** **

**UNITEDSTATES**

**SECURITIESAND EXCHANGE COMMISSION**

**WASHINGTON, D.C.20549**

 

**FORM10-Q**

 

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

 

**FOR THE QUARTER ENDEDDECEMBER 31, 2007**

 

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

 

**COMMISSION FILENUMBER: 814-00237**

 

**GLADSTONECAPITAL CORPORATION**

(Exact name of registrant as specified inits charter)

 

| **MARYLAND**                                                    | ** ** | **54-2040781**                       |
|-----------------------------------------------------------------|------------|--------------------------------------|
| (State or other jurisdiction of  incorporation or organization) |       | (I.R.S. Employer Identification No.) |
|                                                            |       |                                 |
| **1521 WESTBRANCH DRIVE,  SUITE 200**                           |
| **MCLEAN, VIRGINIA 22102**                                      |
| (Address of principal executive office)                         |
|                                                            |       |                                 |
| **(703) 287-5800**                                              |
| (Registrant’s telephone number,  including area code)      |

 

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

 

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

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

 

Indicate by check mark whether the registrant is a shell company(as defined in Rule 12b-2 of the Exchange Act). Yes o  No x .

 

Indicate the number of shares outstanding of each of the issuer’sclasses of common stock, as of the latest practicable date.  The number of shares of the issuer’s CommonStock, $0.001 par value, outstanding as of February 5, 2008 was 20,637,574.

 

 

 

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**GLADSTONE CAPITALCORPORATION**

**TABLE OF CONTENTS**

 
| PART I.    |   | FINANCIAL INFORMATION                                                                                    |
|------------|--------|----------------------------------------------------------------------------------------------------------|
|       |   |                                                                                                     |
| Item 1.    |   | Financial Statements (Unaudited)                                                                         |
|       |   |                                                                                                     |
|       |   | Consolidated  Statements of Assets and Liabilities as of December 31, 2007 and September  30, 2007       |
|       |   | Consolidated  Schedules of Investments as of December 31, 2007 and September 30, 2007                    |
|       |   | Consolidated  Statements of Operations for the three months ended December 31, 2007 and  2006            |
|       |   | Consolidated  Statements of Changes in Net Assets for the three months ended December 31,  2007 and 2006 |
|       |   | Consolidated  Statements of Cash Flows for the three months ended December 31, 2007 and  2006            |
|       |   | Financial  Highlights for the three months ended December 31, 2007 and 2006                              |
|       |   | Notes to  Consolidated Financial Statements                                                              |
|       |   |                                                                                                     |
| Item  2.   |   | Management’s  Discussion and Analysis of Financial Condition and Results of Operations              |
|       |   | Overview                                                                                                 |
|       |   | Results of Operations                                                                                    |
|       |   | Liquidity and  Capital Resources                                                                         |
|       |   |                                                                                                     |
| Item  3.   |   | Quantitative  and Qualitative Disclosure About Market Risk                                               |
|       |   |                                                                                                     |
| Item  4.   |   | Controls  and Procedures                                                                                 |
|       |   |                                                                                                     |
| PART II.   |   | OTHER  INFORMATION                                                                                       |
|       |   |                                                                                                     |
| Item 1.    |   | Legal  Proceedings                                                                                       |
|       |   |                                                                                                     |
| Item 1A.   |   | Risk Factors                                                                                             |
|       |   |                                                                                                     |
| Item  2.   |   | Unregistered  Sales of Equity Securities and Use of Proceeds                                             |
|       |   |                                                                                                     |
| Item  3.   |   | Defaults  Upon Senior Securities                                                                         |
|       |   |                                                                                                     |
| Item  4.   |   | Submission  of Matters to a Vote of Security Holders                                                     |
|       |   |                                                                                                     |
| Item 5.    |   | Other  Information                                                                                       |
|       |   |                                                                                                     |
| Item 6.    |   | Exhibits                                                                                                 |
|       |   |                                                                                                     |
| SIGNATURES |

 

----

**GLADSTONE CAPITALCORPORATION**

**CONSOLIDATEDSTATEMENTS OF ASSETS AND LIABILITIES**

**(Unaudited)**

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

**2007** | ** **  | **September  30,**

**2007** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------|-------------|------------------------------|------------|
| ASSETS                                                                                                                                   |       |                        |        |                         |       |
| Non-Control/Non-Affiliate investments (Cost  12/31/07: $423,933,339; 9/30/07: $354,835,652)                                              |       | $                           | 412,712,262 |                         | $          | 348,920,982 |   |
| Control investments  (Cost 12/31/07: $1,036,861; 9/30/07: $923,548)                                                                      |       | 945,428                     |        | 923,548                      |       |
| Total investments at  fair value (Cost 12/31/07: $424,970,200; 9/30/07 $355,759,200)                                                     |       | 413,657,690                 |        | 349,844,530                  |       |
| Cash and cash  equivalents                                                                                                               |       | 5,530,949                   |        | 8,838,658                    |       |
| U.S. Treasury bill                                                                                                                       |       | 2,484,464                   |        | 2,484,464                    |       |
| Interest receivable –  investments in debt securities                                                                               |       | 2,272,634                   |        | 2,425,555                    |       |
| Interest receivable –  employees                                                                                                    |       | —                      |        | 21,417                       |       |
| Due from custodian                                                                                                                       |       | 4,816,186                   |        | 3,230,385                    |       |
| Deferred financing fees                                                                                                                  |       | 132,292                     |        | 186,270                      |       |
| Prepaid assets                                                                                                                           |       | 405,643                     |        | 337,106                      |       |
| Other assets                                                                                                                             |       | 284,058                     |        | 360,753                      |       |
| TOTAL ASSETS                                                                                                                             |       | $                           | 429,583,916 |                         | $          | 367,729,138 |   |
|                                                                                                                                     |       |                        |        |                         |       |
| LIABILITIES                                                                                                                              |       |                        |        |                         |       |
| Accounts payable                                                                                                                         |       | $                           | 7,257       |                         | $          | 6,013 |   |
| Interest payable                                                                                                                         |       | 595,335                     |        | 587,514                      |       |
| Administration fee due  to Administrator (Refer to Note 4)                                                                               |       | 211,675                     |        | 237,510                      |       |
| Fees due to Adviser  (Refer to Note 4)                                                                                                   |       | 11,054                      |        | 708,517                      |       |
| Borrowings under lines  of credit                                                                                                        |       | 161,831,000                 |        | 144,440,000                  |       |
| Accrued expenses and  deferred liabilities                                                                                               |       | 738,140                     |        | 790,849                      |       |
| Funds held in escrow                                                                                                                     |       | 157,268                     |        | —                       |       |
| TOTAL LIABILITIES                                                                                                                        |       | 163,551,729                 |        | 146,770,403                  |       |
| NET ASSETS                                                                                                                               |       | $                           | 266,032,187 |                         | $          | 220,958,735 |   |
|                                                                                                                                     |       |                        |        |                         |       |
| ANALYSIS OF NET ASSETS                                                                                                                   |       |                        |        |                         |       |
| Common stock, $0.001 par value, 50,000,000 shares  authorized and 17,637,574 and 14,762,574 shares issued and outstanding,  respectively |       | $                           | 17,638      |                         | $          | 14,763 |   |
| Capital in excess of  par value                                                                                                          |       | 286,425,698                 |        | 235,906,665                  |       |
| Notes receivable –  employees                                                                                                       |       | (9,224,176                  | )           | (9,230,502                   | )          |
| Net unrealized  depreciation on investments                                                                                              |       | (11,312,511                 | )           | (5,914,670                   | )          |
| Unrealized depreciation  on derivative                                                                                                   |       | (302,239                    | )           | (291,686                     | )          |
| Accumulated  undistributed net investment income                                                                                         |       | 427,777                     |        | 474,165                      |       |
| TOTAL NET ASSETS                                                                                                                         |       | $                           | 266,032,187 |                         | $          | 220,958,735 |   |
| NET ASSETS PER SHARE                                                                                                                     |       | $                           | 15.08       |                         | $          | 14.97 |   |

* *

*THEACCOMPANYING NOTES ARE AN INTEGRAL PART OF THESE CONSOLIDATED FINANCIAL STATEMENTS.*

 

 

2

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**GLADSTONE CAPITALCORPORATION**

**CONSOLIDATED SCHEDULEOF INVESTMENTSAS OF DECEMBER 31, 2007**

**(UNAUDITED)**

** **
| **Company**                               | ** ** | **Industry**                      | ** ** | **Investment  (1)**                    | ** ** | **Cost**   | ** ** | **Fair  Value** |
|-------------------------------------------|------------|-----------------------------------|------------|----------------------------------------|------------|------------|------------|-----------------|
| ** **                                | ** ** | ** **                        | ** ** | ** **                             | ** ** | ** ** | ** ** | ** **      |
| **NON-CONTROL/NON-AFFILIATE INVESTMENTS** |
| ** **                                |
| Access Television Network,  Inc. (2)      |       | Service-cable airtime             |       | Senior Term Debt (6)                   |       | $          | 2,487,458  |            | $ | 2,401,437 |
|                                      |       | (infomercials)                    |       | (11.3% Due 3/2009)                     |       |       |       |            |
|                                      |       |                              |       |                                   |       |       |       |            |
| ActivStyle Acquisition  Co. (2)           |       | Service-medical products          |       | Line of Credit (6) (9)                 |       | 600,000    |       | 594,750         |
|                                      |       | distribution                      |       | (9.5%, Due 7/2009)                     |       |       |       |            |
|                                      |       |                              |       | Senior Term Debt (6)                   |       | 5,113,875  |       | 5,069,129       |
|                                      |       |                              |       | (9.5%, Due 9/2012)                     |       |       |       |            |
|                                      |       |                              |       | Senior Term Debt (3) (6)               |       | 4,435,000  |       | 4,390,650       |
|                                      |       |                              |       | (12.1%, Due 9/2012)                    |       |       |       |            |
|                                      |       |                              |       |                                   |       |       |       |            |
| Allison Publications,  LLC (2)            |       | Service-publisher of  consumer    |       | Line of Credit (10)                    |       | —     |       | —          |
|                                      |       | oriented magazines                |       | (9.3%, Due 12/2010)                    |       |       |       |            |
|                                      |       |                              |       | Senior Term Debt (6)                   |       | 11,080,085 |       | 10,917,500      |
|                                      |       |                              |       | (9.3%, Due 12/2011)                    |       |       |       |            |
|                                      |       |                              |       |                                   |       |       |       |            |
| Anitox Acquisition  Company (2)           |       | Manufacturing-preservatives  for  |       | Senior Real Estate Term  Debt          |       | 3,107,161  |       | 3,060,000       |
|                                      |       | animal feed                       |       | (8.8%, Due 1/2012)                     |       |       |       |            |
|                                      |       |                              |       | Line of Credit (11)                    |       | —     |       | —          |
|                                      |       |                              |       | (9.5%, Due 1/2010)                     |       |       |       |            |
|                                      |       |                              |       | Senior Term Debt (6)                   |       | 2,750,000  |       | 2,729,375       |
|                                      |       |                              |       | (9.5%, Due 1/2012)                     |       |       |       |            |
|                                      |       |                              |       | Senior Term Debt (3) (6)               |       | 2,750,000  |       | 2,725,938       |
|                                      |       |                              |       | (11.8%, Due 1/2012)                    |       |       |       |            |
|                                      |       |                              |       |                                   |       |       |       |            |
| Badanco Acquisition  Corp.                |       | Service-luggage design  and       |       | Senior Subordinated Term  Debt (6)     |       | 9,603,750  |       | 9,531,722       |
|                                      |       | distribution                      |       | (12.0%, Due 7/2012)                    |       |       |       |            |
|                                      |       |                              |       |                                   |       |       |       |            |
| Bresnan Communications,  LLC              |       | Service-telecommunications        |       | Senior Term Debt (7)                   |       | 3,001,724  |       | 2,872,500       |
|                                      |       |                              |       | (7.1%, Due 9/2013)                     |       |       |       |            |
|                                      |       |                              |       | Senior Subordinated Term  Debt (7)     |       | 1,509,619  |       | 1,470,000       |
|                                      |       |                              |       | (9.4%, Due 3/2014)                     |       |       |       |            |
|                                      |       |                              |       |                                   |       |       |       |            |
| CCS, LLC                                  |       | Service-cable tv  franchise owner |       | Senior Term Debt (6)                   |       | 3,426,892  |       | 3,341,220       |
|                                      |       |                              |       | (11.3%, Due 3/2008)                    |       |       |       |            |
|                                      |       |                              |       |                                   |       |       |       |            |
| CHG Companies, Inc. (2)                   |       | Service-healthcare  staffing      |       | Letter of Credit (6) (7)               |       | 400,000    |       | 380,000         |
|                                      |       |                              |       | (7.2%, Due 12/2012)                    |       |       |       |            |
|                                      |       |                              |       | Senior Term Debt (6) (7)               |       | 1,588,000  |       | 1,508,600       |
|                                      |       |                              |       | (7.7%, Due 12/2012)                    |       |       |       |            |
|                                      |       |                              |       | Senior Subordinated Term  Debt (6) (7) |       | 500,000    |       | 470,000         |
|                                      |       |                              |       | (11.2%, Due 12/2012)                   |       |       |       |            |
|                                      |       |                              |       |                                   |       |       |       |            |
| Chinese Yellow Pages  Company             |       | Service-publisher of  Chinese     |       | Line of Credit (6) (12)                |       | 430,071    |       | 425,770         |
|                                      |       | language directories              |       | (11.3%, Due 9/2010)                    |       |       |       |            |
|                                      |       |                              |       | Senior Term Debt (6)                   |       | 840,030    |       | 820,154         |
|                                      |       |                              |       | (11.3%, Due 9/2010)                    |       |       |       |            |
|                                           |            |                                   |            |                                        |            |            |            |                 |  |  |

