**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON,D.C. 20549**

 

**FORM 10-Q**

 

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

 

**FORTHE QUARTER ENDED MARCH 31, 2004**

 

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

 

**COMMISSIONFILE NUMBER: 814-00237**

 

**GLADSTONE CAPITAL CORPORATION**

(Exact name of registrant as specified in its charter)

 
| **MARYLAND**                                                    |   | **54-2040781**                       |
|-----------------------------------------------------------------|--------|--------------------------------------|
| (State or other jurisdiction of  incorporation or organization) |   | (I.R.S. Employer Identification No.) |
|                                                            |   |                                 |
| **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 SecuritiesExchange Act of 1934 during the preceding 12 months and (2) has been subject tosuch filing 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 May 7, 2004 was 10,105,178.

 

 

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**GLADSTONE CAPITAL CORPORATIONTABLE OF CONTENTS**

 
| PART I.    | FINANCIAL INFORMATION                                                                                                         |
|------------|-------------------------------------------------------------------------------------------------------------------------------|
|       |                                                                                                                          |
| Item 1.    | Financial Statements (Unaudited)                                                                                              |
|       |                                                                                                                          |
|       | Consolidated Balance Sheets  as of March 31, 2004 and September 30, 2003                                            |
|       | Schedules of Investments  as of March 31, 2004 and September 30, 2003                                               |
|       | Consolidated  Statements of Operations for the three months ended March 31, 2004 and  March 31, 2003                |
|       | Consolidated Statements of  Operations for the six months ended March 31, 2004 and March 31,  2003                  |
|       | Consolidated  Statements of Stockholders’ Equity for the three months ended March 31,  2004 and March 31, 2003 |
|       | Consolidated  Statements of Cash Flows for the six months ended March 31, 2004 and  March 31, 2003                  |
|       | Financial Highlights for the three  and six months ended March 31, 2004 and March 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.    | Changes in Securities,  Use of Proceeds, and Issuer Purchases of Equity Securities                                            |
|       |                                                                                                                          |
| Item  3.   | Defaults  Upon Senior Securities                                                                                              |
|       |                                                                                                                          |
| Item 4.    | Submission of Matters to a Vote of  Security Holders                                                                          |
|       |                                                                                                                          |
| Item 5.    | Other Information                                                                                                             |
|       |                                                                                                                          |
| Item 6.    | Exhibits and  Reports on Form 8-K                                                                                             |
|       |                                                                                                                          |
| SIGNATURES |

 

2

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**PART I—FINANCIALINFORMATION**

 

**GladstoneCapital Corporation**

 

**Consolidated FinancialStatements**

 

**(Unaudited)**

 

**March 31,2004**

 

**CONTENTS**

 
| Consolidated Balance Sheets                           |
|-------------------------------------------------------|
|                                                  |
| Schedules of Investments                              |
|                                                  |
| Consolidated  Statements of Operations                |
|                                                  |
| Consolidated  Statements of Stockholders’ Equity |
|                                                  |
| Consolidated  Statements of Cash Flows                |
|                                                  |
| Financial Highlights                                  |
|                                                  |
| Notes to  Consolidated Financial Statements           |

 

3

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**GLADSTONECAPITAL CORPORATION**

 

**CONSOLIDATED BALANCESHEETS**

 
|                                                                                                                                     |   | **(Unaudited)  March 31,  2004** |        | **(Audited)  September 30,  2003** |   |
|------------------------------------------------------------------------------------------------------------------------------------------|--------|---------------------------------------|-------------|-----------------------------------------|--------|
| **ASSETS**                                                                                                                               |   |                                  |        |                                    |   |
| Investments at  fair value (Cost 3/31/2004: $140,626,669; 9/30/2003: $109,529,893)                                                       |   | $                                     | 138,541,292 |                                    | $      | 109,307,553 |   |
| Cash and cash  equivalents                                                                                                               |   | 6,809,323                             |        | 21,143,972                              |   |
| Cash and cash  equivalents pledged to creditors                                                                                          |   | 95,004,939                            |        | 80,022,249                              |   |
| Interest  receivable – investments in debt securities                                                                               |   | 1,270,800                             |        | 1,041,943                               |   |
| Interest  receivable – cash and cash equivalents                                                                                    |   | 361                                   |        | 955                                     |   |
| Interest  receivable – officers                                                                                                     |   | 109,262                               |        | 108,657                                 |   |
| Due from  custodian                                                                                                                      |   | 225,000                               |        | 1,207,000                               |   |
| Prepaid assets                                                                                                                           |   | 1,334,538                             |        | 1,479,815                               |   |
| Other assets                                                                                                                             |   | 995,555                               |        | 254,519                                 |   |
|                                                                                                                                     |   |                                  |        |                                    |   |
| **TOTAL ASSETS**                                                                                                                         |   | $                                     | 244,291,070 |                                    | $      | 214,566,663 |   |
|                                                                                                                                     |   |                                  |        |                                    |   |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                                                            |   |                                  |        |                                    |   |
|                                                                                                                                     |   |                                  |        |                                    |   |
| **LIABILITIES**                                                                                                                          |   |                                  |        |                                    |   |
| Accounts payable                                                                                                                         |   | $                                     | 86,795      |                                    | $      | 23,247 |   |
| Dividends  payable                                                                                                                       |   | —                                |        | 3,327,009                               |   |
| Borrowings under  line of credit                                                                                                         |   | 20,500,000                            |        | —                                  |   |
| Accrued expenses  and deferred liabilities                                                                                               |   | 2,184,166                             |        | 1,965,025                               |   |
| Repurchase  agreement                                                                                                                    |   | 93,105,000                            |        | 78,449,000                              |   |
|                                                                                                                                     |   |                                  |        |                                    |   |
| **Total Liabilities**                                                                                                                    |   | $                                     | 115,875,961 |                                    | $      | 83,764,281 |   |
|                                                                                                                                     |   |                                  |        |                                    |   |
| **STOCKHOLDERS’  EQUITY**                                                                                                           |   |                                  |        |                                    |   |
| Common stock,  $0.001 par value, 50,000,000 shares authorized and 10,105,178 and 10,081,844  shares issued and outstanding, respectively |   | $                                     | 10,105      |                                    | $      | 10,082 |   |
| Capital in  excess of par value                                                                                                          |   | 140,723,063                           |        | 140,416,674                             |   |
| Notes receivable  – officers                                                                                                        |   | (9,232,698                            | )           | (8,985,940                              | )      |
| Net unrealized  depreciation on investments                                                                                              |   | (2,085,377                            | )           | (222,340                                | )      |
| Undistributed/(overdistributed)  net investment income                                                                                   |   | (999,984                              | )           | (416,094                                | )      |
|                                                                                                                                     |   |                                  |        |                                    |   |
| **Total Stockholders’ Equity**                                                                                                      |   | $                                     | 128,415,109 |                                    | $      | 130,802,382 |   |
|                                                                                                                                     |   |                                  |        |                                    |   |
| **TOTAL  LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                                                     |   | $                                     | 244,291,070 |                                    | $      | 214,566,663 |   |

 

SEE ACCOMPANYING NOTES.

 

4

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**GLADSTONE CAPITAL CORPORATIONSCHEDULE OF INVESTMENTSAS OF MARCH 31, 2004(UNAUDITED)**

 

 
| **Company  (1)**                                                                |   | **Industry**                                                 |                        | **Investment**                          |      | **Cost**   |        | **Fair Value** |   |
|---------------------------------------------------------------------------------|--------|--------------------------------------------------------------|-----------------------------|-----------------------------------------|-----------|------------|-------------|----------------|--------|
|                                                                            |   |                                                         |                        |                                    |      |       |        |           |   |
| America’s Water Heater  Rentals, LLC                                       |   | Water heater  rentals and servicing                          |                        | Senior Term Debt  (2)(4)                |      | $          | 12,000,000  |           | $      | 12,060,000 |   |
|                                                                            |   |                                                         |                        |                                    |      |       |        |           |   |
| ARI Holdings, Inc.                                                              |   | Manufacturing-auto  parts                                    |                        | Senior Term Debt  (2)(3)(4)             |      | 3,583,675  |        | 3,243,226      |   |
|                                                                            |   |                                                         |                        | Senior Term Debt  (2)(4)                |      | 1,387,500  |        | 1,332,000      |   |
|                                                                            |   |                                                         |                        |                                    |      |       |        |           |   |
| Burt’s Bees, Inc.                                                          |   | Personal and  household products                             |                        | Senior Term Debt  (4)                   |      | 991,667    |        | 1,000,344      |   |
|                                                                            |   |                                                         |                        |                                    |      |       |        |           |   |
| Coyne International  Enterprises                                                |   | Industrial  services                                         |                        | Senior Term Debt  (2)(3)(4)             |      | 15,578,330 |        | 15,403,074     |   |
|                                                                            |   |                                                         |                        |                                    |      |       |        |           |   |
| Finn Corporation                                                                |   | Manufacturing-landscape  equipment                           |                        | Senior  Subordinated Term Debt(4)       |      | 10,500,000 |        | 9,121,875      |   |
|                                                                            |   |                                                         |                        | Common Stock  Warrants for 2% ownership |      | 37,000     |        | 435,649        |   |
|                                                                            |   |                                                         |                        |                                    |      |       |        |           |   |
| Fugate & Associates, Inc.                                                   |   | Imaging supplies                                             |                        | Senior Term Debt  (4)                   |      | 3,237,500  |        | 3,213,219      |   |
|                                                                            |   |                                                         |                        | Senior Term Debt  (4)                   |      | 1,499,999  |        | 1,494,374      |   |
|                                                                            |   |                                                         |                        |                                    |      |       |        |           |   |
| GQM Acquisition Corp. d/b/a Gammill, Inc.                                       |   | Designer and  assembler of quilting machines and accessories |                        | Senior Term Debt  (4)                   |      | 7,312,500  |        | 7,312,500      |   |
|                                                                            |   |                                                         | Senior Term  Debt  (4) |                                    | 7,000,000 |       | 7,000,000   |           |
|                                                                            |   |                                                         |                        |                                    |      |       |        |           |   |
| Home Care Supply, Inc.                                                          |   | Medical  equipment rental                                    |                        | Senior Term Debt  (2)(4)(5)             |      | 18,000,000 |        | 18,696,600     |   |
|                                                                            |   |                                                         |                        |                                    |      |       |        |           |   |
| Inca Metal  Products Corp.  Kingway Acquisition, Inc.  Clymer Acquisition, Inc. |   | Material  handling and storage products                      |                        | Senior Term Debt  (2)(4)                |      | 2,488,164  |        | 2,239,347      |   |
|                                                                            |   |                                                         |                        |                                    |      |       |        |           |   |
| Marcal Paper Mills, Inc.                                                        |   | Manufacturing-paper  products                                |                        | Senior Term Debt  (2)(4)                |      | 6,800,000  |        | 6,205,000      |   |
|                                                                            |   |                                                         | First Mortgage  Debt (3)    |                                    | 9,210,334 |       | 9,210,334   |           |
|                                                                            |   |                                                         |                        |                                    |      |       |        |           |   |
| Medassets, Inc.                                                                 |   | Pharmaceuticals  and healthcare GPOs                         |                        | Second Lien Term  Debt                  |      | 6,000,000  |        | 6,000,000      |   |
|                                                                            |   |                                                         |                        |                                    |      |       |        |           |   |
| Mistras Holdings, Inc.                                                          |   | Nondestructive  testing instruments, systems and services    |                        | Senior Term  Debt(2)(4)                 |      | 10,000,000 |        | 9,775,000      |   |
|                                                                            |   |                                                         | Senior Term Debt  (2)(4)    |                                    | 5,000,000 |       | 4,837,500   |           |
|                                                                            |   |                                                         |                        |                                    |      |       |        |           |   |
| Wingstop Restaurants                                                            |   | Restaurant –  fast food                                 |                        | Senior Term Debt  (4)                   |      | 3,500,000  |        | 3,473,750      |   |
| International, Inc.                                                             |   |                                                         |                        | Senior Debt (4)                         |      | 2,000,000  |        | 1,987,500      |   |
|                                                                            |   |                                                         |                        |                                    |      |       |        |           |   |
| Woven Electronics Corp.                                                         |   | Cable and wire  harness                                      |                        | Senior Term Debt  (2)                   |      | 2,500,000  |        | 2,500,000      |   |
|                                                                            |   | assemblers                                                   |                        | Senior Term Debt  (2)                   |      | 6,000,000  |        | 6,000,000      |   |
|                                                                            |   |                                                         |                        | Senior Term Debt  (2)                   |      | 6,000,000  |        | 6,000,000      |   |
| Totals                                                                          |   |                                                         |                        |                                    |      | $          | 140,626,669 |           | $      | 138,541,292 |   |

 

5

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

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

(3) Has some paid in kind (PIK) interest.  Refer to Note 2 “Summary of SignificantAccounting Policies” of Form 10-K for the fiscal year ended September 30,2003.

