.

 

NOTE 12. FEE INCOME

 

The 1940 Act requiresthat a business development company make available managerial assistance to itsportfolio companies. The 1940 Act defines managerial assistance as the servicemade available to a portfolio company to provide “significant guidance andcounsel concerning the management, operations, or business objectives andpolicies of a portfolio company.”  Priorto the start of fiscal year 2005, the Company provided managerial assistanceand other services to its portfolio companies through its wholly-ownedsubsidiary, Gladstone Capital Advisers, Inc. and therefore recorded managerialassistance and other fee revenue in connection with these activities.  Effective October 1, 2004, the Company offersmanagerial assistance and other services to its portfolio companies through itsexternal investment adviser, Gladstone Management Corporation (“GladstoneManagement”).  Neither the Company norits external investment adviser, Gladstone Management, charges a fee formanagerial assistance.  However, in thepast the Company, and since October 1, 2004, Gladstone Management, haveprovided other services to portfolio companies in addition to managerialassistance.  These other services includea wide variety of services to the portfolio companies such as investmentbanking work, arranging bank financing, arranging equity financing structuringfinancing from multiple lenders and investors, reviewing existing creditfacilities, restructuring existing loans, raising equity and debt capital, turnaroundmanagement, merger and acquisition services and recruiting new managementpersonnel.  Gladstone Management ischarging for these services and is crediting the funds received from theseother services to the Company as a credit against the investment advisory feedue from the Company under the investment advisory agreement.  Such fees are normally paid in part at thetime of signing a non-binding letter of intent, with the remainder paid at theclosing of the Company’s investments and are generally non-recurring.  For the three months ended December 31, 2004,the Company recorded no revenue from managerial assistance and other feessince, as described above, these fees were remitted by the borrower directly toGladstone Management.  For the threemonths ended December 31, 2003, the Company recorded $255,000 of managerialassistance and other fee revenue.

 

While GladstoneManagement began receiving all managerial assistance and other fees inconnection with the Company’s investments as of October 1, 2004, suchmanagerial assistance and other fees received by Gladstone Management arecredited to the Company as a reduction of the advisory fee payable to GladstoneManagement under the advisory agreement between the Company and GladstoneManagement.  For the three months endedDecember 31, 2004, Gladstone Management received $286,500 of managerialassistance and other fees in connection with the Company’s investments.  Accordingly, the advisory fee payable by theCompany to Gladstone Management for the three months ended December 31, 2004was reduced by $286,500 in respect of these fees received by GladstoneManagement.

 

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NOTE 13. ADVISORYAGREEMENT WITH GLADSTONE MANAGEMENT CORPORATION

 

Effective October 1, 2004,the Company entered into an advisory agreement with Gladstone Management, anunconsolidated affiliate of the Company, whereby Gladstone Management wouldserve as an external adviser to the Company. As compensation for the services of Gladstone Management, the Companypays Gladstone Management an annual advisory fee of 1.25% of total assets (asreduced by cash and cash equivalents pledged to creditors), payable inquarterly increments of 0.3125%, and an annual administrative fee of 0.75% oftotal assets (as reduced by cash and cash equivalents pledged to creditors),payable in quarterly increments of 0.1875%, for a total annual fee of 2.0% (0.50%quarterly) of total assets (as reduced by cash and cash equivalents pledged tocreditors). The Company continues to pay direct expenses including, but notlimited to, directors’ fees, legal and accounting fees, stockholder relatedexpenses, and directors and officers insurance. Under the advisory agreement, Gladstone Management provides themanagerial assistance and other services that the Company previously madeavailable to its portfolio companies through its wholly-owned subsidiaryGladstone Capital Advisers, Inc.  To theextent that Gladstone Management receives any fees directly from a portfoliocompany for such services, Gladstone Management credits these fees directlyagainst the 2% management fee.  For thethree months ended December 31, 2004, Gladstone Management recorded $286,500 ofsuch fees and credited this amount against the 2% management fee received fromthe Company.  Gladstone Management alsoservices the loans held by Business Loan, in return for which, GladstoneManagement receives a 1.5% annual fee based on the monthly aggregate balance ofloans held by Business Loan.  All loanservicing fees paid to Gladstone Management are also credited directly againstthe 2% management fee.  For the threemonths ended December 31, 2004, these loan servicing fees totaled $530,952, allof which were credited against the 2% management fee, reflecting it as a reductionof operating expenses in the consolidated statement of operations. Overall, themanagement fee due to Gladstone Management cannot exceed 2% of total assets (asreduced by cash and cash equivalents pledged to creditors) during any givenfiscal year.  Because the Company wasinternally managed at all times prior to October 1, 2004, no management fee wasrecorded for the three months ended December 31, 2003.

 

The following table setsforth the computation of the management fee for the three months ended December31, 2004, based on the quarterly increment of 0.50% (0.3125% quarterly advisoryfee and 0.1875% quarterly administrative fee):

 
| **Fee:**                                                          | ** ** | ** **  | ** **  |
|-------------------------------------------------------------------|------------|-------------|-------------|
| Total assets at December 31, 2004                                 |       | $           | 194,085,591 |   |
| Less: Borrowings under line of credit at December  31, 2004 *(a)* |       | (22,435,000 | )           |
| Total assets subject to fee as of December 31, 2004               |       | 171,650,591 |        |
| Quarterly fee rate                                                |       | 0.50        | %           |
| Gross management fee before loan servicing fee  credit            |       | 858,254     |        |
| Less: loan servicing fee from Gladstone Business  Loan LLC        |       | 530,952     |        |
| Management fee before credit:                                     |       | 327,302     |        |
| **Direct Credit to Management Fee:**                              |       |        |        |
| Fee revenue recorded by Gladstone Management:                     |       | 286,500     |        |
| Net management fee for the three months ended  December 31, 2004: |       | $           | 40,802      |   |

----

*(a)*  *This amount representsborrowings under one of the Company’s lines of credit that were held in cashand cash equivalents as of December 31, 2004 for the purpose of satisfying theCompany’s asset diversification requirements under the Code.  Solely for the purposes of calculating theamount of the management fee due to Gladstone Management, the Company treatsany such amounts as “cash and cash equivalents pledged to creditors” under theterms of the Company’s advisory agreement with Gladstone Management.  As a result, such amounts are deducted fromthe Company’s total assets for purposes of computing the asset base upon whichthe management fee is determined.*

 

NOTE 14. FEDERAL ANDSTATE INCOME TAXES

 

The Company hashistorically operated, and intends to continue to operate, in a manner to qualifyfor 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.