 

3

----

 
| **Company**                           | ** ** | **Industry**                           | ** ** | **Investment  (1)**                    | ** ** | **Cost**  | ** **       | **Fair  Value** |
|---------------------------------------|------------|----------------------------------------|------------|----------------------------------------|------------|-----------|------------------|-----------------|
|                                  |       |                                   |       |                                   |       |      |             |            |
| Clinton Holdings, LLC  (2)            |       | Distribution-aluminum  sheets          |       | Senior Subordinated Term  Debt         |       | $         |  15,500,000 |            | $ |  15,779,000 |
|                                  |       | and stainless steel                    |       | (13)(12.5%, Due 1/2013)                |       |      |             |            |
|                                  |       |                                   |       | Common Stock Warrants  (8)             |       | 109,124   |             | —          |
|                                  |       |                                   |       |                                   |       |      |             |            |
| CMI Acquisition, LLC (2)              |       | Service-recycling                      |       | Senior Subordinated Term  Debt (6)     |       | 6,500,000 |             | 6,386,250       |
|                                  |       |                                   |       | (11.9%, Due 11/2012)                   |       |      |             |            |
|                                  |       |                                   |       |                                   |       |      |             |            |
| Community Media  Corporation          |       | Service-publisher of  free             |       | Senior Term Debt (6)                   |       | 2,985,889 |             | 2,931,519       |
|                                  |       | weekly newspapers                      |       | (9.3%, Due 8/2012)                     |       |      |             |            |
|                                  |       |                                   |       |                                   |       |      |             |            |
| Country Road Communications  LLC      |       | Service-telecommunications             |       | Senior Subordinated Term  Debt (7)     |       | 5,968,659 |             | 5,910,000       |
| (2)                                   |       |                                   |       | (12.6%, Due 7/2013)                    |       |      |             |            |
|                                  |       |                                   |       |                                   |       |      |             |            |
|                                  |       |                                   |       |                                   |       |      |             |            |
| Defiance Acquisition Corporation      |       | Manufacturing-trucking  parts          |       | Senior Term Debt (3) (6)               |       | 6,325,000 |             | 6,008,750       |
|                                  |       |                                   |       | (13.2%, Due 4/2010)                    |       |      |             |            |
|                                  |       |                                   |       |                                   |       |      |             |            |
| Doe & Ingalls  Management LLC (2) |       | Distributor-specialty  chemicals       |       | Senior Term Debt (6)                   |       | 3,700,000 |             | 3,690,750       |
|                                  |       |                                   |       | (8.7%, Due 11/2010)                    |       |      |             |            |
|                                  |       | ** **                             |       | Senior Term Debt (3) (6)               |       | 4,443,750 |             | 4,421,531       |
|                                  |       |                                   |       | (9.7%, Due 11/2010)                    |       |      |             |            |
|                                  |       |                                   |       |                                   |       |      |             |            |
| Emdeon Business  Services, Inc.       |       | Service-healthcare  technology         |       | Senior Term Debt (6) (7)               |       | 2,377,974 |             | 2,256,879       |
|                                  |       | solutions                              |       | (6.8%, Due 11/2013)                    |       |      |             |            |
|                                  |       |                                   |       | Senior Subordinated Term  Debt (6) (7) |       | 2,012,476 |             | 1,920,000       |
|                                  |       |                                   |       | (9.8%, Due 5/2014)                     |       |      |             |            |
|                                  |       |                                   |       |                                   |       |      |             |            |
| Express Courier  International, Inc.  |       | Service-ground delivery  and logistics |       | Line of Credit (6) (14)                |       | 700,000   |             | 695,625         |
|                                  |       |                                   |       | (9.5%, Due 6/2009)                     |       |      |             |            |
|                                  |       |                                   |       | Senior Term Debt (6)                   |       | 3,877,500 |             | 3,853,266       |
|                                  |       |                                   |       | (9.5%, Due 6/2011)                     |       |      |             |            |
|                                  |       |                                   |       | Senior Term Debt (3) (6)               |       | 3,950,000 |             | 3,910,500       |
|                                  |       |                                   |       | (11.7%, Due 6/2011)                    |       |      |             |            |
|                                  |       |                                   |       |                                   |       |      |             |            |
| Finn Corporation                      |       | Manufacturing-landscape equipment      |       | Common Stock Warrants  (8)             |       | 37,000    |             | 3,034,551       |
|                                  |       |                                   |       |                                   |       |      |             |            |
| GFRC Holdings LLC                     |       | Manufacturing-glass-fiber              |       | Line of Credit (5) (15)                |       | —    |             | —          |
|                                  |       | reinforced concrete                    |       | (9.5%, Due 12/2010)                    |       |      |             |            |
|                                  |       |                                   |       | Senior Term Debt (5)                   |       | 7,750,000 |             | 7,750,000       |
|                                  |       |                                   |       | (9.7%, Due 12/2012)                    |       |      |             |            |
|                                  |       |                                   |       | Senior Subordinated Term  Debt (3) (5) |       | 6,750,000 |             | 6,750,000       |
|                                  |       |                                   |       | (12.2%, Due 12/2012)                   |       |      |             |            |
|                                  |       |                                   |       |                                   |       |      |             |            |
| Global Materials Technologies,  Inc.  |       | Manufacturing-steel wool  products     |       | Senior Term Debt (3) (6)               |       | 5,050,000 |             | 4,816,438       |
|                                  |       | and metal fibers                       |       | (14.2%, Due 11/2009)                   |       |      |             |            |
|                                       |            |                                        |            |                                        |            |           |                  |                 |  |  |

 

4

----

 
| **Company**                              | ** ** | **Industry**                                | ** ** | **Investment  (1)**                | ** ** | **Cost**  | ** **    | **Fair  Value** |
|------------------------------------------|------------|---------------------------------------------|------------|------------------------------------|------------|-----------|---------------|-----------------|
|                                     |       |                                        |       |                               |       |      |          |            |
| GTM Holdings, Inc. (2)                   |       | Manufacturing-socks                         |       | Senior Term Debt (7)               |       | $         |  495,000 |            | $ |  465,300 |
|                                     |       |                                        |       | (7.7%, Due 10/2013)                |       |      |          |            |
|                                     |       |                                        |       | Senior Subordinated Term  Debt (7) |       | 500,000   |          | 485,000         |
|                                     |       |                                        |       | (11.0%, Due 4/2014)                |       |      |          |            |
|                                     |       |                                        |       |                               |       |      |          |            |
| Greatwide Logistics Services,  Inc.      |       | Service - logistics and transportation      |       | Senior Term Debt (7)               |       | 3,960,000 |          | 3,326,400       |
|                                     |       |                                        |       | (8.3%, Due 12/2013)                |       |      |          |            |
|                                     |       |                                        |       | Senior Subordinated Term  Debt (7) |       | 4,000,000 |          | 2,800,000       |
|                                     |       |                                        |       | (11.3%, Due 6/2014)                |       |      |          |            |
|                                     |       |                                        |       |                               |       |      |          |            |
| GS Maritime Intermediate  Holdings       |       | Service-cargo transport                     |       | Senior Subordinated Term  Debt (7) |       | 1,000,000 |          | 1,000,000       |
| LLC                                      |       |                                        |       | (12.8%, Due 12/2013)               |       |      |          |            |
|                                     |       |                                        |       |                               |       |      |          |            |
| Harrington Holdings,  Inc. (2)           |       | Service - healthcare  products              |       | Senior Term Debt (7)               |       | 2,481,250 |          | 2,382,000       |
|                                     |       | distribution                                |       | (7.0%, Due 1/2014)                 |       |      |          |            |
|                                     |       |                                        |       | Senior Subordinated Term  Debt (7) |       | 5,000,000 |          | 4,825,000       |
|                                     |       |                                        |       | (10.8%, Due 1/2014)                |       |      |          |            |
|                                     |       |                                        |       |                               |       |      |          |            |
| Heartland Communications  Group,         |       | Service-radio station  operator             |       | Line of Credit (6) (16)            |       | 9,856     |          | 8,871           |
| LLC (2)                                  |       |                                        |       | (10.8%, Due 5/2008)                |       |      |          |            |
|                                     |       |                                        |       | Senior Term Debt (6)               |       | 4,761,113 |          | 4,241,569       |
|                                     |       |                                        |       | (10.8%, Due 5/2011)                |       |      |          |            |
|                                     |       |                                        |       |                               |       |      |          |            |
| Interfilm Holdings, Inc.                 |       | Service-slitter and  distributor of plastic |       | Senior Term Debt (6)               |       | 5,000,000 |          | 4,962,500       |
|                                     |       | films                                       |       | (11.7%, Due 10/2012)               |       |      |          |            |
|                                     |       |                                        |       |                               |       |      |          |            |
| IJGT Acquisition Company                 |       | Service-golf training                       |       | Line of Credit (6) (17)            |       | —    |          | —          |
|                                     |       |                                        |       | (9.5%, Due 5/2010)                 |       |      |          |            |
|                                     |       |                                        |       | Senior Term Debt (6)               |       | 2,650,000 |          | 2,626,813       |
|                                     |       |                                        |       | (9.5%, Due 5/2012)                 |       |      |          |            |
|                                     |       |                                        |       | Senior Term Debt (3) (6)           |       | 2,500,000 |          | 2,468,750       |
|                                     |       |                                        |       | (11.7%, Due 5/2012)                |       |      |          |            |
|                                     |       |                                        |       |                               |       |      |          |            |
| It’s Just Lunch  International, LLC |       | Service-dating service                      |       | Line of Credit (6) (18)            |       | 550,000   |          | 467,500         |
|                                     |       |                                        |       | (9.2%, Due 6/2009)                 |       |      |          |            |
|                                     |       |                                        |       | Senior Term Debt (6)               |       | 3,300,000 |          | 2,805,000       |
|                                     |       |                                        |       | (9.5%, Due 6/2011)                 |       |      |          |            |
|                                     |       |                                        |       | Senior Term Debt (3) (6)  (18)     |       | 500,000   |          | 425,000         |
|                                     |       |                                        |       | (11.7%, Due 6/2011)                |       |      |          |            |
|                                     |       |                                        |       |                               |       |      |          |            |
| John Henry Holdings,  Inc. (2)           |       | Manufacturing-packaging products            |       | Senior Subordinated Term  Debt (7) |       | 8,000,000 |          | 7,760,000       |
|                                     |       |                                        |       | (11.6%, Due 6/2011)                |       |      |          |            |
|                                     |       |                                        |       |                               |       |      |          |            |
| Kinetek Acquisition  Corp.               |       | Manufacturing-custom engineered             |       | Senior Term Debt (7)               |       | 1,490,262 |          | 1,440,450       |
|                                     |       | motors & controls                       |       | (7.3%, Due 11/2013)                |       |      |          |            |
|                                     |       |                                        |       | Senior Subordinated Term  Debt (7) |       | 1,508,531 |          | 1,410,000       |
|                                     |       |                                        |       | (10.3%, Due 5/2014)                |       |      |          |            |
|                                     |       |                                        |       |                               |       |      |          |            |
| KMBQ Corporation                         |       | Service-AM/FM radio broadcaster             |       | Line of Credit (19)                |       | 152,000   |          | 150,480         |
|                                     |       |                                        |       | (12.3%, Due 3/2010)                |       |      |          |            |
|                                     |       |                                        |       | Senior Term Debt (6)               |       | 1,811,305 |          | 1,776,546       |
|                                     |       |                                        |       | (12.3%, Due 3/2010)                |       |      |          |            |
|                                          |            |                                             |            |                                    |            |           |               |                 |  |  |

 