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

(5) Includes a success fee with a fair value of $516,600 and nocost basis.

 

SEE ACCOMPANYING NOTES.

 

6

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**GLADSTONECAPITAL CORPORATIONSCHEDULE OF INVESTMENTSAS OF SEPTEMBER 30, 2003**

 
| **Company  (1)**                                                                |   | **Industry**                            |   | **Investment**                          |   | **Cost**   |        | **Fair Value** |   |
|---------------------------------------------------------------------------------|--------|-----------------------------------------|--------|-----------------------------------------|--------|------------|-------------|----------------|--------|
|                                                                            |   |                                    |   |                                    |   |       |        |           |   |
| America’s Water Heater Rentals, LLC                                        |   | Water heater  rentals and servicing     |   | Senior Term Debt (2)(4)                 |   | $          | 12,000,000  |           | $      | 12,000,000 |   |
|                                                                            |   |                                    |   |                                    |   |       |        |           |   |
| ARI Holdings, Inc.                                                              |   | Manufacturing-auto parts                |   | Senior Term Debt (2)(3)                 |   | 3,511,667  |        | 3,511,667      |   |
|                                                                            |   |                                    |   | Senior Term Debt (2)                    |   | 1,500,000  |        | 1,500,000      |   |
|                                                                            |   |                                    |   |                                    |   |       |        |           |   |
| Coyne International Enterprises                                                 |   | Industrial services                     |   | Senior Term Debt (2)(3)(4)              |   | 15,421,740 |        | 15,306,077     |   |
|                                                                            |   |                                    |   |                                    |   |       |        |           |   |
| Finn Corporation                                                                |   | Manufacturing-landscape  equipment      |   | Senior  Subordinated Term Debt(4)       |   | 10,500,000 |        | 10,421,250     |   |
|                                                                            |   |                                    |   | Common Stock  Warrants for 2% ownership |   | 37,000     |        | 431,111        |   |
|                                                                            |   |                                    |   |                                    |   |       |        |           |   |
| Fugate & Associates, Inc.                                                   |   | Imaging supplies                        |   | Senior Term Debt  (4)                   |   | 3,412,500  |        | 3,412,500      |   |
|                                                                            |   |                                    |   | Senior Term Debt  (4)                   |   | 1,833,333  |        | 1,833,333      |   |
|                                                                            |   |                                    |   |                                    |   |       |        |           |   |
| Home Care Supply, Inc.                                                          |   | Medical equipment rental                |   | Senior Term Debt (2)(4)(5)              |   | 18,000,000 |        | 18,428,400     |   |
|                                                                            |   |                                    |   |                                    |   |       |        |           |   |
| Inca Metal  Products Corp.  Kingway Acquisition, Inc.  Clymer Acquisition, Inc. |   | Material  handling and storage products |   | Senior Term Debt (2)(4)                 |   | 5,775,000  |        | 4,995,375      |   |
|                                                                            |   |                                    |   |                                    |   |       |        |           |   |
| Kozy Shack Enterprises, Inc.                                                    |   | Food production and sales               |   | Senior Term Debt (2)(4)                 |   | 900,000    |        | 909,000        |   |
|                                                                            |   |                                    |   |                                    |   |       |        |           |   |
| Marcal Paper Mills, Inc.                                                        |   | Manufacturing-paper products            |   | Senior Term Debt (2)(4)                 |   | 6,975,000  |        | 6,922,687      |   |
|                                                                            |   |                                    |   | First Mortgage Debt (3)                 |   | 9,163,653  |        | 9,163,653      |   |
|                                                                            |   |                                    |   |                                    |   |       |        |           |   |
| Mistras Holdings, Inc.                                                          |   | Nondestructive  testing                 |   | Senior Term Debt  (2)                   |   | 10,000,000 |        | 10,000,000     |   |
|                                                                            |   | instruments,  systems and services      |   | Senior Term Debt  (2)                   |   | 5,000,000  |        | 5,000,000      |   |
|                                                                            |   |                                    |   |                                    |   |       |        |           |   |
| Wingstop Restaurants                                                            |   | Restaurant – fast food             |   | Senior Term Debt (4)                    |   | 3,500,000  |        | 3,482,500      |   |
| International, Inc.                                                             |   |                                    |   | Senior Debt (4)                         |   | 2,000,000  |        | 1,990,000      |   |
| Totals                                                                          |   |                                    |   |                                    |   | $          | 109,529,893 |           | $      | 109,307,553 |   |

 

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

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

(3) Has some paid in kind (PIK) interest.  Refer to Note 2 “Summary of SignificantAccounting Policies” of Form 10-K for the fiscal year ended September 30,2003.

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

(5) Includes a success fee with a fair value of $473,400 and nocost basis.

 

SEE ACCOMPANYING NOTES.

 

7

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**GLADSTONECAPITAL CORPORATION**

 

**CONSOLIDATEDSTATEMENT OF OPERATIONS**

 

**(UNAUDITED)**

 
|                                                                                       |   | **Three Months Ended  March 31, 2004** |      | **Three Months Ended  March 31, 2003** |   |
|--------------------------------------------------------------------------------------------|--------|---------------------------------------------|-----------|---------------------------------------------|--------|
| **INVESTMENT INCOME**                                                                      |   |                                        |      |                                        |   |
| Interest income  – investments                                                        |   | $                                           | 3,878,817 |                                        | $      | 3,275,962 |   |
| Interest income  – cash and cash equivalents                                          |   | 17,334                                      |      | 113,338                                     |   |
| Interest income  - notes receivable from officers                                          |   | 109,538                                     |      | 109,737                                     |   |
| Managerial  assistance fees                                                                |   | 356,231                                     |      | 358,000                                     |   |
| Other income                                                                               |   | 6,000                                       |      | 2,256                                       |   |
| Total Investment  Income                                                                   |   | $                                           | 4,367,920 |                                        | $      | 3,859,293 |   |
|                                                                                       |   |                                        |      |                                        |   |
| **EXPENSES**                                                                               |   |                                        |      |                                        |   |
| Salaries and  benefits                                                                     |   | $                                           | 419,769   |                                        | $      | 477,861 |   |
| Rent                                                                                       |   | 33,964                                      |      | 54,525                                      |   |
| Professional  fees                                                                         |   | 282,292                                     |      | 86,577                                      |   |
| Directors fees                                                                             |   | 32,877                                      |      | 20,857                                      |   |
| Insurance                                                                                  |   | 63,274                                      |      | 73,686                                      |   |
| Stockholder  related costs                                                                 |   | 67,320                                      |      | 74,342                                      |   |
| Financing fees                                                                             |   | 149,039                                     |      | —                                      |   |
| Interest                                                                                   |   | 24,602                                      |      | —                                      |   |
| General and  administrative                                                                |   | 173,225                                     |      | 151,854                                     |   |
| Total Expenses                                                                             |   | $                                           | 1,246,362 |                                        | $      | 939,702 |   |
|                                                                                       |   |                                        |      |                                        |   |
| **NET INVESTMENT INCOME**                                                                  |   | $                                           | 3,121,558 |                                        | $      | 2,919,591 |   |
|                                                                                       |   |                                        |      |                                        |   |
| Realized gain on  sale of investment                                                       |   | 12,500                                      |      | —                                      |   |
|                                                                                       |   |                                        |      |                                        |   |
| Net unrealized  (depreciation) appreciation on investments                                 |   | (305,475                                    | )         | 742,424                                     |   |
|                                                                                       |   |                                        |      |                                        |   |
| **NET  INCREASE IN STOCKHOLDERS’ EQUITY RESULTING FROM OPERATIONS**                   |   | $                                           | 2,828,583 |                                        | $      | 3,662,015 |   |
|                                                                                       |   |                                        |      |                                        |   |
| **NET  INCREASE IN STOCKHOLDERS’ EQUITY RESULTING FROM OPERATIONS PER COMMON SHARE:** |   |                                        |      |                                        |   |
| Basic                                                                                      |   | $                                           | 0.28      |                                        | $      | 0.36 |   |
| Diluted                                                                                    |   | $                                           | 0.27      |                                        | $      | 0.36 |   |
|                                                                                       |   |                                        |      |                                        |   |
| **WEIGHTED  AVERAGE SHARES OF COMMON STOCK OUTSTANDING:**                                  |   |                                        |      |                                        |   |
| Basic                                                                                      |   | 10,087,615                                  |      | 10,071,844                                  |   |
| Diluted                                                                                    |   | 10,375,281                                  |      | 10,100,062                                  |   |

 

SEE ACCOMPANYING NOTES.

 

8

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**GLADSTONECAPITAL CORPORATION**

 

**CONSOLIDATED STATEMENT****OF OPERATIONS**

 

**(UNAUDITED)**

 
|                                                                                       |   | **Six Months Ended  March 31, 2004** |      | **Six Months Ended  March 31, 2003** |   |
|--------------------------------------------------------------------------------------------|--------|-------------------------------------------|-----------|-------------------------------------------|--------|
| **INVESTMENT INCOME**                                                                      |   |                                      |      |                                      |   |
| Interest income  – investments                                                        |   | $                                         | 7,418,513 |                                      | $      | 6,203,625 |   |
| Interest income  – cash and cash equivalents                                          |   | 65,955                                    |      | 311,504                                   |   |
| Interest income  – notes receivable from officers                                     |   | 218,170                                   |      | 219,341                                   |   |
| Managerial  assistance fees                                                                |   | 611,231                                   |      | 358,000                                   |   |
| Other income                                                                               |   | 22,000                                    |      | 2,256                                     |   |
| Total Investment  Income                                                                   |   | $                                         | 8,335,869 |                                      | $      | 7,094,726 |   |
|                                                                                       |   |                                      |      |                                      |   |
| **EXPENSES**                                                                               |   |                                      |      |                                      |   |
| Salaries and  benefits                                                                     |   | $                                         | 810,476   |                                      | $      | 911,101 |   |
| Rent                                                                                       |   | 71,724                                    |      | 109,145                                   |   |
| Professional fees                                                                          |   | 459,950                                   |      | 201,267                                   |   |
| Directors fees                                                                             |   | 57,210                                    |      | 34,357                                    |   |
| Insurance                                                                                  |   | 137,285                                   |      | 144,841                                   |   |
| Stockholder  related costs                                                                 |   | 119,980                                   |      | 111,432                                   |   |
| Financing fees                                                                             |   | 294,035                                   |      | —                                    |   |
| Interest                                                                                   |   | 24,602                                    |      | —                                    |   |
| General and  administrative                                                                |   | 300,413                                   |      | 250,837                                   |   |
| Total Expenses                                                                             |   | $                                         | 2,275,675 |                                      | $      | 1,762,980 |   |
|                                                                                       |   |                                      |      |                                      |   |
| **NET  INVESTMENT INCOME**                                                                 |   | $                                         | 6,060,194 |                                      | $      | 5,331,746 |   |
|                                                                                       |   |                                      |      |                                      |   |
| Realized gain on  sale of investment                                                       |   | 12,500                                    |      | —                                    |   |
|                                                                                       |   |                                      |      |                                      |   |
| Net unrealized  (depreciation) appreciation on investments                                 |   | (1,863,037                                | )         | 742,424                                   |   |
|                                                                                       |   |                                      |      |                                      |   |
| **NET  INCREASE IN STOCKHOLDERS’ EQUITY RESULTING FROM OPERATIONS**                   |   | $                                         | 4,209,657 |                                      | $      | 6,074,170 |   |
|                                                                                       |   |                                      |      |                                      |   |
| **NET  INCREASE IN STOCKHOLDERS’ EQUITY RESULTING FROM OPERATIONS PER COMMON SHARE:** |   |                                      |      |                                      |   |
| Basic                                                                                      |   | $                                         | 0.42      |                                      | $      | 0.60 |   |
| Diluted                                                                                    |   | $                                         | 0.41      |                                      | $      | 0.60 |   |
|                                                                                       |   |                                      |      |                                      |   |
| **WEIGHTED  AVERAGE SHARES OF COMMON STOCK OUTSTANDING:**                                  |   |                                      |      |                                      |   |
| Basic                                                                                      |   | 10,084,729                                |      | 10,071,844                                |   |
| Diluted                                                                                    |   | 10,354,405                                |      | 10,112,129                                |   |

 

SEE ACCOMPANYING NOTES.