 

Gladstone CapitalAdvisers, Inc., a wholly-owned subsidiary of Gladstone Capital Corporation, issubject to federal and state income taxation on the income it has recorded suchas managerial assistance fees and any other related fees resulting in aggregatefederal and state income taxes of $138,678.

 

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NOTE 15. SUBSEQUENTEVENTS

 

In January 2005, the Company sold its entire $2.0 million loan participationin Marietta Corporation for a gain of $20,000 and purchased a $2.5 millionadditional loan participation in Polar Corporation, a $1.0 million additionalloan participation in Regency Gas Services LLC and a $5.5 million loanparticipation in John Henry Holdings Inc., an envelope manufacturer.

 

In February 2005, the Inca Metal Products Corporation/KingwayAcquisition, Inc./Clymer Acquisition, Inc. investment was repaid in full.

 

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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, as amended,and Section 21E of the Securities Exchange Act of 1934, as amended. Thesestatements may relate to, among other things, future events or our futureperformance or financial condition. In some cases, you can identifyforward-looking statements by terminology such as “may,” “might,” “believe,” “will,”“provided,” “anticipate,” “future,” “could,” “growth,” “plan,” “intend,” “expect,”“should,” “would,” “if,” “seek,” “possible,” “potential,” “likely” or thenegative of such terms or comparable terminology. These forward-lookingstatements involve known and unknown risks, uncertainties and other factorsthat may cause our actual results, levels of activity, performance orachievements to be materially different from any future results, levels ofactivity, performance or achievements expressed or implied by such forward-lookingstatements. Such factors include, among others: (1) adverse changes in interestrates; (2) our failure or inability to establish or maintain referralarrangements with leveraged buyout funds and venture capital funds to generateloan opportunities; (3) the loss of one or more of our executive officers, inparticular David Gladstone , Terry Lee Brubaker, or George Stelljes III; (4)our inability to maintain a credit facility on terms reasonably acceptable tous, if at all; (5) our inability to successfully securitize our loan portfolioon terms reasonably acceptable to us, if at all; (6) the decision of ourcompetitors to aggressively seek to make senior and subordinated loans to smalland medium-sized businesses on terms more favorable than we intend to provide;and (7) those factors listed under the caption “Risk Factors” of the AnnualReport on Form 10-K as filed with the Securities and Exchange Commission onDecember 14, 2004. We caution readers not to place undue reliance on any suchforward-looking statements, which are made pursuant to the Private SecuritiesLitigation Reform Act of 1995 and, as such, speak only as of the date made. Weundertake no obligation to publicly update or revise any forward-lookingstatements, whether as a result of new information, future events or otherwise,after the date of this 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 wereincorporated under the General Corporation Laws of the State of Maryland on May30, 2001. Our investment objectives are to achieve a high level of currentincome by investing in debt securities, consisting primarily of senior notes,senior subordinated notes and junior subordinated notes, of established privatebusinesses that are backed by leveraged buyout funds, venture capital funds orothers, with a particular emphasis on 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 smalland medium-sized businesses that meet certain criteria, including (1) thepotential for growth in cash flow, (2) adequate assets for loan collateral, (3)experienced management teams with a significant ownership interest in theborrower, (4) profitable operations based on the borrower’s cash flow, (5)reasonable capitalization of the borrower (usually by buyout funds or venturecapital funds) and (6) the potential to realize appreciation and gain liquidityin our equity position, if any. We anticipate that liquidity in our equityposition will be achieved through a merger or acquisition of the borrower, apublic offering by the borrower or by exercise of our right to require theborrower to buy back its warrants. We lend to borrowers that need funds tofinance growth, restructure their balance sheets or effect a change of control.

 

Our loanstypically range from $5 million to $15 million, mature in no more than sevenyears and accrue interest at a fixed or variable rate that exceeds the primerate. A number of our loans have a provision that calls for some portion of theinterest payments to be deferred and added to the principal balance so that theinterest is paid, together with the principal, at maturity. This form ofdeferred interest is often called “paid-in-kind” or “PIK” interest, and, whenearned, we record PIK interest as interest income and add the PIK interest tothe principal balance of the loans. The amount of cost basis PIK interestaccrued on our balance sheet as of December 31, 2004 was approximately $1,279,000.

 

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Because our loanswill generally be subordinated debt of private companies who typically cannotor will not expend the resources to have their debt securities rated by acredit rating agency, we expect that most, if not all, of the debt securitieswe acquire will be unrated. We cannot accurately predict what ratings theseloans might receive if they were in fact rated, and therefore we cannotdetermine whether or not they could be considered to be “investment grade” quality.

 

To the extentpossible, our loans generally are collateralized by a security interest in theborrower’s assets. Interest payments are generally made monthly or quarterly(except to the extent of any PIK interest) with amortization of principal generallybeing deferred for several years. The principal amount of the loans and anyaccrued but unpaid interest generally become due at maturity at five to sevenyears. When we receive a warrant to purchase stock in a borrower in connectionwith a loan, the warrant will typically have an exercise price equal to thefair value of the portfolio company’s common stock at the time of the loan andentitle us to purchase a modest percentage of the borrower’s stock.

 

In addition, as abusiness development company under the 1940 Act, we are required to makeavailable significant managerial assistance to our portfolio companies. Priorto the externalization of our management on October 1, 2004, the start of the2005 fiscal year, we provided these services through our wholly-ownedsubsidiary, Gladstone Capital Advisers, Inc.  Since the externalization of our managementon October 1, 2004, our investment adviser, Gladstone Management Corporation (“GladstoneManagement”), began to provide these services on our behalf.  In addition, Gladstone Management providesother services to our portfolio companies, for which it receives fees, inconnection with our investments.  Thefees for these services are generally paid to Gladstone Management in part atthe time a prospective portfolio company signs a non-binding term sheet with us(as further described in the following paragraph), with the remainder paid atthe closing of the investment. These fees are generally non-recurring, howeverin some instances they may have a recurring component which is also paid toGladstone Management.  Any such feesreceived by Gladstone Management are credited against the management advisoryfee payable to Gladstone Management pursuant to the terms of our advisoryagreement, which has the effect of reducing our expenses to the extent of anysuch fees received by Gladstone Management. The specific services Gladstone Management provides vary by portfoliocompany, but generally include a wide variety of services to the portfoliocompanies such as investment banking work, arranging bank financing, arrangingequity financing, structuring financing from multiple lenders and investors,reviewing existing credit facilities, restructuring existing loans, raisingequity and debt capital, turnaround management, merger and acquisition servicesand recruiting new management personnel. Prior to the start of fiscal year2005, Gladstone Capital Advisers, Inc. provided these services and receivedthese fees and we have recorded fees for these services as fee income for theperiods in which these fees were earned by us.