5

----

 
| **Company**                       | ** ** | **Industry**                          | ** ** | **Investment  (1)**                | ** ** | **Cost**  | ** **       | **Fair  Value** |
|-----------------------------------|------------|---------------------------------------|------------|------------------------------------|------------|-----------|------------------|-----------------|
|                              |       |                                  |       |                               |       |      |             |            |
| Lindmark Outdoor  Advertising LLC |       | Service-advertising                   |       | Senior Subordinated Term  Debt (6) |       | $         |  10,000,000 |            | $ |  9,950,000 |
|                              |       |                                  |       | (11.3%, Due 10/2012)               |       |      |             |            |
|                              |       |                                  |       |                               |       |      |             |            |
| LocalTel, Inc.                    |       | Service-yellow pages publishing       |       | Line of Credit (6) (20)  (29)      |       | 1,170,000 |             | 819,000         |
|                              |       |                                  |       | (non-accrual, Due  6/2009)         |       |      |             |            |
|                              |       |                                  |       | Senior Term Debt (6)  (29)         |       | 2,687,500 |             | 1,881,250       |
|                              |       |                                  |       | (non-accrual, Due  6/2011)         |       |      |             |            |
|                              |       |                                  |       | Senior Term Debt (3) (6)  (29)     |       | 2,750,000 |             | 1,925,000       |
|                              |       |                                  |       | (non-accrual, Due  6/2011)         |       |      |             |            |
|                              |       |                                  |       |                               |       |      |             |            |
| Macfadden Performing  Arts        |       | Service-magazine  publisher           |       | Line of Credit (6) (21)            |       | 1,015,979 |             | 1,002,010       |
| Media, LLC                        |       |                                  |       | (9.8%, Due 6/2009)                 |       |      |             |            |
|                              |       |                                  |       | Senior Term Debt (6)               |       | 6,594,503 |             | 6,442,678       |
|                              |       |                                  |       | (9.8%, Due 6/2009)                 |       |      |             |            |
|                              |       |                                  |       |                               |       |      |             |            |
| Meteor Holding  Corporation (2)   |       | Manufacturing-bar code  scanning and  |       | Senior Term Debt (7)               |       | 2,342,300 |             | 2,201,762       |
|                              |       | data capture                          |       | (7.8%, Due 12/2013)                |       |      |             |            |
|                              |       |                                  |       | Senior Subordinated Term  Debt (7) |       | 1,500,000 |             | 1,380,000       |
|                              |       |                                  |       | (11.0%, Due 12/2013)               |       |      |             |            |
|                              |       |                                  |       |                               |       |      |             |            |
| Multi-Ag Media LLC (2)            |       | Service-dairy magazine  publisher/    |       | Senior Term Debt (6)               |       | 2,442,735 |             | 2,396,213       |
|                              |       | information database                  |       | (11.3%, Due 12/2009)               |       |      |             |            |
|                              |       |                                  |       |                               |       |      |             |            |
| Newhall Holdings,  Inc.(2)        |       | Service-distributor of  personal care |       | Line of Credit (6) (22)            |       | —    |             | —          |
|                              |       | products and supplements              |       | (8.7%, Due 5/2010)                 |       |      |             |            |
|                              |       |                                  |       | Senior Term Debt (3) (6)           |       | 4,410,000 |             | 4,376,925       |
|                              |       |                                  |       | (9.0%, Due 5/2012)                 |       |      |             |            |
|                              |       |                                  |       | Senior Term Debt (3) (6)           |       | 4,500,000 |             | 4,455,000       |
|                              |       |                                  |       | (11.3%, Due 5/2012)                |       |      |             |            |
|                              |       |                                  |       |                               |       |      |             |            |
| Northern Contours, Inc.  (2)      |       | Manufacturing-veneer and  laminate    |       | Senior Subordinated Term  Debt (6) |       | 7,000,000 |             | 6,912,500       |
|                              |       | components                            |       | (12.2%, Due 5/2010)                |       |      |             |            |
|                              |       |                                  |       |                               |       |      |             |            |
| Pinnacle Treatment  Centers, Inc. |       | Service-Addiction  treatment centers  |       | Line of Credit (23)                |       | —    |             | —          |
|                              |       |                                  |       | (9.5%, Due 12/2009)                |       |      |             |            |
|                              |       |                                  |       | Senior Term Debt (6)               |       | 2,500,000 |             | 2,475,000       |
|                              |       |                                  |       | (9.5%, Due 12/2011)                |       |      |             |            |
|                              |       |                                  |       | Senior Term Debt (3) (6)           |       | 4,500,000 |             | 4,432,500       |
|                              |       |                                  |       | (12.2%, Due 12/2011)               |       |      |             |            |
|                              |       |                                  |       |                               |       |      |             |            |
| Precision Acquisition  Group      |       | Manufacturing-consumable              |       | Equipment Note (6) (24)            |       | 671,850   |             | 671,850         |
| Holdings, Inc. (2)                |       | components for the  aluminum          |       | (9.7%, Due 10/2011)                |       |      |             |            |
|                              |       | industry                              |       | Senior Term Debt (6)               |       | 5,000,000 |             | 5,000,000       |
|                              |       |                                  |       | (9.7%, Due 10/2010)                |       |      |             |            |
|                              |       |                                  |       | Senior Term Debt (3) (6)           |       | 4,200,000 |             | 4,200,000       |
|                              |       |                                  |       | (11.7%, Due 10/2010)               |       |      |             |            |
|                              |       |                                  |       |                               |       |      |             |            |
| PROFITSystems                     |       | Service-design and  develop           |       | Line of Credit (25)                |       | —    |             | —          |
| Acquisition Co. (2)               |       | ERP software                          |       | (9.5%, Due 7/2009)                 |       |      |             |            |
|                              |       |                                  |       | Senior Term Debt (6)               |       | 2,650,000 |             | 2,630,125       |
|                              |       |                                  |       | (9.5%, Due 7/2011)                 |       |      |             |            |
|                              |       |                                  |       | Senior Term Debt (3) (6)           |       | 2,900,000 |             | 2,871,000       |
|                              |       |                                  |       | (11.7%, Due 7/2011)                |       |      |             |            |
|                                   |            |                                       |            |                                    |            |           |                  |                 |  |  |

 

6

----

 
| **Company**                           | ** ** | **Industry**                             | ** ** | **Investment  (1)**                    | ** ** | **Cost**   | ** **      | **Fair  Value** |
|---------------------------------------|------------|------------------------------------------|------------|----------------------------------------|------------|------------|-----------------|-----------------|
|                                  |       |                                     |       |                                   |       |       |            |            |
| Puerto Rico Cable                     |       | Service-telecommunications               |       | Senior Subordinated Term  Debt (6) (7) |       | $          |  7,794,854 |            | $ |  7,117,580 |
| Acquisition Company,  Inc.            |       |                                     |       | (12.4%, Due 1/2012)                    |       |       |            |            |
|                                  |       |                                     |       |                                   |       |       |            |            |
| RCS Management Holding  Co.           |       | Service-healthcare  supplies             |       | Senior Term Debt (3) (6)               |       | 3,000,000  |            | 2,835,000       |
|                                  |       |                                     |       | (9.7%, Due 1/2011)                     |       |       |            |            |
|                                  |       |                                     |       | Senior Term Debt (4) (6)               |       | 3,000,000  |            | 2,775,000       |
|                                  |       |                                     |       | (12.2%, Due 1/2011)                    |       |       |            |            |
|                                  |       |                                     |       |                                   |       |       |            |            |
| Reading Broadcasting,  Inc.           |       | Service-television  station operator     |       | Senior Term Debt (6)                   |       | 7,529,715  |            | 7,489,875       |
|                                  |       |                                     |       | (11.8%, Due 3/2008)                    |       |       |            |            |
|                                  |       |                                     |       |                                   |       |       |            |            |
| RedPrairie Holding, Inc.  (2)         |       | Service-design and  develop supply       |       | Senior Term Debt (7)                   |       | 4,435,000  |            | 4,257,600       |
|                                  |       | chain software                           |       | (8.0%, Due 7/2012)                     |       |       |            |            |
|                                  |       |                                     |       | Senior Subordinated Term  Debt (7)     |       | 3,000,000  |            | 2,880,000       |
|                                  |       |                                     |       | (11.4%, Due 1/2013)                    |       |       |            |            |
|                                  |       |                                     |       |                                   |       |       |            |            |
| Reliable  Biopharmaceutical Holdings, |       | Manufacturing-pharmaceutical  and        |       | Line of Credit (5) (26)                |       | —     |            | —          |
| Inc.                                  |       | biochemical  intermediates               |       | (8.7%, Due 10/2010)                    |       |       |            |            |
|                                  |       |                                     |       | Mortgage Note (5)                      |       | 7,453,881  |            | 7,453,881       |
|                                  |       |                                     |       | (9.5%, Due 10/2014)                    |       |       |            |            |
|                                  |       |                                     |       | Senior Term Debt (5)                   |       | 1,800,000  |            | 1,800,000       |
|                                  |       |                                     |       | (9.2%, Due 10/2012)                    |       |       |            |            |
|                                  |       |                                     |       | Senior Term Debt (3) (5)               |       | 12,023,500 |            | 12,023,500      |
|                                  |       |                                     |       | (11.2%, Due 10/2012)                   |       |       |            |            |
|                                  |       |                                     |       | Senior Subordinated Term  Debt (5)     |       | 6,000,000  |            | 6,000,000       |
|                                  |       |                                     |       | (12%, Due 10/2013)                     |       |       |            |            |
|                                  |       |                                     |       | Common Stock Warrants  (5) (8)         |       | 208,675    |            | 208,675         |
|                                  |       |                                     |       |                                   |       |       |            |            |
| RiskMetrics Group  Holdings, LLC      |       | Service - develop risk  and wealth       |       | Senior Term Debt (7)                   |       | 1,985,000  |            | 1,935,375       |
|                                  |       | management solutions                     |       | (7.0%, Due 1/2014)                     |       |       |            |            |
|                                  |       |                                     |       | Senior Subordinated Term  Debt (7)     |       | 500,000    |            | 485,000         |
|                                  |       |                                     |       | (10.3%, Due 7/2014)                    |       |       |            |            |
|                                  |       |                                     |       |                                   |       |       |            |            |
| SCI Cable, Inc.                       |       | Service-cable, internet,  voice provider |       | Senior Term Debt (6)                   |       | 2,727,090  |            | 2,574,500       |
|                                  |       |                                     |       | (13.3%, Due 10/2008)                   |       |       |            |            |
|                                  |       |                                     |       |                                   |       |       |            |            |
| SCS Acquisition Corp.  (2)            |       | Service-chemically  treated equipment    |       | Senior Term Debt (6)                   |       | 3,954,811  |            | 3,944,924       |
|                                  |       | distribution                             |       | (9.2%, Due 12/2011)                    |       |       |            |            |
|                                  |       |                                     |       | Senior Term Debt (3) (6)               |       | 6,475,000  |            | 6,442,625       |
|                                  |       |                                     |       | (11.2%, Due 12/2011)                   |       |       |            |            |
|                                  |       |                                     |       |                                   |       |       |            |            |
| Sunburst Media -  Louisiana, LLC      |       | Service-radio station  operator          |       | Senior Term Debt (6)                   |       | 7,872,831  |            | 7,683,000       |
|                                  |       |                                     |       | (11.0%, Due 6/2011)                    |       |       |            |            |
|                                  |       |                                     |       |                                   |       |       |            |            |
| Sunshine Media Holdings               |       | Service-publisher  regional B2B trade    |       | Credit Facility (6) (27)               |       | 700,000    |            | 692,125         |
|                                  |       | magazines                                |       | (9.2%, Due 5/2010)                     |       |       |            |            |
|                                  |       |                                     |       | Senior Term Debt (6)                   |       | 17,000,000 |            | 16,808,750      |
|                                  |       |                                     |       | (9.2%, Due 5/2012)                     |       |       |            |            |
|                                  |       |                                     |       | Senior Term Debt (3) (6)               |       | 10,000,000 |            | 9,800,000       |
|                                  |       |                                     |       | (12.7%, Due 5/2012)                    |       |       |            |            |
|                                  |       |                                     |       |                                   |       |       |            |            |
| Thibaut Acquisition Co.               |       | Service-design and disbribute            |       | Credit Facility (6) (28)               |       | 1,000,000  |            | 995,000         |
|                                  |       | wall covering                            |       | (9.7%, Due 1/2011)                     |       |       |            |            |
|                                  |       |                                     |       | Senior Term Debt (6)                   |       | 2,537,500  |            | 2,524,813       |
|                                  |       |                                     |       | (9.7%, Due 1/2011)                     |       |       |            |            |
|                                  |       |                                     |       | Senior Term Debt (3) (6)               |       | 3,000,000  |            | 2,973,750       |
|                                  |       |                                     |       | (12.2%, Due 1/2011)                    |       |       |            |            |
|                                       |            |                                          |            |                                        |            |            |                 |                 |  |  |

 

7

----

 
| **Company**                                      | ** ** | **Industry**                                               | ** ** | **Investment  (1)**                                     | ** **              | **Cost**   | ** **      | **Fair  Value** |
|--------------------------------------------------|------------|------------------------------------------------------------|------------|---------------------------------------------------------|-------------------------|------------|-----------------|-----------------|
|                                             |       |                                                       |       |                                                    |                    |       |            |            |
| U.S. HealthCare Communications,                  |       | Service-magazine  publisher/operator                       |       | Senior Term Debt (6)  (29)                              |                    | $          |  2,432,869 |            | $ |  1,684,140 |
| LLC                                              |       |                                                       |       | (non-accrual, Due  4/2011)                              |                    |       |            |            |
|                                             |       |                                                       |       |                                                    |                    |       |            |            |
| Viapack, Inc. (2)                                |       | Manufacturing-polyethylene  film                           |       | Senior Real Estate Term  Debt