 

9

----

 

**GLADSTONECAPITAL CORPORATION**

 

**CONSOLIDATEDSTATEMENTS OF STOCKHOLDERS’ EQUITY**

 

**(UNAUDITED)**

 
|                                                                 |   |       |   |   |   | **Capital in  Excess of  Par Value** |   | **Notes  Receivable  From Sale of  Common Stock** |   | **Under/(Over)  Distributed Net  Investment  Income** |             | **Realized  Gain on  Sale of  Investment** |   | **Unrealized  Appreciation/  (Depreciation)  of Investments** |   | **Total  Stockholders’  Equity** |         |
|----------------------------------------------------------------------|--------|------------|--------|--------|--------|--------------------------------------|--------|---------------------------------------------------|--------|-------------------------------------------------------|------------------|--------------------------------------------|--------|---------------------------------------------------------------|--------|---------------------------------------|--------------|
|                                                                 |   |       |
| **Common Stock**                                                     |
| **Shares**                                                           |   | **Amount** |
| For  the six months endedMarch 31, 2003:                        |   |       |   |   |   |                                 |   |                                              |   |                                                  |             |                                       |   |                                                          |   |                                  |         |
| Balance  at September 30, 2002                                  |   | 10,071,844 |   | $      | 10,072 |                                 | $      | 140,266,684                                       |   | $                                                     |  (8,983,796 | )                                          | $      |  (629,687                                                | )      | $                                     |  — |   | $ |  — |   | $ |  130,663,273 |   |
|                                                                 |   |       |   |   |   |                                 |   |                                              |   |                                                  |             |                                       |   |                                                          |   |                                  |         |
| Net  Increase in Stockholders’ Equity Resulting from Operations |   |       |   |   |   |                                 |   |                                              |   | 5,331,746                                             |             |                                       |   | 742,424                                                       |   | 6,074,170                             |         |
|                                                                 |   |       |   |   |   |                                 |   |                                              |   |                                                  |             |                                       |   |                                                          |   |                                  |         |
| Distributions  Declared ($0.48 per common share)                     |   |       |   |   |   |                                 |   |                                              |   | (4,834,485                                            | )                |                                       |   |                                                          |   | (4,834,485                            | )            |
|                                                                 |   |       |   |   |   |                                 |   |                                              |   |                                                  |             |                                       |   |                                                          |   |                                  |         |
| Balance  at March 31, 2003                                      |   | 10,071,844 |   | $      | 10,072 |                                 | $      | 140,266,684                                       |   | $                                                     | (8,983,796       | )                                          | $      | (132,426                                                      | )      | $                                     | —       |   | $ | 742,424 |   | $ | 131,902,958 |   |
|                                                                 |   |       |   |   |   |                                 |   |                                              |   |                                                  |             |                                       |   |                                                          |   |                                  |         |
| For  the six months ended March 31, 2004:                       |   |       |   |   |   |                                 |   |                                              |   |                                                  |             |                                       |   |                                                          |   |                                  |         |
| Balance  at September 30, 2003                                  |   | 10,081,844 |   | $      | 10,082 |                                 | $      | 140,416,674                                       |   | $                                                     | (8,985,940       | )                                          | $      | (416,094                                                      | )      | $                                     | —       |   | $ | (222,340 | ) | $ | 130,802,382 |   |
|                                                                 |   |       |   |   |   |                                 |   |                                              |   |                                                  |             |                                       |   |                                                          |   |                                  |         |
| Issuance  of Common Stock Under Stock Option Plan                    |   | 23,334     |   | 23     |   | 349,987                              |   | (350,010                                          | )      |                                                  |             |                                       |   |                                                          |   | —                                |         |
|                                                                 |   |       |   |   |   |                                 |   |                                              |   |                                                  |             |                                       |   |                                                          |   |                                  |         |
| Repayment  of Principal on Notes Receivable                          |   |       |   |   |   |                                 |   | 103,252                                           |   |                                                  |             |                                       |   |                                                          |   | 103,252                               |         |
|                                                                 |   |       |   |   |   |                                 |   |                                              |   |                                                  |             |                                       |   |                                                          |   |                                  |         |
| Shelf  Offering                                                      |   |       |   |   |   | (43,598                              | )      |                                              |   |                                                  |             |                                       |   |                                                          |   | (43,598                               | )            |
|                                                                 |   |       |   |   |   |                                 |   |                                              |   |                                                  |             |                                       |   |                                                          |   |                                  |         |
| Net  Increase in Stockholders’ Equity Resulting from Operations |   |       |   |   |   |                                 |   |                                              |   | 6,060,194                                             |             | 12,500                                     |   | (1,863,037                                                    | )      | 4,209,657                             |         |
|                                                                 |   |       |   |   |   |                                 |   |                                              |   |                                                  |             |                                       |   |                                                          |   |                                  |         |
| Distributions  Declared ($0.66 per common share)                     |   |       |   |   |   |                                 |   |                                              |   | (6,656,584                                            | )                |                                       |   |                                                          |   | (6,656,584                            | )            |
|                                                                 |   |       |   |   |   |                                 |   |                                              |   |                                                  |             |                                       |   |                                                          |   |                                  |         |
| Balance  at March 31, 2004                                      |   | 10,105,178 |   | $      | 10,105 |                                 | $      | 140,723,063                                       |   | $                                                     | (9,232,698       | )                                          | $      | (1,012,484                                                    | )      | $                                     | 12,500       |   | $ | (2,085,377 | ) | $ | 128,415,109 |   |

 

SEE ACCOMPANYING NOTES.

 

10

----

 

**GLADSTONECAPITAL CORPORATION**

 

**CONSOLIDATEDSTATEMENT OF CASH FLOWS**

 

**(UNAUDITED)**

 
|                                                                                                                                                              |   | **Six Months  Ended  March 31, 2004** |        | **Six Months  Ended  March 31, 2003** |   |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|--------------------------------------------|-------------|--------------------------------------------|--------|
| **CASH  FLOWS FROM OPERATING ACTIVITIES**                                                                                                                         |   |                                       |        |                                       |   |
| Net increase in  stockholders’ equity resulting from operations                                                                                              |   | $                                          | 4,209,657   |                                       | $      | 6,074,170 |   |
| Adjustments to  reconcile net increase (decrease) in stockholders’ equity resulting from  operations to net cash provided by (used in) operating activities: |   |                                       |        |                                       |   |
| Depreciation                                                                                                                                                      |   | 14,438                                     |        | 13,791                                     |   |
| Change in net  unrealized depreciation (appreciation)                                                                                                             |   | 1,863,037                                  |        | (742,424                                   | )      |
| Increase in  interest receivable                                                                                                                                  |   | (228,868                                   | )           | (253,946                                   | )      |
| Decrease in  funds due from custodian                                                                                                                             |   | 982,000                                    |        | —                                     |   |
| Increase in  other assets                                                                                                                                         |   | (750,918                                   | )           | (121,559                                   | )      |
| Decrease in  prepaid assets                                                                                                                                       |   | 27,949                                     |        | 45,790                                     |   |
| Increase in  accounts payable                                                                                                                                     |   | 63,548                                     |        | —                                     |   |
| Increase in  accrued expenses and deferred liabilities                                                                                                            |   | 219,141                                    |        | 770,601                                    |   |
| Increase in  investment balance due to payment in kind interest                                                                                                   |   | (275,316                                   | )           | (426,122                                   | )      |
| Net Cash  Provided by Operating Activities                                                                                                                        |   | $                                          | 6,124,668   |                                       | $      | 5,360,301 |   |
|                                                                                                                                                              |   |                                       |        |                                       |   |
| **CASH  FLOWS FROM INVESTING ACTIVITIES**                                                                                                                         |   |                                       |        |                                       |   |
| Purchase of  furniture and equipment, net                                                                                                                         |   | $                                          | (4,558      | )                                          | $      | (54,115 | ) |
| Purchase of  investments                                                                                                                                          |   | (36,000,000                                | )           | (21,500,000                                | )      |
| Principal  repayments on investments                                                                                                                              |   | 5,178,541                                  |        | 350,000                                    |   |
| Proceeds from  repurchase agreements                                                                                                                              |   | 186,206,000                                |        | 102,915,974                                |   |
| Repayment of  repurchase agreements                                                                                                                               |   | (171,550,000                               | )           | (78,404,416                                | )      |
| Receipt of  principal on notes receivable – officers                                                                                                         |   | 103,252                                    |        | —                                     |   |
| Net Cash  Provided by (Used in) Investing Activities                                                                                                              |   | $                                          | (16,066,765 | )                                          | $      | 3,307,443 |   |
|                                                                                                                                                              |   |                                       |        |                                       |   |
| **CASH  FLOWS FROM FINANCING ACTIVITIES**                                                                                                                         |   |                                       |        |                                       |   |
|                                                                                                                                                              |   |                                       |        |                                       |   |
| Prepaid  financing fees                                                                                                                                           |   | $                                          | 117,329     |                                       | $      | — |   |
| Increase in  borrowings from the line of credit                                                                                                                   |   | 20,500,000                                 |        | —                                     |   |
| Shelf offering                                                                                                                                                    |   | (43,598                                    | )           | —                                     |   |
| Distributions  paid                                                                                                                                               |   | (9,983,593                                 | )           | (4,431,613                                 | )      |
| Net Cash  Provided by (Used in) Financing Activities                                                                                                              |   | $                                          | 10,590,138  |                                       | $      | (4,431,613 | ) |
|                                                                                                                                                              |   |                                       |        |                                       |   |
| **NET  INCREASE IN CASH AND CASH EQUIVALENTS**                                                                                                                    |   | $                                          | 648,041     |                                       | $      | 4,236,131 |   |
|                                                                                                                                                              |   |                                       |        |                                       |   |
| **CASH  AND CASH EQUIVALENTS, BEGINNING OF PERIOD**                                                                                                               |   | $                                          | 101,166,221 |                                       | $      | 91,929,328 |   |
|                                                                                                                                                              |   |                                       |        |                                       |   |
| **CASH  AND CASH EQUIVALENTS, END OF PERIOD (Note 8)**                                                                                                            |   | $                                          | 101,814,262 |                                       | $      | 96,165,459 |   |
|                                                                                                                                                              |   |                                       |        |                                       |   |
| **NON-CASH  FINANCING ACTIVITIES**                                                                                                                                |   |                                       |        |                                       |   |
| Notes receivable  issued in exchange for common stock associated with the exercise of employee  stock options                                                     |   | $                                          | 350,010     |                                       | $      | — |   |

 

SEE ACCOMPANYING NOTES.

 

11

----

 

**GLADSTONECAPITAL CORPORATION**

 

**FINANCIAL HIGHLIGHTS**

 

**(UNAUDITED)**

 
|                                                               |   | **Three Months Ended  March 31, 2004** |        | **Three Months Ended  March 31, 2003** |   |
|--------------------------------------------------------------------|--------|---------------------------------------------|-------------|---------------------------------------------|--------|
| Per Share Data(1)                                                  |   |                                        |        |                                        |   |
| Net asset value  at beginning of period                            |   | $                                           | 12.79       |                                        | $      | 12.98 |   |
| Net investment  income                                             |   | 0.31                                        |        | 0.29                                        |   |
| Realized gain on  sale of investment                               |   | —                                      |        | —                                      |   |
| Net unrealized  (loss)/gain on investments                         |   | (0.03                                       | )           | 0.07                                        |   |
| Issuance of  common stock under stock option plan                  |   | (0.03                                       | )           | —                                      |   |
| Distributions  from net investment income                          |   | (0.33                                       | )           | (0.25                                       | )      |
| Repayment of  principal on notes receivable                        |   | —                                      |        | —                                      |   |
| Net asset value  at end of period                                  |   | $                                           | 12.71       |                                        | $      | 13.09 |   |
|                                                               |   |                                        |        |                                        |   |
| Per share market  value at beginning of period                     |   | $                                           | 22.35       |                                        | $      | 16.47 |   |
| Per share market  value at end of period                           |   | 22.41                                       |        | 16.18                                       |   |
| Total  Return(2)(3)                                                |   | 1.76                                        | %           | -0.24                                       | %      |
| Shares  outstanding at end of period                               |   | 10,105,178                                  |        | 10,071,844                                  |   |
|                                                               |   |                                        |        |                                        |   |
| Ratios/Supplemental  Data                                          |   |                                        |        |                                        |   |
| Net assets at  end of period                                       |   | $                                           | 128,415,109 |                                        | $      | 131,902,958 |   |
| Average net  assets                                                |   | 127,521,641                                 |        | 132,125,265                                 |   |
| Ratio of  expenses to average net assets - annualized              |   | 3.87                                        | %           | 2.85                                        | %      |
| Ratio of net  investment income to average net assets - annualized |   | 9.68                                        | %           | 11.09                                       | %      |