 

Prior to making aninvestment, we ordinarily enter into a non-binding term sheet with thepotential borrower. These non-binding term sheets are generally subject to anumber of conditions, including but not limited to the satisfactory completionof our due diligence investigations of the potential borrower’s business andreaching agreement on the legal documentation for the loan. Upon execution ofthe non-binding term sheet, the potential borrower generally pays GladstoneManagement a non-refundable fee for its services rendered through the date ofthe non-binding term sheet. Prior to the externalization of our management onOctober 1, 2004, we recognized this as fee revenue upon execution of thenon-binding term sheet. Effective October 1, 2004, these fees are received byGladstone Management and are offset against amounts due to GladstoneManagement, which has the effect of reducing our expenses to the extent of anysuch fees received by Gladstone Management.

 

In the event thatwe expend significant effort in considering and negotiating a potentialinvestment that ultimately is not consummated, we generally will seekreimbursement from the proposed borrower for our reasonable expenses incurredin connection with the proposed transaction. Any amounts collected for expenses incurred by Gladstone Management inconnection with unconsummated investments will be reimbursed to GladstoneManagement. Amounts collected for these expenses incurred by us will be reimbursedto us and will be recognized as “other income” in the period in which suchreimbursement is received.  Also, in theevent that we have incurred significant legal fees in connection with thetransaction, we will typically seek reimbursement for these expenses from theproposed borrower.  However, there can beno guarantee that we will be successful in collecting any such reimbursements.

 

The onlysignificant continuing revenue associated with the investments we have alreadyclosed is interest income and, potentially, capital gains realized inconnection with the liquidation of any associated equity interest (e.g.,warrants).

 

During the threemonths ended December 31, 2004, we extended approximately $47.0 million of newloans to, and loan participations in, a total of eight companies.  Also, during the three months ended December31, 2004, two borrowers repaid their loans ahead of contractual maturity and wesold one loan investment for an aggregate return of capital of approximately$25.3 million.  Since our initial publicoffering in August 2001, we have made 50****differentloans to, or investments in, 31****companiesfor a total of approximately $266.0****million,before giving effect to principal repayments on investments and divestitures.

 

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We are earnestlyworking toward the consummation of more investments. These prospective loansare subject 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.

 

**External Adviser**

 

Effective October1, 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 increments of 0.3125%, and an annual administrative fee of 0.75% ofour total assets (as reduced by cash and cash equivalents pledged to creditors),payable in quarterly increments of 0.1875%. This fee is then directly reducedby the amount of loan servicing fees paid to Gladstone Management and any otherfees received by Gladstone Management from our borrowers and potentialborrowers.  We continue to pay directexpenses including, but not limited to, directors fees, legal and accountingfees, stockholder related expenses, and directors and officers insurance.

 

Effective July 12, 2004, Gladstone Management assumed theresponsibility for servicing our loan portfolio pursuant to a loan servicingagreement with Gladstone Business Loan LLC (“Business Loan”). GladstoneManagement services these loans in return for a 1.5% annual fee, based on themonthly aggregate outstanding loan balance of the loans pledged under thefacility.  For the three months endedDecember 31, 2004, we incurred approximately $531,000 in loan servicingfees.  Prior to July 12, 2004, our loanswere serviced under a similar agreement between Business Loan and GladstoneCapital Advisers Inc., our wholly-owned subsidiary, although the fees fromthese intercompany transactions were eliminated through the consolidation ofour financial results with those of Business Loan and Gladstone CapitalAdvisers.

 

For the threemonths ended December 31, 2004, the gross management fee, before reductions forloan servicing fees and other fees was approximately $858,000.  After being reduced by loan servicing fees ofapproximately $531,000 and other fees received by Gladstone Management ofapproximately $286,500, our net management fee for the three months endedDecember 31, 2004 was $40,802.  There wasno fee for the three months ended December 31, 2003 because we were internallymanaged at all times until October 1, 2004.

 

In July 2003, weentered into an expense sharing arrangement with Gladstone Management, aregistered investment adviser that serves as the external adviser to GladstoneCommercial Corporation (“Gladstone Commercial”), a real estate investment trustaffiliated with us. Under this expense sharing arrangement, GladstoneManagement reimbursed Gladstone Capital Advisers for a portion of our totalpayroll and benefits expenses (based on the percentage of total hours worked byeach of our employees on Gladstone Commercial matters). Gladstone Managementalso reimbursed Gladstone Capital Advisers for its pro rata portion of allother general expenses (based on the percentage of total hours worked by all ofour employees on Gladstone Commercial matters). Gladstone Management furtherpassed its share of these expenses along to Gladstone Commercial under aseparate advisory agreement.  Followingour engagement of Gladstone Management on October 1, 2004, the first day of our2005 fiscal year, Gladstone Management now directly employs all of ourpersonnel and pays its payroll, benefits, and general expenses directly.  Thus, the expense sharing arrangement betweenGladstone Capital Advisers and Gladstone Management terminated upon theexternalization 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 unrealizedappreciation and depreciation of investments recorded.

 

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*GeneralValuation Policy*:We value our investment portfolio each quarter. We carry our investments atfair value, as determined in good faith by our board of directors.  Securities that are publicly traded, if any,are valued at the closing price of the exchange or securities market on whichthey are listed on the valuation date. Securities which are not traded on apublic exchange or securities market, but for which a limited market exists,such as participations in syndicated loans, are valued at the indicative bidprice offered by the syndication agent on the valuation date.