(9.7%, Due 3/2011)       |                    | 925,000    |            | 925,000         |
|                                             |       |                                                       |       | Senior Term Debt (3) (6)                                |                    | 4,170,313  |            | 4,118,184       |
|                                             |       |                                                       |       | (11.3%, Due 3/2011)                                     |                    |       |            |            |
|                                             |       |                                                       |       |                                                    |                    |       |            |            |
| Visual Edge Technology,  Inc. (2)                |       | Service-office equipment  distribution                     |       | Senior Subordinated Term  Debt (6)

(13.2%, Due 8/2011) |                    | 5,000,000  |            | 3,250,000       |
|                                             |       |                                                       |       |                                                    |                    |       |            |            |
| Wesco Holdings, Inc. (2)                         |       | Service-aerospace parts  and distribution                  |       | Senior Term Debt (7)

(7.0%, Due 9/2013)                |                    | 2,453,450  |            | 2,388,703       |
|                                             |       |                                                       |       | Senior Subordinated Term  Debt (7)                      |                    | 2,269,886  |            | 2,238,750       |
|                                             |       |                                                       |       | (11.6%, Due 3/2014)                                     |                    |       |            |            |
|                                             |       |                                                       |       |                                                    |                    |       |            |            |
| West Coast Yellow Pages,  Inc.                   |       | Service-directory  publisher                               |       | Senior Term Debt (6)                                    |                    | 1,538,743  |            | 1,399,716       |
|                                             |       |                                                       |       | (12.8%, Due 8/2010)                                     |                    |       |            |            |
|                                             |       |                                                       |       |                                                    |                    |       |            |            |
| Westlake Hardware, Inc.  (2)                     |       | Retail-hardware and  variety                               |       | Senior Subordinated Term  Debt (6)                      |                    | 15,000,000 |            | 14,850,000      |
|                                             |       |                                                       |       | (11.7%, Due 1/2011)                                     |                    |       |            |            |
|                                             |       |                                                       |       | Senior Subordinated Term  Debt (6)                      |                    | 10,000,000 |            | 9,850,000       |
|                                             |       |                                                       |       | (13.6%, Due 1/2011)                                     |                    |       |            |            |
|                                             |       |                                                       |       |                                                    |                    |       |            |            |
| Winchester Electronics                           |       | Manufacturing-high  bandwidth connectors and cables        |       | Senior Term Debt (6)

(8.9%, Due 5/2013)                |                    | 1,995,000  |            | 1,975,050       |
|                                             |       |                                                       |       | Senior Subordinated Term  Debt (6)                      |                    | 10,000,000 |            | 9,862,500       |
|                                             |       |                                                       |       | (12.2%, Due 4/2013)                                     |                    |       |            |            |
|                                             |       |                                                       |       |                                                    |                    |       |            |            |
| WP Evenflo Group Holdings  Inc. (2)              |       | Manufacturing-infant and  juvenile products                |       | Senior Term Debt (7)

(7.6%, Due 2/2013)                |                    | 1,985,000  |            | 1,925,450       |
|                                             |       |                                                       |       | Senior Subordinated Term  Debt (7)                      |                    | 2,000,000  |            | 1,870,000       |
|                                             |       |                                                       |       | (11.0%, Due 2/2014)                                     |                    |       |            |            |
| **Total  Non-Control/Non-Affiliate Investments** | ** ** | ** **                                                 | ** ** | **$**                                                   | **423,****933****,339** | ** ** | **$**           | **412,712,262** |
| * *                                         | * *   | * *                                                   | * *   | * *                                                | * *                | * *   | * *        | * *        |
| **CONTROL  INVESTMENTS**                         | ** ** | ** **                                                 | ** ** | ** **                                              | ** **              | ** ** | ** **      | ** **      |
|                                             |       |                                                       |       |                                                    |                    |       |            |            |
| BERTL, Inc.                                      |       | Service-web-based  evaluator

of digital imaging  products |       | Line of Credit (30) (31)

(11.5%, Due 10/2009)          |                    | 613,313    |            | 613,313         |
|                                             |       |                                                       |       | Common Stock (5) (8)                                    |                    | 423,548    |            | 332,115         |
| **Total  Control Investments**                   | ** ** | ** **                                                 | ** ** | ** **                                              | ** **              | **$**      | **1,036,861**   | ** **      | **$** | **945,428** |
| ** **                                       | ** ** | ** **                                                 | ** ** | ** **                                              | ** **              | ** ** | ** **      | ** **      |
| **Total  Investments**                           | ** ** | ** **                                                 | ** ** | ** **                                              | ** **              | **$**      | **424,970,200** | ** **      | **$** | **413,657,690** |

----

(1)  Percentage representsinterest rates in effect at December 31, 2007 and due date represents thecontractual maturity date.

(2)  Certain of the listedsecurities are issued by affiliate(s) of the indicated portfolio company.

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

(4)  Last Out Tranche ofsenior debt, meaning if the company is liquidated then the holder of the LastOut Tranche is paid after the senior debt, however the debt is junior toanother Last Out Tranche.

(5)  Investment valued atcost due to recent acquisition.

(6)  Fair value was based onopinions of value submitted by Standard & Poor’s Securities Evaluations,Inc.

(7)  Marketable securities,such as syndicated loans, are valued based on the indicative bid price, as ofDecember 31, 2007, from the respective originating syndication agent’s tradingdesk.

(8)  Security is non-incomeproducing.

(9) Availability under the ActivStyle credit facility totals$1,500,000.  Borrowings of $600,000 wereoutstanding at December 31, 2007.

(10)  Availability under theAllison credit facility totals $4,000,000. There were no borrowings outstanding at December 31, 2007.

(11)  Availability under theAnitox credit facility totals $3,000,000. There were no borrowings outstanding at December 31, 2007.

 

8

----

 

(12) Availability under the Chinese Yellow Pages credit facilitytotals $700,000.  Borrowings of $430,071were outstanding at December 31, 2007.

(13) Clinton includes a success fee with a fair value of $279,000.

(14) Availability under the Express Courier credit facility totals$1,500,000.  Borrowings of $700,000 wereoutstanding at December 31, 2007.

(15) Availability under the GFRC credit facility totals$3,000,000.  There were no borrowingsoutstanding at December 31, 2007.

(16) Availability under the Heartland credit facility totals$500,000.  Borrowings of $9,856 wereoutstanding at December 31, 2007.

(17) Availability under the International Junior Golf creditfacility totals $1,500,000.  There wereno borrowings outstanding at December 31, 2007.

(18) Availability under the It’s Just Lunch revolving creditfacility totals $750,000, borrowings of $550,000 were outstanding at December31, 2007.  The company may borrow anadditional $1,750,000 of the senior term debt facility, subject to certainconditions including Gladstone Capital’s approval, borrowings of $500,000 wereoutstanding at December 31, 2007.

(19) Availability under the KMBQ credit facility totals$200,000.  Borrowings of $152,000 wereoutstanding at December 31, 2007.

(20) Availability under the LocalTel credit facility totals$3,000,000.  Borrowings of $1,170,000were outstanding at December 31, 2007.

(21) Availability under the MacFadden credit facility totals$1,400,000.  Borrowings of $1,015,979were outstanding at December 31, 2007.

(22) Availability under the Newhall credit facility totals$4,000,000.  There were no borrowingsoutstanding as of December 31, 2007.

(23)  Availability under thePinnacle credit facility totals $500,000. There were no borrowings outstanding at December 31, 2007.

(24) Precision may borrow up to $1,000,000 for purposes ofacquiring equipment. Borrowings of $671,850 were outstanding at December 31,2007.

(25) Availability under the ProfitSystems credit facility totals$1,250,000.  There were no borrowingsoutstanding at December 31, 2007.

(26)  Availability under theReliable credit facility totals $5,000,000. There were no borrowingsoutstanding at December 31, 2007.

(27) Availability under the Sunshine credit facility totals$3,000,000.  Borrowings of $700,000 wereoutstanding at December 31, 2007.

(28) Availability under the Thibaut credit facility totals$1,000,000.  The facility was fully drawnat December 31, 2007.

(29) LocalTel and US Healthcare Communications are currently pastdue on interest payments and are on non-accrual.

(30) Availability under the BERTL credit facility totals$700,000.  Borrowings of $613,313 wereoutstanding at December 31, 2007.

(31) BERTL interest is currently being capitalized as Paid in Kind(“PIK”) interest.  Please refer to Note 2“Summary of Significant Accounting Policies”.

 

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

 

9

----

** **

**GLADSTONE CAPITALCORPORATION**

**CONSOLIDATED SCHEDULEOF INVESTMENTS**

**AS OF SEPTEMBER 30,2007**

** **
| **Company**                                | ** ** | **Industry**                      | ** ** | **Investment  (1)**                    | ** ** | **Cost**   | ** ** | **Fair  Value** | ** ** |
|--------------------------------------------|------------|-----------------------------------|------------|----------------------------------------|------------|------------|------------|-----------------|------------|
| ** **                                 | ** ** | ** **                        | ** ** | ** **                             | ** ** | ** ** | ** ** | ** **      | ** ** |
| **NON-CONTROL/NON-AFFILIATE  INVESTMENTS** | ** ** |
|                                       |       |                              |       |                                   |       |       |       |            |       |
| Access Television                          |       | Service-cable airtime             |       | Line of Credit (9)                     |       | $          | —     |            | $          | — |   |
| Network, Inc. (2)                          |       | (infomercials)                    |       | (11.8% Due 3/2009)                     |       |       |       |            |       |
|                                       |       |                              |       | Senior Term Debt (6)                   |       | 2,616,283  |       | 2,557,844       |       |
|                                       |       |                              |       | (11.8% Due 3/2009)                     |       |       |       |            |       |
|                                       |       |                              |       |                                   |       |       |       |            |       |
| ActivStyle Acquisition  Co. (2)            |       | Service-medical products          |       | Line of Credit (6) (10)                |       | 600,000    |       | 597,000         |       |
|                                       |       | distribution                      |       | (10.0%, Due 7/2009)                    |       |       |       |            |       |
|                                       |       |                              |       | Senior Term Debt (6)                   |       | 5,245,000  |       | 5,218,775       |       |
|                                       |       |                              |       | (10.0%, Due 9/2012)                    |       |       |       |            |       |
|                                       |       |                              |       | Senior Term Debt (3) (6)               |       | 4,435,000  |       | 4,407,281       |       |
|                                       |       |                              |       | (12.6%, Due 9/2012)                    |       |       |       |            |       |
|                                       |       |                              |       |                                   |       |       |       |            |       |
| Allison Publications,  LLC (2)             |       | Service-publisher of  consumer    |       | Senior Term Debt (6)                   |       | 7,884,092  |       | 7,779,503       |       |
|                                       |       | oriented magazines                |       | (9.8%, Due 12/2011)                    |       |       |       |            |       |
|                                       |       |                              |       |                                   |       |       |       |            |       |
| Anitox Acquisition  Company (2)            |       | Manufacturing-preservatives  for  |       | Senior Real Estate Term  Debt          |       | 3,110,050  |       | 3,060,000       |       |
|                                       |       | animal feed                       |       | (8.8%, Due 1/2012)                     |       |       |       |            |       |
|                                       |       |                              |       | Line of Credit (11)                    |       | —     |       | —          |       |
|                                       |       |                              |       | (10.0%, Due 1/2010)                    |       |       |       |            |       |
|                                       |       |                              |       | Senior Term Debt (6)                   |       | 2,750,000  |       | 2,736,250       |       |
|                                       |       |                              |       | (10.0%, Due 1/2012)                    |       |       |       |            |       |
|                                       |       |                              |       | Senior Term Debt (3) (6)               |       | 2,750,000  |       | 2,736,250       |       |
|                                       |       |                              |       | (12.3%, Due 1/2012)                    |       |       |       |            |       |
|                                       |       |                              |       |                                   |       |       |       |            |       |
| Badanco Acquisition  Corp.                 |       | Service-luggage design  and       |       | Senior Subordinated Term  Debt (6)     |       | 9,652,500  |       | 9,628,369       |       |
|                                       |       | distribution                      |       | (12.4%, Due 7/2012)                    |       |       |       |            |       |
|                                       |       |                              |       |                                   |       |       |       |            |       |
| Bresnan Communications,  LLC               |       | Service-telecommunications        |       | Senior Term Debt (7)                   |       | 3,001,802  |       | 2,910,000       |       |
|                                       |       |                              |       | (7.4%, Due 9/2013)                     |       |       |       |            |       |
|                                       |       |                              |       | Senior Subordinated Term  Debt (7)     |       | 1,510,006  |       | 1,485,000       |       |
|                                       |       |                              |       | (9.9%, Due 3/2014)                     |       |       |       |            |       |
|                                       |       |                              |       |                                   |       |       |       |            |       |
| CCS, LLC                                   |       | Service-cable tv  franchise owner |       | Senior Term Debt (6)                   |       | 3,432,830  |       | 3,416,330       |       |
|                                       |       |                              |       | (11.8%, Due 10/2007)                   |       |       |       |            |       |
|                                       |       |                              |       |                                   |       |       |       |            |       |
| CHG Companies, Inc. (2)                    |       | Service-healthcare  staffing      |       | Letter of Credit (6) (7)               |       | 400,000    |       | 385,000         |       |
|                                       |       |                              |       | (7.1%, Due 12/2012)                    |       |       |       |            |       |
|                                       |       |                              |       | Senior Term Debt (6) (7)               |       | 1,588,000  |       | 1,528,450       |       |
|                                       |       |                              |       | (7.9%, Due 12/2012)                    |       |       |       |            |       |
|                                       |       |                              |       | Senior Subordinated Term  Debt (6) (7) |       | 500,000    |       | 480,000         |       |
|                                       |       |                              |       | (11.9%, Due 12/2012)                   |       |       |       |            |       |
|                                       |       |                              |       |                                   |       |       |       |            |       |
| Chinese Yellow Pages  Company              |       | Service-publisher of  Chinese     |       | Line of Credit (6) (12)                |       | 230,071    |       | 228,633         |       |
|                                       |       | language directories              |       | (11.8%, Due 9/2010)                    |       |       |       |            |       |
|                                       |       |                              |       | Senior Term Debt (6)                   |       | 1,070,643  |       | 1,051,383       |       |
|                                       |       |                              |       | (11.8%, Due 9/2010)                    |       |       |       |            |       |
|                                       |       |                              |       |                                   |       |       |       |            |       |
| Clinton Holdings, LLC  (2)                 |       | Distribution-aluminum  sheets     |       | Senior Subordinated Term  Debt         |       | 15,500,000 |       | 15,500,000      |       |
|                                       |       | and stainless steel               |       | (13.0%, Due 1/2013)                    |       |       |       |            |       |
|                                       |       |                              |       | Common Stock Warrants  (8)             |       | 109,124    |       | 222,777         |       |
|                                            |            |                                   |            |                                        |            |            |            |                 |            |  |  |  |  |  |