 
|                                                               |   | **Six Months Ended  March 31, 2004** |        | **Six Months Ended  March 31, 2003** |   |
|--------------------------------------------------------------------|--------|-------------------------------------------|-------------|-------------------------------------------|--------|
| Per Share  Data(1)                                                 |   |                                      |        |                                      |   |
| Net asset value  at beginning of period                            |   | $                                         | 12.97       |                                      | $      | 12.97 |   |
| Net investment  income                                             |   | 0.60                                      |        | 0.53                                      |   |
| Realized gain on  sale of investment                               |   | —                                    |        | —                                    |   |
| Net unrealized  (loss)/gain on investments                         |   | (0.18                                     | )           | 0.07                                      |   |
| Issuance of  common stock under stock option plan                  |   | (0.03                                     | )           | —                                    |   |
| Distributions  from net investment income                          |   | (0.66                                     | )           | (0.48                                     | )      |
| Repayment of  principal on notes receivable                        |   | 0.01                                      |        | —                                    |   |
| Net asset value  at end of period                                  |   | $                                         | 12.71       |                                      | $      | 13.09 |   |
|                                                               |   |                                      |        |                                      |   |
| Per share market  value at beginning of period                     |   | $                                         | 19.45       |                                      | $      | 16.88 |   |
| Per share market  value at end of period                           |   | 22.41                                     |        | 16.18                                     |   |
| Total  Return(2)(3)                                                |   | 18.76                                     | %           | -1.30                                     | %      |
| Shares  outstanding at end of period                               |   | 10,105,178                                |        | 10,071,844                                |   |
|                                                               |   |                                      |        |                                      |   |
| Ratios/Supplemental  Data                                          |   |                                      |        |                                      |   |
| Net assets at  end of period                                       |   | $                                         | 128,415,109 |                                      | $      | 131,902,958 |   |
| Average net  assets                                                |   | 128,261,840                               |        | 131,844,204                               |   |
| Ratio of  expenses to average net assets - annualized              |   | 3.55                                      | %           | 2.67                                      | %      |
| Ratio of net  investment income to average net assets - annualized |   | 9.45                                      | %           | 9.21                                      | %      |

 

----

(1)          Basic per share data.

(2)          Amounts were not annualized for the results of the three andsix-month periods ended March 31, 2004 and March 31, 2003.

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

 

SEE ACCOMPANYING NOTES**.**

 

12

----

 

**GLADSTONECAPITAL CORPORATION**

 

**NOTESTO CONSOLIDATED FINANCIAL STATEMENTS**

 

**MARCH 31,2004**

 

**(UNAUDITED)**

 

NOTE 1. UNAUDITED INTERIMFINANCIAL STATEMENTS

 

Interim financialstatements of Gladstone Capital Corporation (the “Company”) are prepared inaccordance with generally accepted accounting principles (“GAAP”) for interimfinancial information and pursuant to the requirements for reporting on Form10-Q and Article 10 of Regulation S-X. Accordingly, certain disclosures accompanying annual financialstatements prepared in accordance with GAAP are omitted.  In the opinion of management, alladjustments, consisting solely of normal recurring accruals, necessary for thefair statement of financial statements for the interim periods have beenincluded.  The current period’s resultsof operations are not necessarily indicative of results that ultimately may beachieved for the year.  The interimfinancial statements and notes thereto should be read in conjunction with thefinancial statements and notes thereto included in the Company’s Form 10-K forthe fiscal year ended September 30, 2003, as filed with the Securities andExchange Commission.

 

NOTE 2. ORGANIZATION

 

The Company wasincorporated under the General Corporation Laws of the State of Maryland on May30, 2001 as a closed-end investment company. The Company has elected to be treated as a business development company,or BDC, under the Investment Company Act of 1940, as amended (the “1940Act”).  In addition, the Company haselected to be treated for tax purposes as a regulated investment company, orRIC, under the Internal Revenue Code of 1986, as amended (the “Code”).  The Company’s investment objectives are toachieve a high level of current income by investing in debt and equitysecurities of established private businesses.

 

Gladstone CapitalAdvisers, Inc., a wholly-owned subsidiary of the Company, conducts the dailyadministrative operations of the Company. The financial statements of this subsidiary are consolidated with thoseof the Company.

 

Gladstone Business LoanLLC, a wholly-owned subsidiary of the Company, was established onFebruary 3, 2003 for the purpose of owning the Company’s portfolio of loaninvestments.  The financial statementsof the subsidiary are consolidated with those of the Company.

 

13

----

 

NOTE 3. STOCK OPTIONS

 

The following tables setforth the pro-forma effect of fair value option accounting for the three andsix months ended March 31, 2004 and March 31, 2003 in accordance withStatement of Financial Accounting Standards (SFAS) Statement No. 148“Accounting for Stock-Based Compensation – Transition and Disclosure”.

 
|                                                                                                             |   | **Three  Months Ended  March 31, 2004** |      | **Three  Months Ended  March 31, 2003** |   |
|------------------------------------------------------------------------------------------------------------------|--------|----------------------------------------------|-----------|----------------------------------------------|--------|
|                                                                                                             |   |                                         |      |                                         |   |
| Increase in stockholders’  equity from operations, as reported                                              |   | $                                            | 2,828,583 |                                         | $      | 3,662,015 |   |
|                                                                                                             |   |                                         |      |                                         |   |
| Deduct:  total stock-based employee compensation  expense determined under fair value method for all awards |   | (406,271                                     | )         | (157,720                                     | )      |
|                                                                                                             |   |                                         |      |                                         |   |
| Pro-forma increase in stockholders’ equity from operations                                                  |   | $                                            | 2,422,312 |                                         | $      | 3,504,295 |   |
|                                                                                                             |   |                                         |      |                                         |   |
| Increase in stockholders’  equity from operations per share                                                 |   |                                         |      |                                         |   |
| Basic, as reported                                                                                               |   | $                                            | 0.28      |                                         | $      | 0.36 |   |
| Basic, pro-forma                                                                                                 |   | $                                            | 0.24      |                                         | $      | 0.35 |   |
|                                                                                                             |   |                                         |      |                                         |   |
| Diluted, as reported                                                                                             |   | $                                            | 0.27      |                                         | $      | 0.36 |   |
| Diluted, pro-forma                                                                                               |   | $                                            | 0.23      |                                         | $      | 0.35 |   |

 
|                                                                                                             |   | **Six Months  Ended  March 31, 2004** |      | **Six Months  Ended  March 31, 2003** |   |
|------------------------------------------------------------------------------------------------------------------|--------|--------------------------------------------|-----------|--------------------------------------------|--------|
|                                                                                                             |   |                                       |      |                                       |   |
| Increase in stockholders’  equity from operations, as reported                                              |   | $                                          | 4,209,657 |                                       | $      | 6,074,170 |   |
|                                                                                                             |   |                                       |      |                                       |   |
| Deduct:  total stock-based employee compensation  expense determined under fair value method for all awards |   | (810,301                                   | )         | (315,441                                   | )      |
|                                                                                                             |   |                                       |      |                                       |   |
| Pro-forma increase in stockholders’ equity from operations                                                  |   | $                                          | 3,399,356 |                                       | $      | 5,758,729 |   |
|                                                                                                             |   |                                       |      |                                       |   |
| Increase in stockholders’  equity from operations per share                                                 |   |                                       |      |                                       |   |
| Basic, as reported                                                                                               |   | $                                          | 0.42      |                                       | $      | 0.60 |   |
| Basic, pro-forma                                                                                                 |   | $                                          | 0.34      |                                       | $      | 0.57 |   |
|                                                                                                             |   |                                       |      |                                       |   |
| Diluted, as reported                                                                                             |   | $                                          | 0.41      |                                       | $      | 0.60 |   |
| Diluted, pro-forma                                                                                               |   | $                                          | 0.33      |                                       | $      | 0.57 |   |

 

14

----

 

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 and six months endedMarch 31, 2004 and March 31, 2003:

 
|                                                                                                            |   | **Three  Months Ended  March 31, 2004** |      | **Three  Months Ended  March 31, 2003** |   |
|-----------------------------------------------------------------------------------------------------------------|--------|----------------------------------------------|-----------|----------------------------------------------|--------|
|                                                                                                            |   |                                         |      |                                         |   |
| Numerator for basic and  diluted net increase in stockholders’ equity resulting from operations per  share |   | $                                            | 2,828,583 |                                         | $      | 3,662,015 |   |
|                                                                                                            |   |                                         |      |                                         |   |
| Denominator for basic  weighted average shares                                                                  |   | 10,087,615                                   |      | 10,071,844                                   |   |
|                                                                                                            |   |                                         |      |                                         |   |
| Dilutive potential shares                                                                                       |   | 287,666                                      |      | 28,218                                       |   |
|                                                                                                            |   |                                         |      |                                         |   |
| Denominator for diluted  weighted average shares                                                                |   | 10,375,281                                   |      | 10,100,062                                   |   |
|                                                                                                            |   |                                         |      |                                         |   |
| Employee stock options                                                                                          |   | 1,040,830                                    |      | 931,664                                      |   |
|                                                                                                            |   |                                         |      |                                         |   |
| Basic net increase in  stockholders’ equity resulting from operations per common share                     |   | 0.28                                         |      | 0.36                                         |   |
| Diluted net increase in stockholders’  equity resulting from operations per common share                   |   | 0.27                                         |      | 0.36                                         |   |
|                                                                                                                 |        |                                              |           |                                              |        |  |  |

 
|                                                                                                            |   | **Six Months  Ended  March 31, 2004** |      | **Six Months  Ended  March 31, 2003** |   |
|-----------------------------------------------------------------------------------------------------------------|--------|--------------------------------------------|-----------|--------------------------------------------|--------|
|                                                                                                            |   |                                       |      |                                       |   |
| Numerator for basic and  diluted net increase in stockholders’ equity resulting from operations per  share |   | $                                          | 4,209,657 |                                       | $      | 6,074,170 |   |
|                                                                                                            |   |                                       |      |                                       |   |
| Denominator for basic  weighted average shares                                                                  |   | 10,084,729                                 |      | 10,071,844                                 |   |
|                                                                                                            |   |                                       |      |                                       |   |
| Dilutive potential shares                                                                                       |   | 269,676                                    |      | 40,285                                     |   |
|                                                                                                            |   |                                       |      |                                       |   |
| Denominator for diluted  weighted average shares                                                                |   | 10,354,405                                 |      | 10,112,129                                 |   |
|                                                                                                            |   |                                       |      |                                       |   |
| Employee stock options                                                                                          |   | 1,040,830                                  |      | 931,664                                    |   |
|                                                                                                            |   |                                       |      |                                       |   |
| Basic net increase in  stockholders’ equity resulting from operations per common share                     |   | 0.42                                       |      | 0.60                                       |   |
| Diluted net increase in  stockholders’ equity resulting from operations per common share                   |   | 0.41                                       |      | 0.60                                       |   |
|                                                                                                                 |        |                                            |           |                                            |        |  |  |

 

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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 as a dividend up to100% of those amounts.  The amount to bepaid out as a dividend is determined by the Board of Directors each quarter andis based on the annual earnings estimated by the management of theCompany.  Based on that estimate, adividend is declared each quarter.  Atyear-end the Company may pay a bonus dividend, in addition to the quarterlydividends, to ensure that it has paid out at least 90% of its ordinary incomeand short-term capital gains for the year. The Company has a policy of retaining long-term capital gains, if any,and not paying them out as dividends. Effective October 31, 2003, the Company began paying a monthlydividend.  The following tableillustrates the 2004 fiscal year monthly dividends per share and the 2003quarterly dividend per share for the six months ended March 31:

 
| **Record Date**     |   | **Payment Date**    |   | **Dividend per  Share** |   | **Monthly  or  Quarterly** |
|---------------------|--------|---------------------|--------|-------------------------|--------|----------------------------|
| 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 |
|                |   |                |   |                    |   |                       |
| Sept. 30, 2003      |   | Oct.  6, 2003       |   | $                       | 0.33   |                       | Quarterly |
| June 30, 2003  |   | July 7,  2003  |   | $                       | 0.29   |                       | Quarterly |
| March 31, 2003 |   | April 7,  2003 |   | $                       | 0.25   |                       | Quarterly |
| Dec. 31, 2002       |   | Jan  7, 2003        |   | $                       | 0.23   |                       | Quarterly |

 

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.  Debt and equity securities that are not publicly traded arevalued at fair value as determined in good faith by the Board of Directors.Beginning in March 2003, the Company engaged Standard & Poor’s LoanEvaluation Service (S&P) to perform independent valuations of itsinvestments.  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 of Directors valuesnon-convertible debt securities at cost plus amortized original issue discountplus PIK interest, if any, unless adverse factors lead to a determination of alesser valuation.  In valuingconvertible debt, equity, success fees or other equity like securities, theBoard of Directors determines the fair value based on the collateral, theissuer’s ability to make payments, the earnings of the issuer, sales to thirdparties of similar securities, the comparison to publicly traded securities,discounted cash flow and other pertinent factors.  Due to the uncertainty inherent in the valuation process, suchestimates of fair value may differ significantly from the values that wouldhave resulted had a ready market for the securities existed, and thedifferences could be material. Additionally, changes in the market environmentand other events that may occur over the life of the investments may cause thegains ultimately realized on these investments to be different than thevaluation currently assigned.  Becausethere is a lag between when we close a loan and when the loan can be evaluatedby S&P, new loans are not valued immediately by S&P; rather, the Boardmakes its own determination about the value of the loan in accordance with ourvaluation policy.  Because S&P doesnot provide values for mortgage loans or equity securities, the directors alsodetermine fair value of these.