 

Debt and equitysecurities that are not publicly traded and for which a limited market does notexist (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 operational issues.  Due to the uncertainty inherent in thevaluation process, such estimates of fair value may differ significantly fromthe values that would have been obtained had a ready market for the securitiesexisted, and the differences could be material. Additionally, changes in the market environment and other events thatmay occur over the life of the investments may cause the gains or lossesultimately realized on these investments to be different than the valuationscurrently assigned.  No single standardfor determining fair value in good faith exists since fair value depends uponcircumstances of each individual case. In general, fair value is the amount that we might reasonably expect toreceive upon the current sale of the security.

 

We currentlyengage Standard & 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.

 

With ourassessment and S&P value estimates as a backdrop, our board of directorsvotes to accept or not accept the analyses and values recommended by managementand S&P.  At December 31, 2004 and September30, 2004, the board of directors elected to accept the valuations recommendedby S&P on those loans as denoted on the Schedules of Investments as of December31, 2004 and September 30, 2004 in our consolidated financial statements.

 

Because there is adelay between when we close a loan and when the loan can be evaluated byS&P, some new loans are not valued immediately by S&P; rather, theboard of directors makes its own determination about the value of these loansin accordance with our valuation policy. Because S&P does not provide values for mortgage loans or equitysecurities, our board of directors also determines the fair value of theseinvestments using our valuation 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.

 

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*LoanGrading and Risk Rating:*As part of our valuation procedures we risk rate all of our loans.  Our risk rating system uses a scale of 0 to10.  This system is used to estimate theprobability of default on our debt securities and the probability of loss ifthere is a default.  These types ofsystems are referred to as risk rating systems and are used by banks and ratingagencies.  The risk rating system coversboth qualitative and quantitative aspects of the business and the securities wehold.  For those investments for whichS&P prepares valuation recommendations, we compile this information and provideit 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 haveour risk rating system mirror the risk rating systems of major risk ratingorganizations such as those provided by nationally recognized statisticalrating organizations (“NRSRO”) as defined in Rule 2a-7 under the 1940 Act.While we seek to mirror the NRSRO systems, we cannot provide any assurance thatour risk 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)the default rates set here are for a ten year term debt, if the company’s debtsecurity is less than ten years then the probability of default is adjusted toa lower percentage for the shorter period which may move the security higher onthe company’s risk rating scale.*

* *

The above scalegives an indication of the probability of default and the magnitude of the lossif there is a default. The following table lists the risk ratings for all ofthe debt securities outstanding at December 31, 2004 and September30, 2004:

 

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

 

The above scalegives an indication of the probability of default and the magnitude of the lossif there is a default.  Our policy is tostop accruing interest on an investment if we determine that interest is nolonger collectible. To date we have not placed any investments on non-accrual.  At December 31, 2004 and September 30,2004, no payments were past due on any of our debt securities.  We do not risk rate our equity securities.

 

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*ValuationMethods:*  For debt securities, we first determine ifthe debt security is publicly traded (i.e., if it is listed on an exchange orsecurities market).  If it is publiclytraded, then we determine the value based on the closing price for the securityon the exchange or securities market on which it is listed on the valuationdate.  If the security is not publiclytraded, but a limited market for the security exists, such as for syndicatedloans, and if the security has been rated by a NRSRO, then we value the loan atthe indicative bid price offered by the syndication agent on the valuationdate.  At December 31, 2004, none of thedebt securities in our portfolio were publicly traded and there was a limitedmarket for nine 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 debtsecurities that either are not publicly traded, for which there is no market, orfor which there is a market but have not been rated by a NRSRO, we begin withthe risk rating designation of the security described above.  Using the risk rating designation above, weseek to determine the value of the security as if we intended to sell thesecurity in a current sale.  To determinethe current sale price of the security, we consider some or all of thefollowing 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.

 

For those debtsecurities for which S&P prepares valuation recommendations, we provide theforegoing information to S&P for its use in preparing its recommendations.

 

For convertibledebt, equity, success fees or other equity-like securities, we first determineif there is any market for the security. If there is a market, then we determine the value based on the marketprices for the security, even if that market is not robust.  At December 31, 2004 and September 30, 2004 therewas 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 valuation techniquesused by major valuation firms to value the equity securities of privatecompanies.  These valuation techniquesconsist of: discounted cash flow of the expected sale price in the future,valuation of the securities based on recent sales in comparable transactions,and a review of similar companies that are publicly traded and the marketmultiple of their equity securities.  At December31, 2004 and September 30, 2004 we had $37,000 invested, at cost, in equitysecurities compared to our debt portfolio with a cost basis of $170,265,735 and$149,152,306, respectively.

 

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At December 31,2004, the value of our warrants of Finn Corporation had an appreciation of $532,535.  This aforementioned appreciation plusappreciation of $875,331 on certain other investments, primarily syndicatedparticipation investments, most notably Valor Telecommunications Inc., whichhad appreciation of $314,048, for overall appreciation of $1,407,866, partiallyoffsets total depreciation of $3,868,327, which was mainly composed ofdepreciation in our senior subordinated term debt investment in FinnCorporation (excluding the warrants) of $2,887,500, our senior subordinatedterm debt investment in Marcal Paper Mills, Inc. of $306,000, our senior termdebt investment in Coyne International Enterprises of $236,138, and our seniorterm debt investment in Inca Metal Products Corporation of $208,487.

 

**Tax Status**

 

*Federal Income Taxes*

 

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

 

**Revenue Recognition**

 

*Interest Income Recognition*

 

Interest income is recorded on the accrual basis to the extent thatsuch amounts are expected to be collected. We will stop accruing interest oninvestments when it is determined that interest is no longer collectible.Conditional interest or a success fee is recorded when earned upon fullrepayment of a loan investment.

 

*Payment in Kind Interest*

 

We also have some loans in our portfolio which contain a payment inkind (“PIK”) provision. The PIK interest, computed at the contractual ratespecified in each loan agreement, is added to the principal balance of the loanand recorded as interest income. To maintain our status as a RIC, this non-cashsource of income must be paid out to stockholders in the form of dividends,even though we have not yet collected the cash.