 

10

----

 
| **Company**                     | ** ** | **Industry**                      | ** ** | **Investment  (1)**                    | ** ** | **Cost**  | ** ** | **Fair  Value** |   |
|---------------------------------|------------|-----------------------------------|------------|----------------------------------------|------------|-----------|------------|-----------------|--------|
|                            |       |                              |       |                                   |       |      |       |            |   |
| CMI Acquisition, LLC (2)        |       | Service-recycling                 |       | Senior Subordinated Term  Debt (6)     |       | $         | 6,500,000  |            | $      | 6,451,250 |   |
|                            |       |                              |       | (12.4%, Due 11/2012)                   |       |      |       |            |   |
|                            |       |                              |       |                                   |       |      |       |            |   |
| Community Media  Corporation    |       | Service-publisher of  free weekly |       | Senior Term Debt (6)                   |       | 2,510,974 |       | 2,481,780       |   |
|                            |       | newspapers                        |       | (9.8%, Due 8/2012)                     |       |      |       |            |   |
|                            |       |                              |       |                                   |       |      |       |            |   |
| Country Road                    |       | Service-telecommunications        |       | Senior Subordinated Term  Debt (6) (7) |       | 5,967,246 |       | 5,880,000       |   |
| Communications LLC (2)          |       |                              |       | (13.1%, Due 7/2013)                    |       |      |       |            |   |
|                            |       |                              |       |                                   |       |      |       |            |   |
| Defiance Acquisition            |       | Manufacturing-trucking  parts     |       | Senior Term Debt (3) (6)               |       | 6,325,000 |       | 6,245,938       |   |
| Corporation                     |       |                              |       | (13.8%, Due 4/2010)                    |       |      |       |            |   |
|                            |       |                              |       |                                   |       |      |       |            |   |
| Doe & Ingalls  Management   |       | Distributor-specialty  chemicals  |       | Senior Term Debt (6)                   |       | 3,900,000 |       | 3,900,000       |   |
| LLC (2)                         |       |                              |       | (9.3%, Due 11/2010)                    |       |      |       |            |   |
|                            |       |                              |       | Senior Term Debt (3) (6)               |       | 4,455,000 |       | 4,455,000       |   |
|                            |       |                              |       | (10.3%, Due 11/2010)                   |       |      |       |            |   |
|                            |       |                              |       |                                   |       |      |       |            |   |
| Emdeon Business  Services,      |       | Service-healthcare  technology    |       | Senior Term Debt (7)                   |       | 2,433,992 |       | 2,382,949       |   |
| Inc.                            |       | solutions                         |       | (7.4%, Due 11/2013)                    |       |      |       |            |   |
|                            |       |                              |       | Senior Subordinated Term  Debt (7)     |       | 2,012,968 |       | 1,985,000       |   |
|                            |       |                              |       | (10.2%, Due 5/2014)                    |       |      |       |            |   |
|                            |       |                              |       |                                   |       |      |       |            |   |
| Express Courier  International, |       | Service-ground delivery  and      |       | Line of Credit (6) (13)                |       | 900,000   |       | 898,875         |   |
| Inc.                            |       | logistics                         |       | (10.0%, Due 6/2009)                    |       |      |       |            |   |
|                            |       |                              |       | Senior Term Debt (6)                   |       | 4,112,500 |       | 4,107,359       |   |
|                            |       |                              |       | (10.0%, Due 6/2011)                    |       |      |       |            |   |
|                            |       |                              |       | Senior Term Debt (3) (6)               |       | 3,950,000 |       | 3,945,063       |   |
|                            |       |                              |       | (12.3%, Due 6/2011)                    |       |      |       |            |   |
|                            |       |                              |       |                                   |       |      |       |            |   |
| Finn Corporation                |       | Manufacturing-landscape           |       | Common Stock Warrants  (8)             |       | 37,000    |       | 3,005,333       |   |
|                            |       | equipment                         |       |                                   |       |      |       |            |   |
|                            |       |                              |       |                                   |       |      |       |            |   |
| Global Materials                |       | Manufacturing-steel wool          |       | Senior Term Debt (3) (6)               |       | 5,100,000 |       | 4,883,250       |   |
| Technologies, Inc.              |       | products and metal  fibers        |       | (14.8%, Due 11/2009)                   |       |      |       |            |   |
|                            |       |                              |       |                                   |       |      |       |            |   |
| GTM Holdings, Inc. (2)          |       | Manufacturing-socks               |       | Senior Term Debt (7)                   |       | 496,250   |       | 481,363         |   |
|                            |       |                              |       | (8.1%, Due 10/2013)                    |       |      |       |            |   |
|                            |       |                              |       | Senior Subordinated Term  Debt (7)     |       | 500,000   |       | 495,000         |   |
|                            |       |                              |       | (11.4%, Due 4/2014)                    |       |      |       |            |   |
|                            |       |                              |       |                                   |       |      |       |            |   |
| Greatwide Logistics             |       | Service - logistics and           |       | Senior Term Debt (7)                   |       | 3,970,000 |       | 3,453,900       |   |
| Services, Inc.                  |       | transportation                    |       | (8.7%, Due 12/2013)                    |       |      |       |            |   |
|                            |       |                              |       | Senior Subordinated Term  Debt (7)     |       | 4,000,000 |       | 3,280,000       |   |
|                            |       |                              |       | (11.7%, Due 6/2014)                    |       |      |       |            |   |
|                            |       |                              |       |                                   |       |      |       |            |   |
| Harrington Holdings,  Inc. (2)  |       | Service - healthcare  products    |       | Senior Term Debt (7)                   |       | 2,487,500 |       | 2,419,094       |   |
|                            |       | distribution                      |       | (7.4%, Due 1/2014)                     |       |      |       |            |   |
|                            |       |                              |       | Senior Subordinated Term  Debt (7)     |       | 5,000,000 |       | 4,825,000       |   |
|                            |       |                              |       | (11.2%, Due 1/2014)                    |       |      |       |            |   |
|                                 |            |                                   |            |                                        |            |           |            |                 |        |  |  |

 

11

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| **Company**                     | ** ** | **Industry**                      | ** ** | **Investment  (1)**                | ** ** | **Cost**  | ** ** | **Fair  Value** |   |
|---------------------------------|------------|-----------------------------------|------------|------------------------------------|------------|-----------|------------|-----------------|--------|
|                            |       |                              |       |                               |       |      |       |            |   |
| Heartland Communications        |       | Service-radio station  operator   |       | Line of Credit (6) (14)            |       | $         | 9,856      |            | $      | 9,807 |   |
| Group, LLC (2)                  |       |                              |       | (11.3%, Due 5/2008)                |       |      |       |            |   |
|                            |       |                              |       | Senior Term Debt (6)               |       | 4,824,340 |       | 4,533,921       |   |
|                            |       |                              |       | (11.3%, Due 5/2011)                |       |      |       |            |   |
|                            |       |                              |       |                               |       |      |       |            |   |
| IJGT Acquisition Company        |       | Service-golf training             |       | Line of Credit (6) (15)            |       | 500,000   |       | 497,500         |   |
|                            |       |                              |       | (10.0%, Due 5/2010)                |       |      |       |            |   |
|                            |       |                              |       | Senior Term Debt (6)               |       | 2,650,000 |       | 2,636,750       |   |
|                            |       |                              |       | (10.0%, Due 5/2012)                |       |      |       |            |   |
|                            |       |                              |       | Senior Term Debt (3) (6)           |       | 2,500,000 |       | 2,481,250       |   |
|                            |       |                              |       | (12.3%, Due 5/2012)                |       |      |       |            |   |
|                            |       |                              |       |                               |       |      |       |            |   |
| It's Just Lunch  International, |       | Service-dating service            |       | Line of Credit (6) (16)            |       | 550,000   |       | 492,250         |   |
| LLC                             |       |                              |       | (9.8%, Due 6/2009)                 |       |      |       |            |   |
|                            |       |                              |       | Senior Term Debt (6)               |       | 3,300,000 |       | 2,953,500       |   |
|                            |       |                              |       | (10.0%, Due 6/2011)                |       |      |       |            |   |
|                            |       |                              |       | Senior Term Debt (3) (6)  (16)     |       | 500,000   |       | 447,500         |   |
|                            |       |                              |       | (12.3%, Due 6/2011)                |       |      |       |            |   |
|                            |       |                              |       |                               |       |      |       |            |   |
| John Henry Holdings,  Inc. (2)  |       | Manufacturing-packaging           |       | Senior Subordinated Term  Debt (7) |       | 8,000,000 |       | 8,000,000       |   |
|                            |       | products                          |       | (12.8%, Due 6/2011)                |       |      |       |            |   |
|                            |       |                              |       |                               |       |      |       |            |   |
| Kinetek Acquisition  Corp.      |       | Manufacturing-custom              |       | Senior Term Debt (7)               |       | 1,494,240 |       | 1,444,087       |   |
|                            |       | engineered motors &  controls |       | (7.6%, Due 11/2013)                |       |      |       |            |   |
|                            |       |                              |       | Senior Subordinated Term  Debt (7) |       | 1,508,870 |       | 1,440,000       |   |
|                            |       |                              |       | (10.6%, Due 5/2014)                |       |      |       |            |   |
|                            |       |                              |       |                               |       |      |       |            |   |
| KMBQ Corporation                |       | Service-AM/FM radio               |       | Line of Credit (17)                |       | 152,000   |       | 151,240         |   |
|                            |       | broadcaster                       |       | (12.8%, Due 3/2010)                |       |      |       |            |   |
|                            |       |                              |       | Senior Term Debt (6)               |       | 1,813,174 |       | 1,785,518       |   |
|                            |       |                              |       | (12.8%, Due 3/2010)                |       |      |       |            |   |
|                            |       |                              |       |                               |       |      |       |            |   |
| LocalTel, Inc.                  |       | Service-yellow pages              |       | Line of Credit (6) (18)            |       | 1,135,000 |       | 947,725         |   |
| `                               |       | publishing                        |       | (10.3%, Due 6/2009)                |       |      |       |            |   |
|                            |       |                              |       | Senior Term Debt (6)               |       | 2,687,500 |       | 2,244,063       |   |
|                            |       |                              |       | (10.3%, Due 6/2011)                |       |      |       |            |   |
|                            |       |                              |       | Senior Term Debt (3) (6)           |       | 2,750,000 |       | 2,200,000       |   |
|                            |       |                              |       | (12.8%, Due 6/2011)                |       |      |       |            |   |
|                            |       |                              |       |                               |       |      |       |            |   |
| Macfadden Performing  Arts      |       | Service-magazine  publisher       |       | Line of Credit (6) (19)            |       | 515,979   |       | 510,175         |   |
| Media, LLC                      |       |                              |       | (10.8%, Due 6/2009)                |       |      |       |            |   |
|                            |       |                              |       | Senior Term Debt (6)               |       | 6,705,338 |       | 6,558,379       |   |
|                            |       |                              |       | (10.8%, Due 6/2009)                |       |      |       |            |   |
|                            |       |                              |       |                               |       |      |       |            |   |
| Meteor Holding  Corporation (2) |       | Manufacturing-bar code  scanning  |       | Senior Term Debt (7)               |       | 2,348,200 |       | 2,324,718       |   |
|                            |       | and data capture                  |       | (8.2%, Due 12/2013)                |       |      |       |            |   |
|                            |       |                              |       | Senior Subordinated Term  Debt (7) |       | 1,500,000 |       | 1,425,000       |   |
|                            |       |                              |       | (11.5%, Due 12/2013)               |       |      |       |            |   |
|                                 |            |                                   |            |                                    |            |           |            |                 |        |  |  |

 