 

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NOTE 7. LOAN ANDMANAGERIAL ASSISTANCE FEES

 

The 1940 Act requiresthat a business development company make available managerial assistance to itsportfolio companies.  The Companyprovides managerial assistance to its portfolio companies through itswholly-owned subsidiary, Gladstone Capital Advisers, Inc.  The Company receives fee income formanagerial assistance it renders to portfolio companies in connection with itsinvestments.  Such fees are normallypaid at the closing of the Company’s investments and are generallynon-recurring.  These managerialassistance services vary by investment, but generally consist of reviewingexisting credit facilities, arranging bank financing, arranging equity financing,structuring financing from multiple lenders, structuring financing from equityinvestors, restructuring existing loans, raising equity and debt capital, andproviding general financial advice.  Forthe three and six months ended March 31, 2004 these fees totaledapproximately $356,000 and $611,000, respectively, and for the three and sixmonths ended March 31, 2003, these fees totaled $358,000.

 

From time to time, theCompany will be invited to participate as a co-lender in a transaction.  Where the Company does not providesignificant managerial assistance services in connection with its investment,loan fees paid to the Company in such situations will be deferred and amortizedover the life of the loan.

 

NOTE 8. PAYMENT IN KINDINTEREST

 

The Company has loans inits portfolio, which 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’sstatus as a RIC (as discussed in Note 5, above), this non-cash source of incomemust be paid out to stockholders in the form of dividends, even though theCompany has not yet collected the cash. For the three and six months endedMarch 31, 2004, the Company recorded PIK income of $137,862 and $276,405,respectively, and for the three and six months ended March 31, 2003, theCompany recorded PIK income of $223,754 and $435,076, respectively.  At March 31, 2004 andSeptember 30, 2003 the Company had accrued on its balance sheet, a totalin PIK income of $887,890 and $608,572 respectively.  The Company does not have any original issue discount income.

 

NOTE 9. 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.

 

On March 31, 2004,the Company entered into a Repurchase Agreement with UBS Paine Webber for$93,105,000, which agreement was settled on April 1, 2004.  The Repurchase Agreement was recorded atcost and was fully collateralized by a United States Treasury Bill with a fairvalue of $95,025,000 and a carrying value of $95,004,939 that matured onApril 8, 2004.  The interest rateon the Repurchase Agreement was 0.92%. On September 30, 2003, the Company entered into a RepurchaseAgreement with UBS for $78,449,000, which agreement was settled onOctober 1, 2003.  The RepurchaseAgreement was recorded at cost and was fully collateralized by a United StatesTreasury Bill with a fair value of $80,050,000 and a carrying value of$80,022,249 that matured on October 16, 2003.  The interest rate on the Repurchase Agreement was 0.80%.

 

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NOTE 10. CONTRACTUALOBLIGATIONS

 

The Company occupies itsMcLean, Virginia office space pursuant to a license agreement scheduled toexpire on October 31, 2004.  TheCompany’s New York City office facility has a service agreement scheduled to expireAugust 31, 2004.  The futurescheduled payments are as follows:

 
|                         |   | **Payment  due by period** |    |
|------------------------------|--------|----------------------------|---------|
| **Contractual  Obligations** |   | **Total**                  |    | **Less than  1  year** |   | **1-3  years** |   | **3-5  years** |   | **More than  5  years** |   |
| Office Lease Obligations     |   | $                          | 113,473 |   | $ | 113,473 |   | — |   | — |   | — |   |
| **Total**                    |   | $                          | 113,473 |   | $ | 113,473 |   | — |   | — |   | — |   |

 

NOTE 11. INTEREST RATECAP AGREEMENT

 

Pursuant to ourline of credit, we have agreed to enter into hedging transactions, and as suchhave purchased an interest rate cap agreement in February 2004 as a resultof our borrowing under the line of credit. The transaction will effectively limit the interest rate on a portion ofour borrowings.

 

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

 

InFebruary 2004, the Company entered into a cap agreement at a cost of$304,000 which is recorded in other assets on the Company’s consolidatedbalance sheet at March 31, 2004. The agreement provides that the Company’s floating interest rate or costof funds on a portion of the portfolio’s borrowings will be capped at 5% whenthe LIBOR rate is in excess of 5%.

 

NOTE 12. DEFERREDCOMPENSATION PLAN

 

The Company has adopted adeferred compensation plan (the “Plan”) effective January 1, 2002.  The Plan permits an employee to defer thelesser of 75% of his or her total compensation or the applicable InternalRevenue Service (“IRS”) limit.  Theemployees are eligible to participate in the Plan upon completion of 1,000hours of service within the first six months of employment or after one year ofservice.  The service requirement iswaived for those employees who were employed as of January 1, 2002.    The Company has funded $23,987 incontributions to the Plan that were accrued in the fiscal year endedSeptember 30, 2003.  The Companyhas received a determination letter from the IRS concurring that the deferredcompensation plan satisfies the qualification requirements of the Code.

 

NOTE 13. SUBSEQUENTEVENTS

 

In April 2004, the Company sold $4.6 million of its principalinterests in Gammill, Inc.  TheCompany’s remaining investments in Gammill, subsequent to the sale, are $4.963million and $4.75 million, or a total of $9.713 million.

 

Also, in April 2004, Wingstop Restaurants International, Inc.repaid its entire $5.5 million outstanding loan obligations for full settlementof any further obligations and remitted the related prepayment fees and successfee upon termination.

 

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**ITEM 2. MANAGEMENT’S****DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTSOF OPERATIONS.**

 

**All statements contained herein, other thanhistorical facts, may constitute “forward-looking statements” within themeaning of Section 27A of the Securities Act of 1933, as amended, andSection 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” orthe negative of such terms or comparable terminology. These forward-lookingstatements involve known and unknown risks, uncertainties and other factorsthat may cause our actual results, levels of activity, performance orachievements to be materially different from any future results, levels ofactivity, performance or achievements expressed or implied by suchforward-looking statements. Such factors include, among others: (1) adversechanges in interest rates; (2) our failure or inability to establish ormaintain referral arrangements with leveraged buyout funds and venture capitalfunds to generate loan opportunities; (3) the loss of one or more of ourexecutive officers, in particular David Gladstone or Terry Lee Brubaker; (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 11, 2003. We caution readers not to place undue reliance on anysuch forward-looking statements, which are made pursuant to the PrivateSecurities Litigation Reform Act of 1995 and, as such, speak only as of thedate made. We undertake no obligation to publicly update or revise anyforward-looking statements, whether as a result of new information, futureevents or otherwise, after the date of this Form 10-Q**.

 

*The following analysis of our financialcondition and results of operations should be read in conjunction with ourfinancial statements and the notes thereto contained elsewhere in this report.*

 

**OVERVIEW**

 

We were incorporated under the General Corporation Laws of the State ofMaryland on May 30, 2001. Our investment objectives are to achieve a high levelof current income by investing in debt securities, consisting primarily ofsenior notes, senior subordinated notes and junior subordinated notes, ofestablished private businesses that are backed by leveraged buyout funds,venture capital funds or others, with a particular emphasis on seniorsubordinated notes.  In addition, we mayacquire existing loans, which meet this profile, from leveraged buyout funds,venture capital funds and others. We also seek to provide our stockholders withlong-term capital growth through the appreciation in the value of warrants, orother equity instruments that we may receive when we extend loans. We operateas a closed-end, non-diversified management investment company, and haveelected to be treated as a business development company under the 1940 Act.

 

We seek out small and medium-sized businesses that meet certaincriteria, including (1) the potential for growth in cash flow, (2) adequateassets for loan collateral, (3) experienced management teams with a significantownership interest in the borrower, (4) profitable operations based on theborrower’s cash flow, (5) reasonable capitalization of the borrower (usually byleveraged buyout funds or venture capital funds) and (6) the potential torealize appreciation and gain liquidity in our equity position, if any. Weanticipate that liquidity in our equity position will be achieved through amerger or acquisition of the borrower, a public offering by the borrower or byexercise of our right to require the borrower to buy back its warrants. We lendto borrowers that need funds to finance growth, restructure their balancesheets or effect a change of control.

 

Our loans typically range from $5 million to $15 million, mature in nomore than seven years and accrue interest at a fixed or variable rate thatexceeds the prime rate. A number of our loans have a provision that calls forsome portion of the interest payments to be deferred and added to the principalbalance so that the interest is paid, together with the principal, at maturity.This form of deferred interest is often called “paid-in-kind” or “PIK”interest, and, when earned, we record PIK interest as interest income and addthe PIK interest to the principal balance of the loans. The amount of PIK interestaccrued and on our books as of March 31, 2004 was approximately $888,000.

 

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

 

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

 

In addition, as a business development company under the 1940 Act, weare required to make available significant managerial assistance to ourportfolio companies. We provide these services, for which we receive fees,through our wholly owned subsidiary, Gladstone Capital Advisers, Inc. Such feesare typically paid in part at the time a prospective portfolio company signs anon-binding term sheet with us, with the remainder paid at the closing of theinvestments. These fees are generally non-recurring, however in some instancesthey may have a recurring component. The specific services we provide vary byportfolio company, but generally consist of reviewing existing creditfacilities, arranging bank financing, arranging equity financing, structuringfinancing from multiple lenders, structuring financing from equity investors,restructuring existing loans, raising equity and debt capital and providinggeneral financial advice. We record these fees as managerial assistance feerevenue in the period in which the fees are earned.

 

Our business plan has historically called for managerial assistance feerevenue to equal or exceed our operating expenses (excluding interest expense).However, during the quarters ended March 31, 2004, and March 31,2003, operating expenses (excluding interest expense) exceeded managerialassistance fee revenue by approximately $866,000 and $582,000, respectively,and $1.6 million and $1.4 million for the six months ended March 31, 2004and March 31, 2003, respectively. Because we typically generate managerial assistance fee revenue onlywhen we make new loans, our relatively slow pace of loans during the 2003 and2002 fiscal years and the start of fiscal year 2004 led to this shortfall.

 

Prior to making an investment, we ordinarily enter into a non-bindingterm sheet with the potential borrower. These non-binding term sheets aregenerally subject to a number of conditions, including but not limited to thesatisfactory completion of our due diligence investigations of the potentialborrower’s business and reaching agreement on the legal documentation for theloan. Typically, upon execution of the non-binding term sheet, the potentialborrower pays us a non-refundable fee for our services rendered through thedate of the non-binding term sheet. We have historically recognized this asmanagement fee revenue upon execution of the non-binding term sheet.  Following the externalization of ourmanagement, these services will be provided by Gladstone Management, which willreceive substantially all of the fees associated with these services.  In the future, we may provide certainservices to our portfolio companies in addition to those provided by GladstoneManagement, for which we may receive fees.

 

In the event that we expend significant effort in considering andnegotiating a potential investment that ultimately is not consummated, wegenerally will seek reimbursement from the proposed borrower for our reasonableexpenses incurred in connection with the proposed transaction. Any amountscollected are recognized as “other income” in the quarter in which suchreimbursement is received. Also, in the event that we have incurred significantlegal fees in connection with the transaction, we will typically also seekreimbursement for these expenses from the proposed borrower.   Following our engagement of GladstoneManagement, any amounts colle4cted for expenses incurred by GladstoneManagement in connection with unconsummated investments will be reimbursed toGladstone Management.  Amounts collectedfor these expenses incurred by us will continue to be reimbursed to us.However, there can be no guarantee that we will be successful in collecting anysuch reimbursements.

 

The only significant continuing revenue associated with the investmentswe have already closed is interest income and, potentially, capital gainsrealized in connection with the liquidation of any associated equity interest(e.g., warrants). While in some instances we may also receive on-going managerialassistance fee revenue in connection with a consummated investment, any suchamounts have been, and in the future are expected to be, insignificant.