 

**FeeIncome**

 

The 1940 Act requires that a business developmentcompany make available managerial assistance to its portfolio companies byproviding significant guidance and counsel concerning the management,operations, or business objective and policies of the respective portfoliocompany. Prior to October 1, 2004, we provided managerial assistance to ourportfolio companies in connection with our investments through our wholly-ownedsubsidiary, Gladstone Capital Advisers, Inc.  Effective October 1, 2004, we began providingthese 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 feesfor the other services it provides, which are credited to the investmentadvisory fees due to Gladstone Management. These other fees are generally paid to Gladstone Management in part atthe time a prospective portfolio company signs a non-binding term sheet withus, with the remainder paid at the closing of the investment.  These fees are generally non-recurring, arerecognized as revenue when earned and are paid directly to Gladstone Managementby the borrower or potential 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 work, arrangingbank financing, arranging equity financing, structuring financing from multiplelenders and investors, reviewing existing credit facilities, restructuringexisting loans, raising equity and debt capital, turnaround management, mergerand acquisition services and recruiting new management personnel. Any servicesof this nature subsequent to the closing would generally generate a separatefee at the time of completion. From time to time, we are invited to participateas 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**

 

*Comparison of thethree months ended December 31, 2004 to the three months ended December 31,2003*

 

**InvestmentIncome**

 

Investment incomefor the three months ended December 31, 2004 was approximately $6.1 million ascompared to approximately $4.0 million for the three months ended December 31,2003. This increase was primarily a result of increased interest income from anincreased number of investments during the three months ended December 31,2004, as compared to the same period of the prior year, offset by a decline infee revenue resulting from the receipt of such fees by our external investmentadviser.

 

Interest incomefrom our investments in debt securities of private companies was approximately$5.7 million, including approximately $141,000 of PIK interest, for the threemonths ended December 31, 2004 as compared to approximately $3.5 million forthe three months ended December 31, 2003, which included approximately $138,000of PIK interest. This increase****was primarily a result of anincrease in investments of $117.7 million, partially offset by principalrepayments of approximately $69.8 million, at December 31, 2004 as compared toinvestments at December 31, 2003.

 

The annualized weightedaverage yield on our portfolio for the three months ended December 31, 2004 was14.7% (without giving effect to PIK interest) and 15.0% (after giving effect toPIK interest). The annualized weighted average yield on our portfolio for thethree months ended December 31, 2003 was 12.3% (without giving effect to PIKinterest) and 13.1% (after giving effect to PIK interest).

 

Interest incomefrom invested cash and cash equivalents for the three months ended December 31,2004 was approximately $16,000, as compared to approximately $49,000 for thethree months ended December 31, 2003. This decrease****was primarily a result of a decrease in invested cash andcash equivalents resulting from an increase in investments of $117.7 million,partially offset by principal repayments of approximately $69.8 million,between December 31, 2003 and December 31, 2004.

 

For the threemonths ended December 31, 2004 and December 31, 2003, we recorded approximately$115,000 and $109,000, respectively, in interest income from loans to ouremployees in connection with the exercise of employee stock options.

 

No fee income wasrecorded for the three months ended December 31, 2004, as compared to $255,000for the three months ended December 31, 2003. This decrease was the result ofthe externalization of our management, effective October 1, 2004, through theengagement 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 December 31, 2004, Gladstone Management received anaggregate of $286,500 in such fees.

 

For the threemonths ended December 31, 2004, we recorded $240,000 of other income ascompared to $16,000 of other income for the three months ended December 31,2003.  The income for both periodsconsisted of prepayment penalty fees received upon the full repayment of a loaninvestment ahead of contractual maturity which, in both instances was based ona percentage of the outstanding principal amount of the loan at the date ofprepayment.

 

**OperatingExpenses**

 

Operating expensesfor the three months ended December 31, 2004 were approximately $1.2 million,as compared to approximately $1.0 million for the three months ended December31, 2003. This increase****was mainlya result of an increase in interest expense and professional fees.  Additionally, operating expenses for thethree months ended December 31, 2004 reflected a significant reduction indirect operating expenses, offset by the loan servicing fees and management feeincurred as a result of the externalization of our management effective October1, 2004.

 

Loan servicing fees of approximately $531,000 were incurred for thethree months ended December 31, 2004. These fees were incurred in connection with a loan servicing agreementbetween Gladstone Business Loan LLC (“Business Loan”) and Gladstone Management,which became effective July 12, 2004.  Thesefees were directly credited against the amount of the management fee due toGladstone Management.  During the threemonths ended December 31, 2003, our loan portfolio was serviced under a similaragreement with Gladstone Capital Advisers Inc., our wholly-owned subsidiary, andthe fees Business Loan paid to Gladstone Capital Advisers, Inc. were eliminatedupon 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),payable in quarterly increments of 0.3125%, and an annual administrative fee of0.75% of total assets (as reduced by cash and cash equivalents pledged tocreditors), payable in quarterly increments of 0.1875%, for a total fee of 2%of total assets (as reduced by cash and cash equivalents pledged to creditors).We continue to pay direct expenses including, but not limited to, directors’fees, legal and accounting fees, stockholder related expenses, and directorsand officers insurance.  Under theadvisory agreement, Gladstone Management provides the managerial assistance andother services to our portfolio companies that we previously provided throughour wholly-owned subsidiary Gladstone Capital Advisers, and likewise GladstoneManagement 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 Gladstone Management.Overall, the management fee due to Gladstone Management cannot exceed 2% oftotal assets (as reduced by cash and cash equivalents pledged to creditors)during any given fiscal year.  Because wewere internally managed at all times prior to October 1, 2004, no managementfee was recorded for the three months ended December 31, 2003.