12

----

 
| **Company**                       | ** ** | **Industry**                       | ** ** | **Investment  (1)**                    | ** ** | **Cost**  | ** ** | **Fair  Value** |   |
|-----------------------------------|------------|------------------------------------|------------|----------------------------------------|------------|-----------|------------|-----------------|--------|
|                              |       |                               |       |                                   |       |      |       |            |   |
| Multi-Ag Media LLC (2)            |       | Service-dairy magazine  publisher/ |       | Senior Term Debt (6)                   |       | $         | 2,548,152  |            | $      | 2,523,045 |   |
|                              |       | information database               |       | (11.8%, Due 12/2009)                   |       |      |       |            |   |
|                              |       |                               |       |                                   |       |      |       |            |   |
| Newhall Holdings,  Inc.(2)        |       | Service-distributor of  personal   |       | Line of Credit (6) (20)                |       | —    |       | —          |   |
|                              |       | care products and supplements      |       | (8.8%, Due 5/2010)                     |       |      |       |            |   |
|                              |       |                               |       | Senior Term Debt (3) (6)               |       | 4,500,000 |       | 4,488,750       |   |
|                              |       |                               |       | (9.5%, Due 5/2012)                     |       |      |       |            |   |
|                              |       |                               |       | Senior Term Debt (3) (6)               |       | 4,500,000 |       | 4,488,750       |   |
|                              |       |                               |       | (11.8%, Due 5/2012)                    |       |      |       |            |   |
|                              |       |                               |       |                                   |       |      |       |            |   |
| Northern Contours, Inc.  (2)      |       | Manufacturing-veneer and           |       | Senior Subordinated Term  Debt (6)     |       | 7,000,000 |       | 6,982,500       |   |
|                              |       | laminate components                |       | (12.8%, Due 5/2010)                    |       |      |       |            |   |
|                              |       |                               |       |                                   |       |      |       |            |   |
| Pinnacle Treatment  Centers, Inc. |       | Service-Addiction  treatment       |       | Line of Credit (21)                    |       | —    |       | —          |   |
|                              |       | centers                            |       | (10.0%, Due 12/2009)                   |       |      |       |            |   |
|                              |       |                               |       | Senior Term Debt (6)                   |       | 2,500,000 |       | 2,487,500       |   |
|                              |       |                               |       | (10.0%, Due 12/2011)                   |       |      |       |            |   |
|                              |       |                               |       | Senior Term Debt (3) (6)               |       | 4,500,000 |       | 4,466,250       |   |
|                              |       |                               |       | (12.8%, Due 12/2011)                   |       |      |       |            |   |
|                              |       |                               |       |                                   |       |      |       |            |   |
| Precision Acquisition  Group      |       | Manufacturing-consumable           |       | Equipment Note (6) (22)                |       | 671,850   |       | 671,850         |   |
| Holdings, Inc. (2)                |       | components for the  aluminum       |       | (10.3%, Due 10/2011)                   |       |      |       |            |   |
|                              |       | industry                           |       | Senior Term Debt (6)                   |       | 5,000,000 |       | 5,006,250       |   |
|                              |       |                               |       | (10.3%, Due 10/2010)                   |       |      |       |            |   |
|                              |       |                               |       | Senior Term Debt (3) (6)               |       | 4,200,000 |       | 4,205,250       |   |
|                              |       |                               |       | (12.3%, Due 10/2010)                   |       |      |       |            |   |
|                              |       |                               |       |                                   |       |      |       |            |   |
| PROFITSystems                     |       | Service-design and  develop        |       | Line of Credit (23)                    |       | —    |       | —          |   |
| Acquisition Co. (2)               |       | ERP software                       |       | (10.0%, Due 7/2009)                    |       |      |       |            |   |
|                              |       |                               |       | Senior Term Debt (6)                   |       | 2,800,000 |       | 2,796,500       |   |
|                              |       |                               |       | (10.0%, Due 7/2011)                    |       |      |       |            |   |
|                              |       |                               |       | Senior Term Debt (3) (6)               |       | 2,900,000 |       | 2,896,375       |   |
|                              |       |                               |       | (12.3%, Due 7/2011)                    |       |      |       |            |   |
|                              |       |                               |       |                                   |       |      |       |            |   |
| Puerto Rico Cable                 |       | Service-telecommunications         |       | Senior Subordinated Term  Debt (6) (7) |       | 7,798,538 |       | 7,388,358       |   |
| Acquisition Company,  Inc.        |       |                               |       | (11.5%, Due 1/2012)                    |       |      |       |            |   |
|                              |       |                               |       |                                   |       |      |       |            |   |
| RCS Management Holding  Co.       |       | Service-healthcare  supplies       |       | Senior Term Debt (3) (6)               |       | 3,000,000 |       | 2,880,000       |   |
|                              |       |                               |       | (10.3%, Due 1/2011)                    |       |      |       |            |   |
|                              |       |                               |       | Senior Term Debt (4) (6)               |       | 3,000,000 |       | 2,865,000       |   |
|                              |       |                               |       | (12.8%, Due 1/2011)                    |       |      |       |            |   |
|                              |       |                               |       |                                   |       |      |       |            |   |
| Reading Broadcasting,  Inc.       |       | Service-television  station        |       | Senior Term Debt (6)                   |       | 7,560,031 |       | 7,497,971       |   |
|                              |       | operator                           |       | (12.3%, Due 3/2008)                    |       |      |       |            |   |
|                              |       |                               |       |                                   |       |      |       |            |   |
| RedPrairie Holding, Inc.  (2)     |       | Service-design and  develop        |       | Senior Term Debt (7)                   |       | 4,457,500 |       | 4,234,625       |   |
|                              |       | supply chain software              |       | (8.5%, Due 7/2012)                     |       |      |       |            |   |
|                              |       |                               |       | Senior Subordinated Term  Debt (7)     |       | 3,000,000 |       | 2,850,000       |   |
|                              |       |                               |       | (11.9%, Due 1/2013)                    |       |      |       |            |   |
|                              |       |                               |       |                                   |       |      |       |            |   |
| RiskMetrics Group  Holdings,      |       | Service - develop risk  and        |       | Senior Term Debt (7)                   |       | 1,990,000 |       | 1,965,125       |   |
| LLC                               |       | wealth management  solutions       |       | (7.4%, Due 1/2014)                     |       |      |       |            |   |
|                              |       |                               |       | Senior Subordinated Term  Debt (7)     |       | 500,000   |       | 495,000         |   |
|                              |       |                               |       | (10.7%, Due 7/2014)                    |       |      |       |            |   |
|                              |       |                               |       |                                   |       |      |       |            |   |
| SCI Cable, Inc.                   |       | Service-cable, internet,  voice    |       | Senior Term Debt (6)                   |       | 2,482,106 |       | 2,398,388       |   |
|                              |       | provider                           |       | (13.8%, Due 10/2008)                   |       |      |       |            |   |
|                                   |            |                                    |            |                                        |            |           |            |                 |        |  |  |

 

13

----

 
| **Company**                                      | ** ** | **Industry**                    | ** ** | **Investment  (1)**                | ** ** | **Cost**   | ** **      | **Fair  Value** |       |
|--------------------------------------------------|------------|---------------------------------|------------|------------------------------------|------------|------------|-----------------|-----------------|------------|
|                                             |       |                            |       |                               |       |       |            |            |       |
| SCS Acquisition Corp.  (2)                       |       | Service-chemically  treated     |       | Senior Term Debt (6)  (18)         |       | $          | 5,117,311       |            | $          | 5,110,914 |   |
|                                             |       | equipment distribution          |       | (9.8%, Due 12/2011)                |       |       |            |            |       |
|                                             |       |                            |       | Senior Term Debt (3) (6)  (18)     |       | 6,493,750  |            | 6,477,516       |       |
|                                             |       |                            |       | (11.8%, Due 12/2011)               |       |       |            |            |       |
|                                             |       |                            |       |                               |       |       |            |            |       |
| Sunburst Media -  Louisiana, LLC                 |       | Service-radio station  operator |       | Senior Term Debt (6)               |       | 7,878,036  |            | 7,800,000       |       |
|                                             |       |                            |       | (11.5%, Due 6/2011)                |       |       |            |            |       |
|                                             |       |                            |       |                               |       |       |            |            |       |
| Sunshine Media Holdings                          |       | Service-publisher  regional B2B |       | Credit Facility (6) (24)           |       | 700,000    |            | 694,750         |       |
|                                             |       | trade magazines                 |       | (9.8%, Due 5/2010)                 |       |       |            |            |       |
|                                             |       |                            |       | Senior Term Debt (6)               |       | 17,000,000 |            | 16,915,000      |       |
|                                             |       |                            |       | (9.8%, Due 5/2012)                 |       |       |            |            |       |
|                                             |       |                            |       | Senior Term Debt (3) (6)           |       | 10,000,000 |            | 9,925,000       |       |
|                                             |       |                            |       | (12.3%, Due 5/2012)                |       |       |            |            |       |
|                                             |       |                            |       |                               |       |       |            |            |       |
| Thibaut Acquisition Co.                          |       | Service-design and  disbribute  |       | Credit Facility (6) (25)           |       | 800,000    |            | 798,000         |       |
|                                             |       | wall covering                   |       | (10.3%, Due 1/2011)                |       |       |            |            |       |
|                                             |       |                            |       | Senior Term Debt (6)               |       | 2,712,500  |            | 2,709,109       |       |
|                                             |       |                            |       | (10.3%, Due 1/2011)                |       |       |            |            |       |
|                                             |       |                            |       | Senior Term Debt (3) (6)           |       | 3,000,000  |            | 2,992,500       |       |
|                                             |       |                            |       | (12.8%, Due 1/2011)                |       |       |            |            |       |
|                                             |       |                            |       |                               |       |       |            |            |       |
| U.S. HealthCare                                  |       | Service-magazine  publisher/    |       | Senior Term Debt (6)  (26)         |       | 2,244,657  |            | 1,809,158       |       |
| Communications, LLC                              |       | operator                        |       | (non-accrual, Due  4/2011)         |       |       |            |            |       |
|                                             |       |                            |       |                               |       |       |            |            |       |
| Viapack, Inc. (2)                                |       | Manufacturing-polyethylene      |       | Senior Real Estate Term  Debt      |       | 975,000    |            | 975,000         |       |
|                                             |       | film                            |       | (10.3%, Due 3/2011)                |       |       |            |            |       |
|                                             |       |                            |       | Senior Term Debt (3) (6)           |       | 4,223,438  |            | 4,191,762       |       |
|                                             |       |                            |       | (11.8%, Due 3/2011)                |       |       |            |            |       |
|                                             |       |                            |       |                               |       |       |            |            |       |
| Visual Edge Technology,  Inc. (2)                |       | Service-office equipment        |       | Senior Subordinated Term  Debt (6) |       | 5,000,000  |            | 3,575,000       |       |
|                                             |       | distribution                    |       | (13.8%, Due 8/2011)                |       |       |            |            |       |
|                                             |       |                            |       |                               |       |       |            |            |       |
| Wesco Holdings, Inc. (2)                         |       | Service-aerospace parts  and    |       | Senior Term Debt (7)               |       | 2,454,430  |            | 2,382,625       |       |
|                                             |       | distribution                    |       | (7.5%, Due 9/2013)                 |       |       |            |            |       |
|                                             |       |                            |       | Senior Subordinated Term  Debt (7) |       | 2,270,690  |            | 2,233,125       |       |
|                                             |       |                            |       | (11.0%, Due 3/2014)                |       |       |            |            |       |
|                                             |       |                            |       |                               |       |       |            |            |       |
| West Coast Yellow Pages,  Inc.                   |       | Service-directory  publisher    |       | Senior Term Debt (6)               |       | 1,584,335  |            | 1,518,441       |       |
|                                             |       | (13.3%, Due 8/2010)             |       |                               |       |       |            |            |       |
|                                             |       |                            |       |                               |       |       |            |            |       |
| Westlake Hardware, Inc.  (2)                     |       | Retail-hardware and  variety    |       | Senior Subordinated Term  Debt (6) |       | 15,000,000 |            | 14,986,500      |       |
|                                             |       |                            |       | (13.0%, Due 1/2011)                |       |       |            |            |       |
|                                             |       |                            |       |                               |       |       |            |            |       |
| Winchester Electronics                           |       | Manufacturing-high  bandwidth   |       | Senior Term Debt (6)               |       | 1,995,000  |            | 1,990,013       |       |
|                                             |       | connectors and cables           |       | (9.5%, Due 5/2013)                 |       |       |            |            |       |
|                                             |       |                            |       | Senior Subordinated Term  Debt (6) |       | 10,000,000 |            | 9,950,000       |       |
|                                             |       |                            |       | (12.8%, Due 4/2013)                |       |       |            |            |       |
|                                             |       |                            |       |                               |       |       |            |            |       |
| WP Evenflo Group                                 |       | Manufacturing-infant and        |       | Senior Term Debt (7)               |       | 1,990,000  |            | 1,850,700       |       |
| Holdings Inc. (2)                                |       | juvenile products               |       | (8.0%, Due 2/2013)                 |       |       |            |            |       |
|                                             |       |                            |       | Senior Subordinated Term  Debt (7) |       | 2,000,000  |            | 1,860,000       |       |
|                                             |       |                            |       | (11.5%, Due 2/2014)                |       |       |            |            |       |
| **Total Non-Control/Non-Affiliate  Investments** |       |                            | ** ** | ** **                         | ** ** | **$**      | **354,835,652** | ** **      | **$**      | **348,920,982** | ** ** |
| * *                                         | * *   | * *                        | * *   | * *                           | * *   | * *   | * *        | * *        | * *   |
| **CONTROL INVESTMENTS**                          | ** ** | ** **                      | ** ** | ** **                         | ** ** | ** ** | ** **      | ** **      | ** ** |
|                                             |       |                            |       |                               |       |       |            |            |       |
| BERTL, Inc.                                      |       | Service-web-based  evaluator    |       | Common Stock (5) (8)               |       | 923,548    |            | 923,548         |       |
|                                             |       | of digital imaging  products    |       |                               |       |       |            |            |       |
|                                             |       |                            |       |                               |       |       |            |            |       |
| **Total Investments (27)**                       |       |                            |       |                               | ** ** | **$**      | **355,759,200** | ** **      | **$**      | **349,844,530** | ** ** |

 

14

----

 

----

(1)  Percentage represents interest rates in effect atSeptember 30, 2007 and due date represents the contractual maturity date.