 

The general economic climate during the quarter and six months endedMarch 31, 2004 and the previous fiscal year ended September 30, 2003was unfavorable.  Many businesses sawtheir sales and business prospects decline during the year.  Consequently, many of these companies wereforced to lay off employees and engage in other cost cutting measures.  As a result of the difficult businessclimate, we determined it prudent to proceed cautiously in making loans duringthese periods.  Since our initial publicoffering in August 2001, we have made 28different loans to, or investments in, 17****companies for a total of approximately $168.9****million (including the maximum aggregateamount outstanding under an $8 million line of credit in favor of one of ourportfolio companies, that has subsequently been retired). In the fourth quarterof the 2002 fiscal year, one of our investments, including all

 

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amountsoutstanding under a $7 million senior term loan and an $8 million senior lineof credit, was repaid in full.  Duringthe six months ended March 31, 2004, one company paid in full itsoutstanding loan balance of $900,000 and we entered into new loans with fourcompanies, in the aggregate amount of $36.0 million.

 

In spite of the economic environment, we are earnestly working towardthe consummation of more investments. These prospective loans are subject to,among other things, the satisfactory completion of our due diligenceinvestigation of each borrower, acceptance of terms and structure and necessaryconsents. With respect to each prospective loan, we will only agree to providethe 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 can not 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.

 

In July 2003, we entered into an expense sharing arrangement withGladstone Management Corporation (“Gladstone Management”), a registeredinvestment adviser that serves as the external adviser to Gladstone CommercialCorporation, a real estate investment trust affiliated with us. Under thisexpense sharing arrangement, Gladstone Management reimburses Gladstone CapitalAdvisers for a portion of our total payroll and benefits expenses (based on thepercentage of total hours worked by each employee on Gladstone Commercialmatters). Gladstone Management also reimburses Gladstone Capital Advisers forits pro rata portion of all other general expenses (based on the percentage oftotal hours worked by all employees on Gladstone Commercial matters). GladstoneManagement further passes its share of these expenses along to GladstoneCommercial under a separate advisory agreement. As a result of this expensesharing arrangement, certain of our expenses declined during the quarter endedMarch 31, 2004. The actual amountof our expenses in future periods will depend upon the relative time that ourpersonnel spend on our and Gladstone Commercial matters.   In the near term, we expect to hireadditional personnel that will devote a substantial portion of their time toour matters, resulting in an increase in our expenses as compared to thequarter ended March 31, 2004.  Weexpect these expenses to continue to increase in subsequent periods until theexternalization of our management as described below. **  **Followingour engagement of Gladstone Management, Gladstone Management will pay itspayroll, benefits, and general expenses directly.  Thus, the expense sharing arrangement between Gladstone CapitalAdvisers and Gladstone Management will terminate upon the externalization of ourmanagement.

 

At our 2004 annual meeting of stockholders our stockholders approved aproposal to enter into an advisory agreement with Gladstone Management, wherebywe would pay Gladstone Management an annual advisory fee of 1.25% of our totalassets (as reduced by cash and cash equivalents pledged to creditors), payablein quarterly increments of 0.3125%, and an annual administrative fee of 0.75%of our total assets (as reduced by cash and cash equivalents pledged tocreditors), payable in quarterly increments of 0.1875%. We would continue topay direct expenses including, but not limited to, directors fees, legal andaccounting fees, and stockholder related expenses.  Under the proposed advisory agreement, Gladstone Management willalso provide the managerial assistance services that we have historically madeavailable to our portfolio companies, and will receive substantially all of thefees associated with such services.   Inthe future, we may provide certain services to our portfolio companies in additionto those provided by Gladstone Management, for which we may receive fees.  While we expect to engage GladstoneManagement later in fiscal year 2004, we cannot determine with certainty whenthis engagement will take effect.

 

**CriticalAccounting Policies**

 

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

 

**InvestmentValuation**

 

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

 

We value our investment portfolio each quarter. Members of ourportfolio management team prepare the portfolio company valuations using themost recent portfolio company financial statements and forecasts.  These individuals also consult with therespective principal who originated the portfolio investment to obtain furtherupdates on the portfolio company’s performance, including information such asindustry trends, new product development, and other operational issues.  As of March 31, 2003, we engagedStandard & Poor’s Loan Evaluation Service (S&P) to help evaluate thevalue of the majority of our loan securities. Since June 30, 2003, our S&P engagement includes evaluations onexit fees (conditional interest included in some loan securities).  We and S&P only evaluate the value

 

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of an exit fee ifthe probability of receiving the exit fee on a given loan is above 6-8%, athreshold of significance, in which case a value is assigned.  Upon completing the data collection, thevaluation data is presented to S&P. S&P makes its independent assessment of the data and assesses itsown data to determine market values for the securities.  With regard to its work, S&P has issuedthe following paragraph:

 

S&P provides evaluated price opinions which are reflective of whatS&P believes the bid side of the market would be for each loan aftercareful review and analysis of descriptive, market and credit information.  Each price reflects S&P’s best judgmentbased upon careful examination of a variety of market factors.  Because of fluctuation in the market and inother factors beyond its control, S&P cannot guarantee theseevaluations.  The evaluations reflectthe market prices, or estimate thereof, on the date specified.  The prices are based on comparable marketprices for similar securities.  Marketinformation has been obtained from reputable secondary market sources.  Although these sources are consideredreliable, S&P cannot guarantee their accuracy.

 

With our assessment and S&P value estimates as a backdrop, ourBoard votes to accept or not accept the analyses and values recommended bymanagement and S&P.  AtMarch 31, 2004, the Board elected to accept the valuations recommended byS&P on those loans as denoted on the Schedule of Investments in theConsolidated Financial Statements. Because there is a lag between when we close a loan and when the loancan be evaluated by S&P, new loans are not valued immediately by S&P;rather, the Board makes its own determination about the value of the loan inaccordance with our valuation policy. Because S&P does not provide values for mortgage loans or equitysecurities, the directors also determine fair value of these using thevaluation policy:

 

*GeneralValuation Policy:* We carry our investments at fair value, asdetermined by our Board of Directors. Securities that are publicly traded, if any, are valued at the closingprice on the valuation date. Debt and equity securities that are not publiclytraded 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 ofthe securities, we start with the cost basis of the security, which includesthe amortized original issue discount, exit fee (defined interest) and PIKinterest, if any.  We then apply themethods set out below in Valuation Methods. Due to the uncertainty inherent in the valuation process, such estimatesof fair value may differ significantly from the values that would have beenobtained had a ready market for the securities existed, and the differencescould be material.  Additionally,changes in the market environment and other events that may occur over the lifeof the investments may cause the gains or losses ultimately realized on theseinvestments to be different than the valuations currently assigned.  No single standard for determining fairvalue in good faith exists since fair value depends upon circumstances of eachindividual case.  In general, fair valueis the amount that we might reasonably expect to receive upon the current saleof the security.

 

*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 monthly, unaudited financialstatements.  Using these statements, wecalculate and evaluate the credit statistics. For purposes of analyzing the financial performance of our portfoliocompanies, we may make certain adjustments to their cash flow statements toreflect the pro forma results of a company consistent with a change of controltransaction, to reflect anticipated cost savings resulting from a merger orrestructuring, costs related to new product development, compensation toprevious owners, and other acquisition or restructuring related items.

 

*LoanGrading and Risk Rating:*****Ourloan grading system uses a scale of 0 to 10. This system is used to estimate the probability of default on our debtsecurities and the probability of loss if there is a default.  These types of systems are referred to asrisk rating systems and are used by banks and rating agencies.  We risk rate each of our debtsecurities.  The risk rating systemcovers both qualitative and quantitative aspects of the business and thesecurities we hold.

 

We seek to have our risk rating system mirror the risk rating systemsof major risk rating organizations such as those provided by nationallyrecognized statistical rating organizations (“NRSRO”) as defined in Rule 2a-7under the 1940 Act. While we seek to mirror the NRSRO systems, we cannotprovide any assurance that our risk rating system provides the same risk ratingas a NRSRO. The following chart is an estimate of the relationship of our riskrating system to the designations used by two NRSROs as they risk rate debtsecurities of major companies.  Becausewe have established our system to rate debt securities of companies that areunrated by any NRSRO there can be no assurance that the correlation to theNRSRO set out below is accurate. It is our understanding that most debtsecurities of middle market companies do not exceed the grade of BBB on a NRSROscale; so there would be no debt securities in the middle market that wouldmeet the definition of AAA, AA or A. Therefore, our scale begins with the designation BBB as the best riskrating.

 

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| **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 termdebt, if the company’s debt security is less than ten years then theprobability of default is adjusted to a lower percentage for the shorter periodwhich may move the security higher on the company’s risk rating scale.*

* *

At September 30, 2003, the average debt security was risk rated 7.8for all debt securities and the weighted average risk rating was 7.6 for allthe debt securities.  At March 31,2004 the average debt security was risk rated 7.7 for all debt securities andthe weighted average risk rating was 7.7 for all debt securities. The highestrated loan was 9.0 and the lowest was 6.0. The above scale gives an indicationof the probability of default and the magnitude of the loss if there is adefault using the expanded risk rating scale.

 
| **Rating**       |   | **March 31,  2004** |   | **December 31,  2003** |
|------------------|--------|--------------------------|--------|-----------------------------|
| Average          |   | 7.7                      |   | 7.8                         |
| Weighted Average |   | 7.7                      |   | 7.6                         |
| Highest          |   | 9.0                      |   | 9.0                         |
| Lowest           |   | 6.0                      |   | 7.0                         |

 

Our policy is to stop accruing interest on an investment if wedetermine that interest is no longer collectible. To date we have not placedany investments on non-accrual. At September 30, 2003 and March 31,2004 no payments were past due on any of our debt securities. We do not riskrate our equity securities.

 

*ValuationMethods:*  For debtsecurities, we first determine if there is a market for the debt security.  If there is a market, then we will determinethe value based on the market prices for the security, even if that market isnot robust.  At March 31, 2004, andSeptember 20, 2003, there was no market for any of the debt securities inour portfolio.  If there is no marketfor the debt securities, then we begin with the risk rating designation of thesecurity described above.  Using therisk rating designation above, we seek to determine the value of the securityas if we intended to sell the security in a current sale.  To determine the current sale price of thesecurity, we may use some or all of the following items: financial standing ofthe issuer of the security, comparison of the business and financial plan ofthe issuer with actual results, the cost of the security, the size of thesecurity held as it relates to the liquidity of the market for such securities,contractual restrictions on the disposition of the security, pending publicoffering of the issuer of the security, pending reorganization activity affectingthe issuer such as mergers or debt restructuring, reported prices of similarsecurities of the issuer or comparable issuers, ability of the issuer to obtainneeded financing, changes in the economy affecting the issuer, recent purchasesor sale of a security of the issuer, pricing by other buyers or sellers ofsimilar securities, financial statements of the borrower, the type of security,cost at date of purchase, size of holding, discount from market value ofunrestricted securities of the same class at the time of purchase, specialreports prepared by analysts, information as to any transactions or offers withrespect to the security, existence of merger proposals or tender offersaffecting the securities, the collateral, the issuer’s ability to makepayments, the current and forecasted earnings of the issuer, sales to thirdparties of similar securities, statistical ratios compared to lendingstandards, statistical ratios compared to other similar securities and otherpertinent factors.

 

For equity securities, we first determine if there is any market forthe equity security.  If there is amarket, then we determine the value based on the market prices for thesecurity, even if that market is not robust. At March 31, 2004 and September 30, 2003 there was no marketfor any of the equity securities we owned. If there is no market for the equity securities, then we use the sameinformation we would use for a debt security valuation described above, exceptrisk-rating, as well as standard valuation techniques used by major valuationfirms to value the equity securities of private companies.  These valuation techniques consist of:discounted cash flow of the expected sales price in the future, the value ofthe securities based on the recent sale of comparable transactions and a

 

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review of similarcompanies that are publicly traded and the market multiple of their equitysecurities.  At March 31, 2004 wehad $37,000 invested, at cost, in equity securities compared to our debtportfolio with a cost basis of $140,589,668.

 

At March 31, 2004, The Home Care Supply, Inc. senior loan had anappreciation of $696,600 in its value as a result of the value applied to theexit fee.  Also, the value of ourwarrants in Finn Corporation had an appreciation of $398,649 at March 31,2004.  This appreciation plus anincrease of $60,000 on the America’s Water Heater Rentals investment and $8,667on the Burt’s Bee’s investment totals $1,163,926 and partially offsetsdepreciation of $3,249,303.

 

**Commitments and Contingencies**

 

One of our investments currently has an outstanding liquidity agreementwhich could require us to purchase an additional last out tranche note for$350,000.  The agreement will expireupon the earlier of the following to occur: (1) the portfolio company reachingand maintaining a certain liquidity level or (2) January 2005.

 

We currently have outstanding commitments to fund approximately $30.5million of new loans.