 

           The following table sets forth thecomputation of the management fee for the three months ended December 31, 2004,based on the quarterly increment of 0.50% (0.3125% quarterly advisory fee plus0.1875% quarterly administrative fee):

 

| **Fee:**                                                          | ** ** | ** **  | ** **  |
|-------------------------------------------------------------------|------------|-------------|-------------|
| Total assets at December 31, 2004                                 |       | $           | 194,085,591 |   |
| Less: Borrowings under line of credit at December  31, 2004 *(a)* |       | (22,435,000 | )           |
| Total assets subject to fee as of December 31, 2004               |       | 171,650,591 |        |
| Quarterly fee rate                                                |       | 0.50        | %           |
| Gross management fee before loan servicing fee  credit            |       | 858,254     |        |
| Less: loan servicing fee from Gladstone Business  Loan LLC        |       | 530,952     |        |
| Management fee before credit:                                     |       | 327,302     |        |
| **Direct Credit to Management Fee:**                              |       |        |        |
| Fee revenue recorded by Gladstone Management:                     |       | 286,500     |        |
| Net management fee for the three months ended  December 31, 2004: |       | $           | 40,802      |   |

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*(a)*  *This amount represents borrowings under one of our lines of credit thatwere held in cash and cash equivalents as of December 31, 2004 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.*

 

                Professionalfees, consisting primarily of legal and audit fees, for the three months endedDecember 31, 2004 were approximately $239,000, as compared to approximately$153,000 for the three months ended December 31, 2003.  The increase is due primarily to legal andaudit fees incurred in connection with the fiscal year 2004 audit and annualreport preparation, proxy preparation, which are recurring in nature, andnon-reimbursable legal fees

 

                Financing feesconsist of the amortization of deferred financing costs in connection with ourlines of credit.  Financing fees wereapproximately $92,000 for the three months ended December 31, 2004 andapproximately $84,000 for the three months ended December 31, 2003.  The increase is due to the amortization ofdeferred financing costs for both lines of credit during the three months endedDecember 31, 2004 as compared to the amortization of deferred financing feesfor only one line of credit fee which was in place during the three monthsended December 31, 2003.

 

                Interestexpense for the three months ended December 31, 2004 was approximately $172,000as compared to approximately $78,000 for the three months ended December 31,2003.   This increase is a result ofincreased borrowings under our lines of credit during the three months endedDecember 31, 2004, which borrowings were used, in part, to finance ourincreased investments.  There were noborrowings outstanding during the three months ended December 31, 2003 and theinterest expense for this period represents commitment fees paid to the lenderunder the line of credit, regardless of outstanding borrowings.

 

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                Stockholderrelated costs for the three months ended December 31, 2004 were approximately$72,000, as compared to approximately $53,000 for the three months endedDecember 31, 2003.  Stockholder relatedcosts include such recurring items as transfer agent fees, electronic filingfees and printing of annual reports to stockholders.

 

                Directors’ feesfor the three months ended December 31, 2004 were $27,000, as compared toapproximately $24,000 for the three months ended December 31, 2003. This is theresult of the addition of a director in December 2003 and the related directorfees that were amortized for the full three months ended December 31, 2004 ascompared to one month during the three months ended December 31, 2003.

 

                Insuranceexpense for the three months ended December 31, 2004 was approximately $46,000,as compared to approximately $74,000 for the three months ended December 31,2003. The decrease is primarily the result of the externalization of ourmanagement.  Effective October 1, 2004,Gladstone Management pays general insurance expenses directly and suchinsurance coverage is included in the services we receive in consideration forthe 2% management fee we pay to Gladstone Management.  Insurance expense incurred during the threemonths ended December 31, 2004 represents the amortization of our directors andofficers insurance premiums, which are expenses for which we continue to beresponsible for following the externalization of our management.

 

Effective October1, 2004, all of our employees became employees of Gladstone Management andtherefore no salaries or benefit expenses were incurred by us for the threemonths ended December 31, 2004 as compared to approximately $391,000 for thethree months ended December 31, 2003.  Wereimburse Gladstone Management for its employee services as part of the 2% oftotal assets (excluding cash and cash equivalents pledged to creditors)management fee.

 

                EffectiveOctober 1, 2004, our external adviser, Gladstone Management, began to pay rentdirectly and therefore for the three months ended December 31, 2004 no rentexpense was incurred by us as compared to approximately $38,000 for the threemonths ended December 31, 2003.  Generaloverhead expenses such as rent are also included as part of the management feeto Gladstone Management.

 

General andadministrative expenses were approximately $43,000 for the three months ended December31, 2004, as compared to approximately $135,000 for the three months ended December31, 2003. This decrease****isprimarily a result of Gladstone Management handling general overhead type expenses.  The expenses for the three months endedDecember 31, 2004 primarily represent direct expenses such as travel relatedspecifically to our portfolio companies, loan evaluation services for ourportfolio companies, press releases and backup servicer expenses.

 

**Income Tax Expense**

 

                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 managerial assistance and other fees.  During the three months ended December 31,2004, 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 substantially allrevenues previously received by Gladstone Capital Advisers are now received byGladstone Management.  As a result, we donot anticipate incurring significant tax expense as a result of the activitiesof Gladstone Capital Advisers in the future.

 

**Realized Gain on Sale ofInvestment**

 

                During thethree months ended December 31, 2004, we sold our $975,000 syndicatedparticipation in Burt’s Bees, Inc. for a gain of $9,750.  We did not realize a gain or loss on anyinvestment during the three months ended December 31, 2003.

 

**Net Unrealized Depreciation onDerivative**

 

               As a result ofthe decline in fair market value of our interest rate cap agreement, werecorded net unrealized depreciation on derivative of approximately $25,000 forthe three months ended December 31, 2004. There were no derivatives held during the same period of the prior year.

 

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

 

               For the threemonths ended December 31, 2004, we recorded net unrealized appreciation on investmentsof approximately $283,000 as compared to net unrealized depreciation ofapproximately $1.6 million, for the three months ended December 31, 2003.  The appreciation is mainly attributable tothe increase in the value of the Finn warrant as well as the appreciation onthe syndicated loan participations.

 

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**NetIncrease in Stockholders’ Equity from Operations**

 

Overall, we realized a net increase in stockholders’ equityresulting from operations of approximately $5.0 million for the three monthsended December 31, 2004.  Based on aweighted-average of 11,278,510 (basic) and 11,615,796 (diluted) sharesoutstanding, our net increase in stockholders’ equity from operations per weightedaverage common share for the three months ended December 31, 2004 was $0.44 (basic)and $0.43 (diluted).

 

 Forthe three months ended December 31, 2003, we realized a net increasein stockholders’ equity resulting from operations of approximately $1.4million.  Based on a weighted-average of10,081,844 (basic) and 10,333,529 (diluted) shares outstanding, our netincrease in stockholders’ equity resulting from operations per weighted averagecommon share for the three months ended December 31, 2003 was $0.14 (basic) and$0.13 (diluted).