(2)  Certain of the listed securities are issued byaffiliate(s) of the indicated portfolio company.

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

(4)  Last Out Tranche of senior debt, meaning if thecompany is liquidated then the holder of the Last Out Tranche is paid after thesenior debt, however the debt is junior to another Last Out Tranche.

(5)  Investment valued at cost due to recentacquisition.

(6)  Fair value was based on opinions of value submittedby Standard & Poor’s Securities Evaluations, Inc.

(7)  Marketable securities, such as syndicated loans,are valued based on the indicative bid price, as of September 28, 2007, fromthe respective originating syndication agent’s trading desk.

(8)  Security is non-income producing.

(9)  Availability under the Access TV credit facilitytotals $500,000. There were no borrowings outstanding as of September 30, 2007.

(10)  Availability under the ActivStyle credit facilitytotals $1,500,000.  Borrowings of $600,000were outstanding at September 30, 2007.

(11)  Availability under the Anitox credit facilitytotals $3,000,000.  There were noborrowings outstanding at September 30, 2007.

(12)  Availability under the Chinese Yellow Pages creditfacility totals $950,000.  Borrowings of$230,071 were outstanding at September 30, 2007.

(13)  Availability under the Express Courier creditfacility totals $1,500,000.  Borrowingsof $900,000 were outstanding at September 30, 2007.

(14)  Availability under the Heartland credit facilitytotals $500,000.  Borrowings of $9,856were outstanding at September 30, 2007.

(15)  Availability under the International Junior Golfcredit facility totals $1,000,000. Borrowings of $500,000 were outstanding at September 30, 2007.

(16)  Availability under the It’s Just Lunch revolvingcredit facility totals $750,000, borrowings of $550,000 were outstanding atSeptember 30, 2007.  The company mayborrow an additional $1,750,000 of the senior term debt facility, subject tocertain conditions including Gladstone Capital’s approval, borrowings of$500,000 were outstanding at September 30, 2007.

(17)  Availability under the KMBQ credit facility totals$200,000.  Borrowings of $152,000 wereoutstanding at September 30, 2007.

(18)  Availability under the LocalTel credit facilitytotals $3,000,000.  Borrowings of$1,135,000 were outstanding at September 30, 2007.

(19)  Availability under the MacFadden credit facilitytotals $1,400,000.  Borrowings of$515,979 were outstanding at September 30, 2007.

(20)  Availability under the Newhall credit facilitytotals $4,000,000.  There were noborrowings outstanding as of September 30, 2007.

(21)  Availability under the Pinnacle credit facilitytotals $500,000.  There were noborrowings outstanding at September 30, 2007.

(22)  Precision may borrow up to $1,000,000 for purposesof acquiring equipment. Borrowings of $671,850 were outstanding at September30, 2007.

(23)  Availability under the ProfitSystems creditfacility totals $1,250,000.  There wereno borrowings outstanding at September 30, 2007.

(24)  Availability under the Sunshine credit facilitytotals $3,000,000.  Borrowings of$700,000 were outstanding at September 30, 2007.

(25)  Availability under the Thibaut credit facilitytotals $1,000,000.  Borrowings of$800,000 were outstanding at September 30, 2007.

(26)  US Healthcare Communications, LLC is currentlypast due on interest payments and is on non-accrual.

(27)  Aggregate gross unrealized depreciation forfederal income tax purposes is $9,107,156; aggregate gross unrealizedappreciation for federal income tax purposes is $3,192,486.  Net unrealized depreciation is $5,914,670based on a tax cost of $355,759,200.

 

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

 

15

----

 

 

**GLADSTONE CAPITALCORPORATION**

**CONSOLIDATEDSTATEMENTS OF OPERATIONS**

**(UNAUDITED)**

 
| ** **                                                                   | ** ** | **Three Months Ended December 31,** | ** ** |
|------------------------------------------------------------------------------|------------|------------------------------------------|------------|
| ** **                                                                   | ** ** | **2007**                                 | ** ** | **2006** | ** ** |
| INVESTMENT INCOME                                                            |       |                                     |       |   |   |
| Interest income — investments                                           |       | $                                        | 11,138,978 |   | $ | 7,898,600 |   |
| Interest income — cash and cash equivalents                             |       | 144,485                                  |       | 37,269 |   |
| Interest income — notes receivable from employees                       |       | 118,176                                  |       | 138,191 |   |
| Prepayment fees and other income                                             |       | —                                   |       | 159,658 |   |
| Total investment income                                                      |       | 11,401,639                               |       | 8,233,718 |   |
|                                                                         |       |                                     |       |   |   |
| EXPENSES                                                                     |       |                                     |       |   |   |
| Interest expense                                                             |       | 2,356,315                                |       | 1,120,257 |   |
| Loan servicing fee (Refer to Note 4)                                         |       | 1,381,307                                |       | 719,152 |   |
| Base management fee (Refer to Note 4)                                        |       | 577,920                                  |       | 476,849 |   |
| Incentive fee (Refer to Note 4)                                              |       | 1,460,657                                |       | 1,148,483 |   |
| Administration fee (Refer to Note 4)                                         |       | 211,675                                  |       | 126,085 |   |
| Professional fees                                                            |       | 129,253                                  |       | 110,920 |   |
| Amortization of deferred financing fees                                      |       | 73,799                                   |       | 58,300 |   |
| Stockholder related costs                                                    |       | 119,769                                  |       | 63,728 |   |
| Directors fees                                                               |       | 54,250                                   |       | 54,250 |   |
| Insurance expense                                                            |       | 54,213                                   |       | 62,694 |   |
| Other expenses                                                               |       | 65,131                                   |       | 88,485 |   |
| Expenses before credit from Adviser                                          |       | 6,484,289                                |       | 4,029,203 |   |
|                                                                         |       |                                     |       |   |   |
| Credit to base management and incentive fees from  Adviser (Refer to Note 4) |       | (2,385,935                               | )          | (958,411 | ) |
| Total expenses net of credit to base management and  incentive fees          |       | 4,098,354                                |       | 3,070,792 |   |
|                                                                         |       |                                     |       |   |   |
| NET INVESTMENT INCOME                                                        |       | 7,303,285                                |       | 5,162,926 |   |
|                                                                         |       |                                     |       |   |   |
| REALIZED AND UNREALIZED  GAIN (LOSS) ON INVESTMENTS:                         |       |                                     |       |   |   |
| Realized gain on sale of investments                                         |       | —                                   |       | 2,314 |   |
| Realized gain on settlement of derivative                                    |       | 5,606                                    |       | 12,554 |   |
| Unrealized depreciation on derivative                                        |       | (10,553                                  | )          | (9,812 | ) |
| Net unrealized depreciation on investments                                   |       | (5,397,841                               | )          | (1,004,379 | ) |
| Net loss on investments                                                      |       | (5,402,788                               | )          | (999,323 | ) |
|                                                                         |       |                                     |       |   |   |
| NET INCREASE IN NET  ASSETS RESULTING FROM OPERATIONS                        |       | $                                        | 1,900,497  |   | $ | 4,163,603 |   |
|                                                                         |       |                                     |       |   |   |
| NET INCREASE IN NET ASSETS RESULTING FROM OPERATIONS  PER COMMON SHARE:      |       |                                     |       |   |   |
| Basic and Diluted                                                            |       | $                                        | 0.11       |   | $ | 0.34 |   |
|                                                                         |       |                                     |       |   |   |
| WEIGHTED AVERAGE SHARES  OF COMMON STOCK OUTSTANDING:                        |       |                                     |       |   |   |
| Basic and Diluted                                                            |       | 16,953,703                               |       | 12,294,340 |   |

 

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

 

16

----

 

**GLADSTONE CAPITALCORPORATION**

**CONSOLIDATEDSTATEMENTS OF CHANGES IN NET ASSETS**

**(UNAUDITED)**

** **
| ** **                                                         | ** ** | **Three Months Ended December 31,** | ** **  |
|--------------------------------------------------------------------|------------|------------------------------------------|-------------|
| ** **                                                         | ** ** | **2007**                                 | ** **  | **2006** | ** ** |
| *Operations:*                                                      | * *   | * *                                 | * *    | * * | * * |
| Net investment income                                              |       | $                                        | 7,303,285   |   | $ | 5,162,926 |   |
| Net realized gain on sale of investments                           |       | —                                   |        | 2,314 |   |
| Realized gain on settlement of derivative                          |       | 5,606                                    |        | 12,554 |   |
| Unrealized depreciation on derivative                              |       | (10,553                                  | )           | (9,812 | ) |
| Net unrealized depreciation on investments                         |       | (5,397,841                               | )           | (1,004,379 | ) |
| Net increase in net assets from operations                         |       | 1,900,497                                |        | 4,163,603 |   |
|                                                               |       |                                     |        |   |   |
| *Capital transactions:*                                            | * *   | * *                                 | * *    | * * | * * |
| Issuance of common stock under shelf offering                      |       | 50,801,250                               |        | — |   |
| Distributions from net investment income                           |       | (7,355,281                               | )           | (5,162,927 | ) |
| Repayment of principal on employee notes                           |       | 6,326                                    |        | 152 |   |
| Shelf offering costs                                               |       | (279,340                                 | )           | — |   |
| Stock surrendered in settlement of withholding tax                 |       | —                                   |        | (1,488,193 | ) |
| Increase (decrease) in net assets from capital share  transactions |       | 43,172,955                               |        | (6,650,968 | ) |
|                                                               |       |                                     |        |   |   |
| Total increase  (decrease) in net assets                           |       | 45,073,452                               |        | (2,487,365 | ) |
| Net assets at beginning  of year                                   |       | 220,958,735                              |        | 172,570,487 |   |
| Net assets at end of  period                                       |       | $                                        | 266,032,187 |   | $ | 170,083,122 |   |

 

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

 

17

----

 