 

**ManagerialAssistance Fees**

 

The 1940 Act requires that a business development company makeavailable managerial assistance to its portfolio companies. We providemanagerial assistance to our portfolio companies in connection with ourinvestments through our wholly owned subsidiary, Gladstone Capital Advisers,Inc. and receive fees for our managerial assistance services. These fees arenormally paid at the closing of our investments in our portfolio companies, aregenerally non-recurring and are recognized as revenue when earned. Themanagerial assistance services we provide vary by investment, but generallyconsist of reviewing existing credit facilities, arranging bank financing,arranging equity financing, structuring financing from multiple lenders,structuring financing from equity investors, restructuring existing loans,raising equity and debt capital, and providing general financial advice. Fromtime to time, we are invited to participate as a co-lender in a transaction. Inthe event that we do not provide significant managerial assistance services inconnection with our investment, loan fees paid to us in such situations aredeferred and amortized over the life of the loan.  Following our transition to external management these managerialassistance services will be made available by Gladstone Management, andGladstone Management will receive substantially all of the fees associated withthese services.

 

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**RESULTS OF OPERATIONS**

 

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

 

**Investment Income**

 

Investment income for the three months ended March 31, 2004 wasapproximately $4.4 million as compared to $3.9 million for the three monthsended March 31, 2003. This increase was primarily a result of increasedinterest income from an increased number of investments as compared to the sameperiod of the prior year.

 

Interest income from our investments in debt securities of privatecompanies was approximately $3.9 million, including $138,000 of PIK interest, forthe three months ended March 31, 2004 as compared to $3.3 million for thethree months ended March 31, 2003, which included $224,000 of PIKinterest. This increase****was primarily a result of anincrease in investments of $39.3 million at March 31, 2004 as compared toinvestments at March 31, 2003.

 

The weighted average yield on our portfolio for the three months endedMarch 31, 2004 was 11.80% (without giving effect to PIK interest) and13.07% (after giving effect to PIK interest). The weighted average yield on ourportfolio for the three months ended March 31, 2003 was 14.69% (withoutgiving effect to PIK interest) and 15.89% (after giving effect to PIKinterest).

 

Interest income from invested cash and cash equivalents for the threemonths ended March 31, 2004 was approximately $17,000, as compared to$113,000 for the three months ended March 31, 2003. This decrease****was primarily a result of the $62.5million of new investments made between March 31, 2003 and March 31,2004.

 

For the three months ended March 31, 2004 and March 31, 2003,we recorded approximately $110,000 in interest income from loans to ouremployees in connection with the exercise of employee stock options.  In March 2004 we extended a $350,000loan to an employee for the exercise of employee stock options.

 

Managerial assistance fees were $356,000 for the three months endedMarch 31, 2004, as compared to $358,000 for the three months endedMarch 31, 2003. This decreasestemmed from the closing of a $14.5 million investment (Woven ElectronicsCorp.) with such fees during the three months ended March 31, 2004 ascompared to closing $17.5 million of investments (America’s Water HeaterRentals, LLC and Wingstop Restaurants International, Inc.) with such feesduring the three months ended March 31, 2003.

 

**OperatingExpenses**

 

Operating expenses for the three months ended March 31, 2004 wereapproximately $1.2 million, as compared to approximately $940,000 for the threemonths ended March 31, 2003. This increase****was mainly a result of an increase in professional fees,directors fees, financing fees, and interest expense.

 

Salaries and benefits for the three months ended March 31, 2004were approximately $420,000, as compared to approximately $478,000 for thethree months ended March 31, 2003. Although employee headcount increasedfor the quarter ended March 31, 2004 as compared to March 31, 2003,the salaries and benefits expense decreased due to the expense sharingarrangement with Gladstone Management which allocates expenses based on eachemployee’s time to Gladstone Commercial Corporation.

 

Rent expense for the three months ended March 31, 2004 wereapproximately $34,000, as compared to approximately $55,000 for the threemonths ended March 31, 2003.  Thedecrease in rent is due to the expense sharing arrangement with GladstoneManagement which allocates general expenses based on a ratio of all employeestime allocated to Gladstone Commercial Corporation to total time spent.

 

Professional fees, consisting primarily of legal and audit fees, forthe three months ended March 31, 2004 were approximately $282,000, ascompared to approximately $87,000 for the three months ended March 31,2003.  The increase is due to anincrease in legal fees in connection with the proxy statement and quarterlyreport reviews.

 

Directors’ fees for the three months ended March 31, 2004 wereapproximately $33,000, as compared to approximately $21,000 for the threemonths ended March 31, 2003. The increase is due to an increase in thenumber of directors during the three months ended March 31, 2004 ascompared to March 31, 2003.

 

Insurance expense for the three months ended March 31, 2004 wasapproximately $63,000, as compared to approximately $74,000 for the threemonths ended March 31, 2003. The decrease is due to the expense sharingarrangement with Gladstone Management which allocates general expenses based ona ratio of all employees time allocated to Gladstone Commercial Corporation tototal time spent each month.

 

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Stockholder related costs for the three months ended March 31,2004 were approximately $67,000, as compared to approximately $74,000 for thethree months ended March 31, 2003. The decrease is mainly due to a decline in printing fees as compared tothe prior period.

 

Financing fees consist of the related service fees associated with theline of credit, backup service, interest rate cap agreement and theamortization of deferred financing costs. Financing fees for the three months ended March 31, 2004 were approximately$149,000.  There were no financing feesincurred the three months ended March 31, 2003 as these line of credit andrelated expenses were not incurred until May 2003.

 

Interest expense for the three months ended March 31, 2004 wasapproximately $25,000 and was incurred on borrowings from our line ofcredit.  There was no interest expensefor the three months ended March 31, 2003.

 

General and administrative expenses, consisting primarily of officeoperations, travel, and data communications expenses, for the three monthsended March 31, 2004 were approximately $173,000, as compared toapproximately $152,000 for the three months ended March 31, 2003. Thisincrease****was primarily a result ofthe related expenses from increased operations during the three months endedMarch 31, 2004 as compared to the three months ended March 31,2003.  General and administrativeexpenses are also in accordance with the new management advisory agreementwhich allocates general expenses based on a ratio of all employees timeallocated to Gladstone Commercial Corporation to total time spent.

 

**Realized Gain on Sale of Investment**

 

During the three months ended March 31, 2004, we bought and sold a$1.0 million investment in Metokote Corporation for a gain of $12,500.

 

**Net Increase inStockholders’ Equity from Operations**

 

Overall, we had a net increase instockholders’ equity resulting from operations of $2,828,583 for the threemonths ended March 31, 2004.  Basedon a weighted-average of 10,087,615 (basic) and 10,375,281 (diluted) sharesoutstanding, our net increase in stockholders’ equity from operations perweighted average common share for the three months ended March 31, 2004was $0.28 for basic earnings and $0.27 for diluted earnings.

 

For thethree months ended March 31, 2003, we realized a net increase instockholders’ equity resulting from operations of approximately $3.7million.  Based on a weighted-average of10,071,844 (basic) and 10,100,062 (diluted) shares outstanding, our net increasein stockholders’ equity resulting from operations per common share for thethree months ended March 31, 2003 was $0.36 for both basic and diluted.

 

26

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*Comparison of the sixmonths ended March 31, 2004 to the six months ended March 31, 2003*

 

**Investment Income**

 

Investment income for the six months ended March 31, 2004 wasapproximately $8.3 million as compared to $7.1 million for the six months endedMarch 31, 2003. This increase was primarily a result of increased interestincome from an increased number of investments as compared to the same periodof the prior year.

 

Interest income from our investments in debt securities of privatecompanies was approximately $7.4 million, including $276,000 of PIK interest,for the six months ended March 31, 2004 as compared to $6.2 million,including $435,000 of PIK interest, for the six months ended March 31,2003. This increase****was primarily a result of anincrease in investments of $39.3 million at March 31, 2004 as compared toinvestments at March 31, 2003.

 

The weighted average yield on our portfolio for the six months endedMarch 31, 2004 was 12.10% (without giving effect to PIK interest) and12.93% (after giving effect to PIK interest). The weighted average yield on ourportfolio for the six months ended March 31, 2003 was 13.31% (withoutgiving effect to PIK interest) and 14.21% (after giving effect to PIKinterest).

 

Interest income from invested cash and cash equivalents for the sixmonths ended March 31, 2004 was approximately $66,000, as compared to$312,000 for the six months ended March 31, 2003. This decrease****was primarily a result of the $62.5million of new investments made between March 31, 2003 and March 31,2004.

 

For the six months ended March 31, 2004 and March 31, 2003,we recorded approximately $218,000 and $219,000, respectively, in interestincome from loans to our employees in connection with the exercise of employeestock options.  In March 2004 weextended a $350,000 loan to an employee for the exercise of employee stock options.

 

Managerial assistance fees were $611,000 for the six months endedMarch 31, 2004, as compared to $358,000 for the six months endedMarch 31, 2003. This increase****was mainly attributable to theclosing of the GQM Acquisition Corp. and Woven Electronics Corp. investmentswith such fees during the six months ended March 31, 2004.

 

**OperatingExpenses**

 

Operating expenses for the six months ended March 31, 2004 wereapproximately $2.3 million, as compared to approximately $1.8 million for thesix months ended March 31, 2003. This increase****was primarily a result of an increase in professional fees,directors fees, stockholder related costs, financing fees and interest expense.

 

Salaries and benefits for the six months ended March 31, 2004 wereapproximately $810,000, as compared to approximately $911,000 for the sixmonths ended March 31, 2003. Although employee headcount increased for thequarter ended March 31, 2004 as compared to March 31, 2003, thesalaries and benefits expense decreased due to the expense sharing arrangementwith Gladstone Management which allocates expenses based on each employees timeto Gladstone Commercial Corporation.

 

Rent expenses for the six months ended March 31, 2004 wereapproximately $72,000, as compared to approximately $109,000 for the six monthsended March 31, 2003.  The decreasein rent is due to the expense sharing arrangement with Gladstone Managementwhich allocates general expenses based on a ratio of all employees time allocatedto Gladstone Commercial Corporation to total time spent.

 

Professional fees, consisting primarily of legal and audit fees, forthe six months ended March 31, 2004 were approximately $460,000, ascompared to approximately $201,000 for the six months ended March 31,2003.  The increase is due to a rise inlegal fees associated with the proxy statement and review of the quarterlyreports.

 

Directors’ fees for the six months ended March 31, 2004 wereapproximately $57,000, as compared to approximately $34,000 for the six monthsended March 31, 2003. The increase is due to an increase in the number ofdirectors during the six months ended March 31, 2004 as compared toMarch 31, 2003.

 

Insurance expense for the six months ended March 31, 2004 wasapproximately $137,000, as compared to approximately $145,000 for the sixmonths ended March 31, 2003.  Thedecrease is due to the expense sharing arrangement with Gladstone Managementwhich allocates general expenses based on a ratio of all employees timeallocated to Gladstone Commercial Corporation to total time incurred eachmonth.

 

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Stockholder related costs for the six months ended March 31, 2004were approximately $120,000, as compared to approximately $111,000 for the sixmonths ended March 31, 2003.  Theincrease is mainly due to the printing of the 2004 annual report tostockholders and proxy statement.

 

Financing fees consist of the related service fees associated with theline of credit, interest rate cap agreement, backup service and theamortization of deferred financing costs. Financing fees for the six months ended March 31, 2004 wereapproximately $294,000.  There were nofinancing fees incurred during the six months ended March 31, 2003 asthese line of credit and related service expenses were not incurred until May2003.

 

Interest expense for the three months ended March 31, 2004 wasapproximately $25,000 and was incurred on borrowings from our line ofcredit.  There was no interest expensefor the six months ended March 31, 2004.

 

General and administrative expenses, consisting primarily of officeoperations, travel, and data communications expenses for the six months endedMarch 31, 2004 were approximately $300,000, as compared to approximately$251,000 for the six months ended March 31, 2003. This increase****was primarily a result of the relatedexpenses from increased operations during the six months ended March 31,2004 as compared to the six months ended March 31, 2003.  General and administrative expenses are alsoin accordance with expense sharing agreement with Gladstone Management whichallocates general expenses based on a ratio of all employees time allocated toGladstone Commercial Corporation to total time spent.

 

**Realized Gain on Sale of Investment**

 

During the three months ended March 31, 2004, we bought andshortly thereafter sold a $1.0 million investment in Metokote Corporation for again of $12,500.

 

**Net Increase inStockholders’ Equity from Operations**

 

We had a net increase instockholders’ equity resulting from operations of $4,209,657 for the six monthsended March 31, 2004.  Based on aweighted-average of 10,084,729 (basic) and 10,354,405 (diluted) sharesoutstanding, our net increase in stockholders’ equity from operations percommon share for the six months ended March 31, 2004 was $0.42 for basicearnings and $0.41 for diluted earnings.