 

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**LIQUIDITY AND CAPITALRESOURCES**

 

At December 31,2004, we had investments in debt securities of, or loans to 21 privatecompanies, totaling approximately $170.3 million (cost basis) of total assets.This number includes approximately $141,000 in accrued PIK interest income forthe three months ended December 31, 2004, which as described in “Overview,” isadded to the carrying value of our investments.

 

                      InOctober 2004, we sold our $975,000 participation in Burt’s Bees, Inc. for again of $9,750.

 

During November 2004, we extended a $5.5 million loan to GlobalMaterials Technologies, Inc. a manufacturer of steel wool products and metalfibers and also extended a $7.95 million loan to Santana Plastics, Inc., amanufacturer of polyethylene bathroom partitions. We also purchased syndicated loanparticipations in Valor Telecommunications, a rural telecommunications company,in the amount of $8.0 million and Tech Lighting LLC, a manufacturer of lowvoltage lighting systems in the amount of $7.0 million. We also received fullprincipal repayments ahead of contractual maturity of $12.25 million from A& G, Inc. and $12.0 million from America’s Water Heater Rentals, Inc.,which also remitted $1.4 million of prepayment and success fees with its finalpayment.

 

In December 2004 we purchased an additional $2.0 million loanparticipation of Tech Lighting and an additional $2.0 million loanparticipation of Valor Telecommunications. We also purchased loan participations of $3.0 million of PolarCorporation, a manufacturer of trailer parts, $2.0 million of Regency GasServices LLC, a company specializing in midstream gas gathering and processing,$2.0 million of Marietta Corporation, a manufacturer of personal care products,and $7.5 million of Advanced Homecare Management, Inc., a provider home healthnursing services.

 

In January 2005, we sold our entire $2.0 million loanparticipation in Marietta Corporation for a gain of $20,000.  In January 2005, we also purchased anadditional $2.5 million loan participation in Polar Corporation, an additional$1.0 million loan participation in Regency Gas Services LLC and a $5.5 millionloan participation in John Henry Holdings Inc., an envelope manufacturer.

 

In February 2005, the Inca Metal Products Corporation/KingwayAcquisition, Inc./Clymer Acquisition, Inc. repaid its entire $2.3 millioninvestment.

 

The following table summarizes the contractual principal amortizationand maturity of our investment portfolio by fiscal year:

 

| **Year**   | ** ** | **Amount** | ** **  |
|------------|------------|------------|-------------|
| 2005       |       | $          | 3,301,508   |   |
| 2006       |       | $          | 20,623,431  |   |
| 2007       |       | $          | 37,371,682  |   |
| 2008       |       | $          | 21,258,974  |   |
| 2009       |       | $          | 31,683,456  |   |
| Thereafter |       | $          | 56,063,684  |   |
| Total      |       | $          | 170,302,735 |   |

 

Net cash providedby operating activities for the three months ended December 31, 2004,consisting primarily of the items described in “Results of Operations,” wasapproximately $4.1 million.  Net cash usedin investing activities was approximately $42.2 million during the three monthsended December 31, 2004 and primarily consisted of new investments in theaggregate amount of approximately $46.9 million and the repayment of therepurchase agreement of approximately $21.3 million, partially offset by principalrepayments of approximately $26.0 million from our portfolio companies. ** **Netcash used in financing activities was approximately $4.5 million for the threemonths ended December 31, 2004 and consisted primarily of the payment ofdividends of approximately $4.1 million, repayments, net of borrowings, of ourline of credit of approximately $0.3 million, and some costs incurredsubsequent to the shelf offering in September 2004.

 

As a result of theabove factors, during the three months ended December 31, 2004, cash and cashequivalents decreased from approximately $66.0 million at the beginning of theperiod to approximately $23.4 million at the end of the period.

 

On October 1, 2004, we settled an outstanding repurchase agreement (the“Repurchase Agreement”) with Ferris Baker Watts Incorporated for $21,345,997.The interest rate on the Repurchase Agreement was 4.25% for a cost of $7,831.In the future, we may or may not use a similar form of repurchase agreement asan investment option or in order to satisfy certain asset diversificationrequirements and maintain our status as a RIC under Subchapter M of theInternal Revenue Code.  At December 31,2004, we did not use a repurchase agreement as an investment option in order tosatisfy our asset diversification requirement; however, of the $40.4 million ofborrowings outstanding under our line of credit at December 31, 2004,approximately $22.4 million were invested in cash and cash equivalents in orderto satisfy our asset diversification requirement.

 

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In order toqualify as a regulated investment company and to avoid corporate level tax onthe income we distribute to our stockholders, we are required, under SubchapterM of the Code, to distribute at least 90% of our ordinary income and short-termcapital gains to our stockholders on an annual basis. In accordance with theserequirements, we declared and paid a monthly cash dividend of $0.12 per commonshare for each of October, November and December 2004 and declared a $0.12monthly dividend for each of January, February, and March 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**

 

Through our wholly-owned subsidiary, Business Loan, we have a $100million revolving credit facility with Deutsche Bank AG, as administrativeagent.  Pursuant to the credit facility,Business Loan has pledged the loans it holds to secure future advances bycertain institutional lenders.  Interestrates charged on the advances under the facility will be based on the LondonInterbank Offered Rate (“LIBOR”), the Prime Rate or the Federal Funds Rate,depending on market conditions, and will adjust periodically.  As of December 31, 2004, our outstandingprincipal balance under this credit facility was approximately $25.4 million atan interest rate of 2.28%.  Availableborrowings are subject to various constraints imposed by Deutsche Bank AG, basedon the aggregate loan balance pledged by Business Loan, which varies as loansor added and repaid, regardless of whether such repayments are early prepaymentor are made as contractually required. At December 31, 2004, the remaining borrowing capacity available underthis line of credit was approximately $23.0 million.

 

The facility contains covenants that, among other things, requireBusiness Loan to maintain its status as a separate entity; prohibit certainsignificant corporate transactions (such as mergers, consolidations,liquidations or dissolutions); and restrict material changes to our credit andcollection policies.  The facility alsorestricts some of the terms and provisions (including interest rates, terms tomaturity and payments schedules) and limits the borrower and industryconcentrations of loans that are eligible to secure advances.  As of December 31, 2004, Business Loan was incompliance with all of the facility covenants. We currently intend to securitize all of the loans held by Business Loanand to use the proceeds from the securitization to pay down any amounts thenoutstanding under the revolving credit facility.  However, there can be no assurance that wewill be able to successfully securitize any of these loans on terms acceptableto us, if at all.