 

For thesix months ended March 31, 2003, we realized a net increase in stockholders’ equity resulting fromoperations of approximately $6.1 million. Based on a weighted-average of 10,071,844 (basic) and 10,112,129(diluted) shares outstanding, our net increase in stockholders’ equityresulting from operations per common share for the six months endedMarch 31, 2003 was $0.60 for both basic and diluted.

 

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**LIQUIDITY AND CAPITAL RESOURCES**

 

At March 31, 2004, we had investments in debt securities of, orloans to, 14 private companies, totaling approximately $137.4 million of totalinvestment assets. This number includes approximately $276,000 in accrued PIKinterest, which as described in “Overview,” is added to the carrying value ofour investments.

 

In November 2003, we purchaseda $1.0 million participation in a $55.0 million senior term loan to Burt’sBees, Inc., a manufacturer of personal and household products.

 

In December 2003 we closed twoloans with GQM Acquisition Corp. totaling $14.5 million and also containing asuccess fee provision.  GQM AcquisitionCorp conducts business as Gammill, Inc. and is the designer and assembler ofquilting machines and accessories.

 

In November 2003, Kozy ShackEnterprises repaid $900,000 to fully settle its principal obligation.  In December 2003, we sold a $3.2million principal portion of our Inca Metal Products Corp/Kingway AcquisitionInc./Clymer Acquisition Inc. investment. The remaining portion of this investment currently has a cost basis of$2.5 million.

 

During March 2004, we enteredinto a $14.5 million loan investment with Woven Electronics Corporation, whichspecializes in custom electrical cable assemblies and also purchased a $6.0million participation investment with Medassets, Inc., a pharmaceutical andhealthcare group purchasing organization (GPO).

 

In April 2004, we sold $4.6million of our principal portions of our investments in Gammill, Inc.  Our remaining investments in Gammill,subsequent to the sale, are $4.963 million and $4.75 million.  Another portfolio company, WingstopRestaurants International, Inc. repaid its entire $5.5 million outstanding loanobligations in April 2004.  WingstopRestaurants International, Inc. also remitted related prepayment fees and asuccess fee with its final payment.

 

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

 
| **Year**   |   | **Amount** |        |
|------------|--------|------------|-------------|
| 2004       |   | $          | 1,900,533   |   |
| 2005       |   | $          | 5,386,843   |   |
| 2006       |   | $          | 19,049,459  |   |
| 2007       |   | $          | 39,074,584  |   |
| 2008       |   | $          | 22,463,671  |   |
| Thereafter |   | $          | 52,751,578  |   |
| Total      |   | $          | 140,626,668 |   |

 

Cash provided by operating activities for the six months endedMarch 31, 2004, consisting primarily of the items described in “Results ofOperations,” was approximately $6.4 million. Net cash used in investing activities was approximately $16.1 millionduring the six months ended March 31, 2004. The net cash provided byinvesting activities was mainly due to the proceeds of $186.2 million from therepurchase agreement and principal repayments of $5.2 million from ourportfolio companies, offset by new investments of $36.0 million and repaymentof repurchase agreement of $171.6 million. ** **Net cash provided by financingactivities was approximately $10.3 million for the six months endedMarch 31, 2004 and consisted mainly of $20.5 million borrowed under our line of credit in order to purchase twonew investments as well as the payment of dividends, an increase in prepaidfinancing fees and also expenses incurred in connection with the shelfoffering.

 

During the six months ended March 31, 2004, cash and cashequivalents increased from approximately $101.1 million at the beginning of theperiod to approximately $101.8 million at the end of the period.

 

On March 31, 2004, the Company entered into a Repurchase Agreementwith UBS Paine Webber for $93,105,000, which agreement was settled onApril 1, 2004.  The RepurchaseAgreement was recorded at cost and was fully collateralized by a United StatesTreasury Bill with a fair value of $95,025,000 and a carrying value of$95,000,939 that matured on April 8, 2004.  The interest rate on the Repurchase Agreement was 0.92%. Thisrepurchase agreement was reflected on our balance sheet as of March 31,2004 as an increase in cash and cash equivalents pledged to creditors of $95.0million, along with a corresponding liability for approximately $93.1 million.The repurchase agreement was settled on April 1, 2004. In the future, weplan to use a similar form of repurchase agreement as an investment option orin order to satisfy certain asset diversification requirements and maintain ourstatus as a RIC.

 

In order to qualify as a regulated investment company and to avoid corporatelevel tax on the income we distribute to our stockholders, we are required,under Subchapter M of the Code, to distribute at least 90% of our ordinaryincome and short-term

 

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capital gains toour stockholders on an annual basis. In accordance with these requirements, wedeclared and paid a monthly cash dividend of $0.11 per common share for eachmonth in October, November and December 2003 and January, February,and March 2004.

 

We anticipate borrowing funds and issuing additional equity securitiesto obtain additional capital once the proceeds of our initial public offeringhave been fully invested. To this end, we have filed with the Securities andExchange Commission (“SEC”) a registration statement that would permit us toissue, through one or more transactions, up to an aggregate of $75 million insecurities, which may consist of shares of our common stock, preferred stock,and/or debt securities. On March 19, 2003, the SEC declared the registrationstatement effective, and we currently have no immediate plans to issue anysecurities under the registration statement.

 

**Revolving Credit Facility**

 

Through our wholly-owned subsidiary, Gladstone Business Loan LLC(“Business Loan”), we have obtained a $100 million revolving creditfacility.  On May 19, 2003, weexecuted a Purchase and Sale Agreement pursuant to which we agreed to sellcertain loans to Business Loan in consideration of a membership interest therein.  Simultaneously, Business Loan executed aCredit Agreement with CIBC World Markets Inc., as administrative agent, andothers, pursuant to which Business Loan pledged the loans purchased from us tosecure future advances by certain institutional lenders.  Interest rates charged on the advances underthe facility will be based on LIBOR, the Prime Rate or the Federal Funds Rate,depending on market conditions, and will adjust periodically.  As of March 31, 2004, our outstandingprincipal balance under this credit facility was $20.5 million at an interestrate of 2.54%.

 

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 industry concentrationsof loans that are eligible to secure advances. As of March 31, 2004, Business Loan was in compliance with all ofthe facility covenants.  We currentlyintend to securitize all of the loans held by Business Loan and will use theproceeds from the securitization to pay down any amounts then outstanding underthe revolving credit facility. Currently there are $20.5 million of advances outstanding under thisfacility.

 

Gladstone Capital Advisers, Inc. (“Advisers”), our servicingsubsidiary, will service the loans pledged under the facility.  As a condition to this servicingarrangement, we executed a Performance Guaranty pursuant to which we guaranteedthat Advisers would comply fully with all of its obligations under thefacility.    The Performance Guarantyrequires us to maintain a minimum net worth of $100 million and to maintain“asset coverage” with respect to “senior securities representing indebtedness”of at least 200%, in accordance with Section 18 of the 1940 Act.  As of March 31, 2004, we were incompliance with our covenants under the Performance Guaranty.

 

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**ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURESABOUT MARKET RISK.**

 

We are subject to financial marketrisks, including changes in interest rates. We expect that ultimately approximately 50% of the loans in ourportfolio will be made at fixed rates, with approximately 50% made at variablerates.  Currently our portfolio hasapproximately 53% of the total of the loan portfolio cost value at fixed rates,approximately 35% of the total loan portfolio cost value at variable rates witha floor and the remaining 12% of the total loan portfolio cost value atvariable rates.

 

Pursuant to our line of credit, we have agreed to enter into hedging transactions,and as such have entered into an interest rate cap agreement inFebruary 2004 as a result of our borrowing under the line of credit.  Such transactions will effectively convertour fixed rate portfolio loans into variable rate loans in an effort tomitigate our exposure to increases in interest rates on our borrowings on theline of credit, which will be at variable rates.  Furthermore, in the event that we securitize a portion of ourloan portfolio in the future, we believe that we will likely be required toenter into similar arrangements with respect to securitized loans.

 

While hedging activities may insulate us against adverse fluctuationsin interest rates, they may also limit our ability to participate in thebenefits of lower interest rates with respect to our portfolio of investments.

 

**ITEM4. CONTROLS AND PROCEDURES.**

 

As of March 31, 2004, we,including our Chief Executive Officer and Chief Financial Officer, evaluatedthe effectiveness of the design and operation of our disclosure controls andprocedures.  Based on that evaluation,our management, including the Chief Executive Officer and Chief FinancialOfficer, concluded that our disclosure controls and procedures were effectivein timely alerting management, including the Chief Executive Officer and ChiefFinancial Officer, of material information about us required to be included inperiodic Securities and 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 ourinternal control over financial reporting that occurred during the quarterended March 31, 2004, that have materially affected, or are reasonablylikely to materially affect, our internal control over financial reporting.

 

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**PART II–OTHER INFORMATION**

 

**ITEM 1. LEGAL PROCEEDINGS.**

 

Neither the Company nor its subsidiary is currently subject to anymaterial legal proceeding, nor, to the Company’s knowledge, is any materiallegal proceeding threatened against the Company or its subsidiary.

 

**ITEM2. CHANGES IN SECURITIES****, USE OF PROCEEDS AND ISSUER PURCHASES OF EQUITYSECURITIES.**

 

Not applicable.

 

**ITEM3. DEFAULTS****UPON SENIOR SECURITIES.**

 

Not applicable.

 

**ITEM4. SUBMISSION****OF MATTERS TO A VOTE OF SECURITY HOLDERS.**

 

The Annual Meeting of Stockholders was held on February 18,2004.  The stockholders voted andapproved the following matters:

 

•                  The election of three Class IIIdirectors to hold office until the 2007 Annual Meeting of Stockholders.

 
| **Nominee**     |   | **Shares Voted For** |   | **Authority Withheld** |
|-----------------|--------|----------------------|--------|------------------------|
| Paul Adelgren   |   | 9,849,668            |   | 50,508                 |
| John Outland    |   | 8,850,166            |   | 1,050,010              |
| David Gladstone |   | 9,845,583            |   | 54,593                 |

 

•                  To approve an investment advisoryand administrative agreement between the Company and Gladstone ManagementCorporation.

 
| Shares voted for     |   | 5,672,127 |
|----------------------|--------|-----------|
| Shares voted against |   | 906,885   |
| Shares abstained     |   | 47,059    |

 

**ITEM5. OTHER INFORMATION.**

 

Not applicable

 

**ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K**

 

**(a)****                                 ****EXHIBITS**

 

See the exhibit index.

 

**(b)****                                 ****REPORTS ON FORM 8-K**

 

On February 18, 2004, the Company filed an Item 12 on Form8-K announcing the release of earnings for the quarter ended December 31,2003.

 

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**SIGNATURE**

 

Pursuant to the requirements of the Securities Exchange Act of1934, the registrant has duly caused this report to be signed on its behalf bythe undersigned thereunto duly authorized.

 

 
|               | **GLADSTONE CAPITAL  CORPORATION**    |
|--------------------|---------------------------------------|
|               |                                  |
|               | By:                                   | /s/ HARRY BRILL |   |
|               |                                  |
|               | Harry Brill                           |
|               | Chief Financial Officer and Treasurer |
|               |                                  |
|               |                                  |
| Date: May 13, 2004 |                                  |

 

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**EXHIBITINDEX**

 
| **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.                                                                   |
|        |   |                                                                                                                                                                                                                                           |
| 10.19       |   | Amendment No. 2 to Credit Agreement dated as of February 6,  2004.                                                                                                                                                                        |
|        |   |                                                                                                                                                                                                                                           |
| 11          |   | Computation of Per Share Earnings (included in the notes to the  unaudited financial statements contained in this report).                                                                                                                     |
|        |   |                                                                                                                                                                                                                                           |
| 31.1        |   | Certification of Chief Executive Officer pursuant to  section 302 of The Sarbanes-Oxley Act of 2002.                                                                                                                                      |
|        |   |                                                                                                                                                                                                                                           |
| 31.2        |   | Certification of Chief Financial Officer pursuant to  section 302 of The Sarbanes-Oxley Act of 2002.                                                                                                                                      |
|        |   |                                                                                                                                                                                                                                           |
| 32.1        |   | Certification of Chief Executive Officer pursuant to  section 906 of The Sarbanes-Oxley Act of 2002.                                                                                                                                      |
|        |   |                                                                                                                                                                                                                                           |
| 32.2        |   | Certification of Chief Financial Officer pursuant to  section 906 of The Sarbanes-Oxley Act of 2002.                                                                                                                                      |

 

All other exhibits for which provision is made in the applicableregulations of the Securities and Exchange Commission are not required underthe related instruction or are inapplicable and therefore have been omitted.

 

34

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