 

Gladstone Management, our affiliated external adviser, services theloans pledged under the facility.  As acondition to this servicing arrangement, we executed a Performance Guarantypursuant to which we guaranteed that Gladstone Management would comply fullywith all of its obligations under the facility. The Performance Guarantyrequires us to maintain a minimum net worth of $100 million and to maintain “assetcoverage” with respect to “senior securities representing indebtedness” of atleast 200%, in accordance with Section 18 of the 1940 Act.  As of December 31, 2004, we were incompliance with our covenants under the Performance Guaranty.

 

We also have a $15.0 million line of credit agreement with BranchBanking and Trust Company (“BB&T Agreement”) which matures on June 1,2005.  Interest on outstanding borrowingsis based on the one month LIBOR plus 2.5% per annum.  The unused portion of the line of credit issubject to a fee of 0.2% per annum.  TheBB&T Agreement requires us to meet and maintain certain covenants andratios with respect to leverage and liquidity. As of December 31, 2004, therewas $15.0 million outstanding under the BB&T line of credit at an interestrate of 4.9%.

 

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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 50% of the loans in our portfolio will be made atfixed rates, with approximately 50% made at variable rates.  Currently ourportfolio has approximately 30% of the total of the loan portfolio cost basisat fixed rates, approximately 30% of the total loan portfolio cost basis atvariable rates with a floor and the remaining 40% of the total loan portfoliocost basis at variable rates.

 

In addition, wehave two variable rate borrowing facilities. We have a $100 million revolving credit facility with Deutsche Bank AGwhich matures in May 2005.  We also havea $15 million line of credit agreement with Branch Banking and Trust Companywhich matures in June 2005.

 

To illustrate thepotential impact of changes in interest rates on our net increase instockholders’ equity resulting from operations, we have performed the followinganalysis, which assumes that our balance sheet remains constant and no furtheractions beyond the interest rate cap agreement are taken to alter our existinginterest rate sensitivity.  Under thisanalysis, a hypothetical increase in the one month LIBOR by 1% would increaseour net increase in stockholders’ equity resulting from operations byapproximately $607,000 or 4.3%, over the next twelve months, compared to thenet increase in stockholders’ equity resulting from operations for the twelvemonths ended December 31, 2004.  Ahypothetical decrease in the one month LIBOR by 1% would decrease net increasein stockholders’ equity resulting from operations by approximately $607,000, or4.3%, over the next twelve months, compared to the net increase in stockholders’equity resulting from operations for the twelve months ended December 31,2004.  Although management believes thatthis analysis is indicative of our existing interest rate sensitivity, it doesnot adjust 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 February 2004, weentered into an interest rate cap agreement in order to fulfill an obligationunder our line of credit to enter into certain hedging transactions inconnection with our borrowings under the line of credit.  We purchasedthis interest rate cap agreement with a notional amount of $35 million for aone-time, up-front payment of $304,000.  The interest rate cap agreemententitles us to receive payments, if any, equal to the amount by which interestpayments on $35 million at the pointwhich one month LIBOR exceed the payments on $35 million at 5%. The cap expires in February 2009.  This interest rate cap agreementeffectively caps our interest payments on our line of credit borrowing, up tothe notional amount of the interest rate cap, at five percent.  Thismitigates our exposure to increases in interest rates on our borrowings on ourlines of credit, which are at variable rates. At December 31, 2004, the cap agreement had a fair market value of$64,930.  At December 31, 2004, the onemonth LIBOR rate was approximately 2.4%.

 

In the event thatwe securitize a portion of our loan portfolio, we believe that we will likelybe required to enter into further hedging arrangements in the future withrespect to securitized loans.  Whilehedging activities may mitigate our exposure to adverse fluctuations ininterest rates, certain hedging transactions that we may enter into in thefuture, such as interest rate swap agreements, may also limit our ability toparticipate in the benefits of lower interest rates with respect to ourportfolio of investments.

 

**ITEM 4. CONTROLS ANDPROCEDURES.**

 

As of December 31, 2004, we, including our Chief Executive Officerand Chief Financial Officer, evaluated the effectiveness of the design andoperation of our disclosure controls and procedures.  Based on that evaluation, our management,including the Chief Executive Officer and Chief Financial Officer, concludedthat our 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 December 31, 2004, that havematerially affected, or are reasonably likely to materially affect, ourinternal control over financial reporting.

 

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**PARTII—OTHER INFORMATION**

 

**ITEM1. LEGAL PROCEEDINGS.**

 

Neither we, nor any of our subsidiaries, arecurrently subject to any material legal proceeding, nor, to our knowledge, isany material legal proceeding threatened against us or any of our subsidiaries.

 

**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.**

 

Not applicable.

 

**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: February 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.                               |
|        |       |                                                                                                                                                                                                                                      |
| 10.29       |       | Trademark License Agreement between Gladstone Management  Corporation and Gladstone Capital Corporation.                                                                                                                                  |
|        |       |                                                                                                                                                                                                                                      |
| 11          |       | Computation of Per Share Earnings (included in the notes to the  unaudited financial statements contained in this report).                                                                                                                |
|        |       |                                                                                                                                                                                                                                      |
| 31.1        |       | Certification of Chief Executive Officer pursuant to section 302  of The Sarbanes-Oxley Act of 2002.                                                                                                                                      |
|        |       |                                                                                                                                                                                                                                      |
| 31.2        |       | Certification of Chief Financial Officer pursuant to section 302  of The Sarbanes-Oxley Act of 2002.                                                                                                                                      |
|        |       |                                                                                                                                                                                                                                      |
| 32.1        |       | Certification of Chief Executive Officer pursuant to section 906  of The Sarbanes-Oxley Act of 2002.                                                                                                                                      |
|        |       |                                                                                                                                                                                                                                      |
| 32.2        |       | Certification of Chief Financial Officer pursuant to section 906  of The Sarbanes-Oxley Act of 2002.                                                                                                                                      |

 

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

 

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