**GLADSTONE CAPITALCORPORATION**

**CONSOLIDATEDSTATEMENTS OF CASH FLOWS**

**(UNAUDITED)**

 
| ** **                                                                                                                              | ** ** | **Three Months Ended December 31,** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------------------------|------------|
| ** **                                                                                                                              | ** ** | **2007**                                 | ** ** | **2006** | ** ** |
| **CASH FLOWS FROM OPERATING  ACTIVITIES**                                                                                               | ** ** | ** **                               | ** ** | ** ** | ** ** |
| ** **                                                                                                                              | ** ** | ** **                               | ** ** | ** ** | ** ** |
| Net increase in net assets resulting from operations                                                                                    |       | $                                        | 1,900,497  |   | $ | 4,163,603 |   |
| Adjustments to reconcile net increase in net assets  resulting from operations to net cash provided by (used in) operating  activities: |       |                                     |       |   |   |
| Purchase of investments                                                                                                                 |       | (73,340,781                              | )          | (52,311,008 | ) |
| Principal repayments on investments                                                                                                     |       | 4,046,711                                |       | 23,967,229 |   |
| Net amortization of premiums and discounts                                                                                              |       | 92,666                                   |       | 9,181 |   |
| Amortization of deferred financing fees                                                                                                 |       | 73,799                                   |       | 58,300 |   |
| Unrealized depreciation on derivative                                                                                                   |       | 10,553                                   |       | 9,812 |   |
| Change in net unrealized depreciation on investments                                                                                    |       | 5,397,841                                |       | 1,004,379 |   |
| Decrease (increase) in interest receivable                                                                                              |       | 174,338                                  |       | (530,270 | ) |
| Increase in funds due from custodian                                                                                                    |       | (1,585,801                               | )          | (297,409 | ) |
| Increase in prepaid assets                                                                                                              |       | (68,540                                  | )          | (53,686 | ) |
| Decrease (increase) in other assets                                                                                                     |       | 66,143                                   |       | (5,572 | ) |
| Increase in accounts payable                                                                                                            |       | 1,244                                    |       | 6,859 |   |
| Increase in interest payable                                                                                                            |       | 7,821                                    |       | 111,075 |   |
| Decrease in accrued expenses and deferred  liabilities                                                                                  |       | (52,708                                  | )          | (118,189 | ) |
| (Decrease) increase in fees due to affiliate                                                                                            |       | (697,463                                 | )          | 608,743 |   |
| (Decrease) increase in administration fee due to  Gladstone Administration                                                              |       | (25,835                                  | )          | 126,085 |   |
| Increase in funds held in escrow                                                                                                        |       | 157,268                                  |       | 47 |   |
| Increase in investment balance due to payment in  kind interest                                                                         |       | (9,597                                   | )          | — |   |
| Net cash used in operating activities                                                                                                   |       | (63,851,844                              | )          | (23,250,821 | ) |
|                                                                                                                                    |       |                                     |       |   |   |
| **CASH FLOWS FROM FINANCING  ACTIVITIES:**                                                                                              | ** ** | ** **                               | ** ** | ** ** | ** ** |
| ** **                                                                                                                              | ** ** | ** **                               | ** ** | ** ** | ** ** |
| Net proceeds from the issuance of common shares                                                                                         |       | 50,801,250                               |       | — |   |
| Borrowings from the line of credit                                                                                                      |       | 75,000,000                               |       | 69,900,000 |   |
| Repayments on the line of credit                                                                                                        |       | (57,609,000                              | )          | (34,707,000 | ) |
| Distributions paid                                                                                                                      |       | (7,355,281                               | )          | (5,162,927 | ) |
| Receipt of principal on notes receivable - employees                                                                                    |       | 6,326                                    |       | 152 |   |
| Deferred financing fees                                                                                                                 |       | (19,820                                  | )          | (26,275 | ) |
| Shelf offering costs                                                                                                                    |       | (279,340                                 | )          | — |   |
| Withholding tax obligation settlement                                                                                                   |       | —                                   |       | (1,488,193 | ) |
| Net cash provided by financing activities                                                                                               |       | 60,544,135                               |       | 28,515,757 |   |
|                                                                                                                                    |       |                                     |       |   |   |
| **NET (DECREASE) INCREASE IN CASH  AND CASH EQUIVALENTS (1)**                                                                           |       | (3,307,709                               | )          | 5,264,936 |   |
| **CASH AND CASH EQUIVALENTS,  BEGINNING OF PERIOD**                                                                                     |       | 8,838,658                                |       | 731,744 |   |
| **CASH AND CASH EQUIVALENTS, END  OF PERIOD**                                                                                           |       | $                                        | 5,530,949  |   | $ | 5,996,680 |   |
|                                                                                                                                    |       |                                     |       |   |   |
| **CASH PAID DURING PERIOD FOR  INTEREST**                                                                                               |       | $                                        | 2,348,495  |   | $ | 1,009,182 |   |

 

----

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

 

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

 

18

----

 

**GLADSTONE CAPITALCORPORATION**

**FINANCIALHIGHLIGHTS**

**(UNAUDITED)**

** **
| ** **                                                       | ** ** | **Three Months Ended December 31,** | ** **  |
|------------------------------------------------------------------|------------|------------------------------------------|-------------|
| ** **                                                       | ** ** | **2007**                                 | ** **  | **2006** | ** ** |
| Per Share Data (1)                                               |       |                                     |        |   |   |
| Net asset value at beginning of period                           |       | $                                        | 14.97       |   | $ | 14.02 |   |
| *Income from investment operations:*                             | * *   | * *                                 | * *    | * * | * * |
| Net investment income (2)                                        |       | 0.43                                     |        | 0.42 |   |
| Net unrealized depreciation on investments (2)                   |       | (0.32                                    | )           | (0.08 | ) |
| Total from investment operations                                 |       | 0.11                                     |        | 0.34 |   |
| Less distributions:                                              |       |                                     |        |   |   |
| Distributions to stockholders                                    |       | (0.42                                    | )           | (0.42 | ) |
| Total distributions                                              |       | (0.42                                    | )           | (0.42 | ) |
| Issuance of common stock under shelf offering                    |       | 0.44                                     |        | — |   |
| Offering costs                                                   |       | (0.02                                    | )           | — |   |
| Dilutive effect of share issuance                                |       | —                                   |        | (0.06 | ) |
| Net asset value at end of period                                 |       | $                                        | 15.08       |   | $ | 13.88 |   |
|                                                             |       |                                     |        |   |   |
| Per share market value at beginning of period                    |       | $                                        | 19.52       |   | $ | 22.01 |   |
| Per share market value at end of period                          |       | 17.01                                    |        | 23.86 |   |
| Total return (3)(4)                                              |       | -10.86                                   | %           | 10.31 | % |
| Shares outstanding at end of period                              |       | 17,637,574                               |        | 12,249,683 |   |
|                                                             |       |                                     |        |   |   |
| Ratios/Supplemental Data                                         |       |                                     |        |   |   |
| Net assets at end of period                                      |       | $                                        | 266,032,187 |   | $ | 173,083,122 |   |
| Average net assets (5)                                           |       | $                                        | 265,360,346 |   | $ | 170,331,785 |   |
| Ratio of expenses to average net assets-annualized  (6)          |       | 9.77                                     | %           | 9.28 | % |
| Ratio of net expenses to average net  assets-annualized (7)      |       | 6.18                                     | %           | 7.21 | % |
| Ratio of net investment income to average net  assets-annualized |       | 11.01                                    | %           | 12.12 | % |

 

----

(1)                  Based on actual shares outstanding at the end of the correspondingperiod.

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

(3)                  Total return equals the change in the ending market value of theCompany’s common stock from the beginning of the period taking into accountdividends reinvested in accordance with the terms of our dividend reinvestmentplan. Total return does not take into account dividends that may becharacterized as a return of capital. For further information on estimatedcharacter of our dividends please refer to Note 9.

(4)                  Amounts were not annualized.

(5)                  Average net assets are computed using the average of the balanceof net assets at the end of each month of the reporting period.

(6)                  Ratio of expenses to average net assets is computed using expensesbefore credits from Adviser to the base management and incentive fees andincluding income tax expense.

(7)                  Ratio of net expenses to average net assets is computed usingtotal expenses net of credits from Adviser to the base management and incentivefees and including income tax expense.

 

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

 

19

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** **

**GLADSTONE CAPITALCORPORATION**

**NOTES TO CONSOLIDATEDFINANCIAL STATEMENTS**

**DECEMBER 31, 2007**

**(UNAUDITED)**

 

NOTE 1.  ORGANIZATION

 

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

 

Gladstone Business Loan,LLC (“Business Loan”), a wholly-owned subsidiary of the Company, wasestablished on February 3, 2003 for the purpose of holding the Company’sportfolio of loan investments.  GladstoneCapital Advisers, Inc. is also a wholly-owned subsidiary.

 

Gladstone SSBICCorporation (“Gladstone SSBIC”), a wholly-owned subsidiary of the Company, wasestablished on November 21, 2006 for the purpose of holding a license tooperate as a Specialized Small Business Investment Company.  Gladstone SSBIC acquired this license inFebruary 2007.  This will enable the Company,through this subsidiary, to make investments in accordance with the UnitedStates Small Business Administration guidelines for specialized small businessinvestment companies.  Currently,Gladstone SSBIC holds a U.S. Treasury Bill that it purchased with proceeds fromthe Company’s initial stock purchase in Gladstone SSBIC of approximately $2.5million.

 

The financial statementsof the subsidiaries are consolidated with those of the Company.

 

The Company isexternally managed by Gladstone Management Corporation (the “Adviser”), anunconsolidated affiliate of the Company.

 

NOTE 2.  SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

 

*Unaudited Interim FinancialStatements*

* *

Interim financialstatements of the Company are prepared in accordance with accounting principlesgenerally accepted in the United States of America (“GAAP”) for interimfinancial information and pursuant to the requirements for reporting on 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, 2007, as filed with the Securities andExchange Commission (the “SEC”) on December 3, 2007.

 

*Consolidation*

 

UnderArticle 6 of Regulation S-X under the Securities Act of 1933, asamended, and the authoritative accounting guidance provided by the AICPA Auditand Accounting Guide for Investment Companies, the Company is not permitted toconsolidate any subsidiary or other entity that is not an investment company.

 

*Use of Estimates*

 

The preparation offinancial statements in conformity with GAAP requires management to makeestimates and assumptions that affect the reported amounts of assets andliabilities and disclosure of contingent assets and liabilities at the date ofthe financial statements and reported amounts of revenues and expenses duringthe reporting period. Actual results could differ from those estimates.

 

*Reclassifications*

 

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

 

 

20

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*Cash and Cash Equivalents*

* *

The company considersall short-term, highly liquid investments that are both readily convertible tocash and have a maturity of three months or less at the time of purchase to becash equivalents.  Items classified ascash equivalents include temporary investments in U.S. Treasury bills and canalso include commercial paper and money-market funds.  All of the Company’s cash at December 31,2007 was deposited with three financial institutions, and the Company’sbalances exceed federally insurable limits. The Company seeks to mitigate this risk by depositing funds with majorfinancial institutions. Cash and cash equivalents are carried at cost whichapproximates fair value as of December 31, 2007 and September 30, 2007.

 

*Classification of Investments*

* *

The 1940 Actrequires classification of the Company’s investments by its respective level ofcontrol.  As defined in the 1940 Act,“Control Investments” are investments in those portfolio companies that theCompany is deemed to “Control.” “Affiliate Investments” are investments in those portfolio companiesthat are “Affiliated Companies” of the Company, as defined in the 1940 Act,other than Control Investments. “Non-Control/Non-Affiliate Investments” are those that are neitherControl Investments nor Affiliate Investments. In general, the 1940 Act prescribes that the Company has control over aportfolio company if it owns greater than 25% of the voting securities of theportfolio company.  The Company is deemedto be an affiliate of a portfolio company if it owns between 5% and 25% of thevoting securities of such portfolio company or has one or more seats on theaffiliated company’s board of directors. However, if the Company holds 50% or more contractual representation ona portfolio company’s board of directors, the Company will be deemed to havecontrol over the portfolio company.

 

*Investment Valuation*

 

The Companycarries its investments at fair value, as determined by its Board of Directors.Securities that are publicly traded are valued at the closing price on thevaluation date. Securities for which a limited market exists, such as certainparticipations in syndicated loans, are valued at the indicative bid price onor near the valuation date from the respective originating syndication agent’strading desk. Debt and equity securities that are not publicly traded, or forwhich a limited market does not exist, are valued at fair value based on theCompany’s valuation policy. The Company’s Board of Directors has established avaluation policy and consistently applied valuation procedures used todetermine the fair value of these securities quarterly.

 

The procedures forthe determination of the fair value of the Company’s debt securities that thatare not publicly traded and that are issued to portfolio companies where theCompany has no equity, or equity-like securities, rely on the opinions of valuesubmitted to it by Standard & Poor’s Securities Evaluations, Inc.(“SPSE”). The Company may also submit paid in kind (“PIK”) interest to SPSE forvaluation when it is determined the PIK interest is likely to be received. SPSEwill only evaluate the debt portion of the Company’s investments for which theCompany specifically requests evaluation, and may decline to make requestedevaluations for any reason at its sole discretion. SPSE opinions of value aresubmitted to the Board of Directors along with the Adviser’s supplementalassessment and recommendation regarding valuation of each of these investments.

 

The fair value ofconvertible debt, equity, success or exit fees or other equity-like securitiesis determined based on the collateral, the enterprise value of the issuer, theissuer’s ability to make payments, the earnings of the issuer, recent sales tothird parties of similar securities, the comparison to publicly tradedsecurities, discounted cash flow or other pertinent factors. In gathering thesales to third parties of similar securities, the Company may referenceindustry statistics and use outside experts.

 

Debt securitiesthat are issued by portfolio companies where the Company has equity, or equity-likesecurities are valued at cost, if there is adequate total enterprise valuedetermined when valuing the Company’s equity securities of the portfoliocompany. Fair values are discounted for any shortfall of total enterprise valueover the total debt outstanding for the borrower.

 

The Board ofDirectors then reviews whether the Adviser has followed its establishedprocedures for determinations of fair value, and votes whether or not to acceptthe recommended valuation of the Company’s investment portfolio.

 

Due to theuncertainty inherent in the valuation process, such estimates of fair value maydiffer significantly from the values that would have resulted had a readymarket for the securities existed, and the differences could be material.Additionally, changes in the market environment and other events that may occurover the life of the investments may cause the gains or losses ultimatelyrealized on these investments to be different than the valuation currentlyassigned. Because there is a delay between when the Company closes aninvestment and when the investment can be evaluated by SPSE, new investmentsare not valued immediately by SPSE; rather, the Adviser makes its owndetermination about the recommended value of these investments in accordancewith the Company’s valuation policy without the input of SPSE during thespecific quarter in which the investment is made. Because SPSE does notcurrently perform independent valuations of mortgage loans or equity securitiesfor the Company, the Adviser also determines a recommendation for the fairvalue of these investments, if any, without the input of SPSE. The Adviserconsiders a number of qualitative and quantitative factors in current marketconditions when performing valuations. The Board of Directors then determines 

 

21

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whether or not toaccept the Adviser’s recommendations for the aggregate valuation of the Company’sportfolio of investments. The Board of Directors is ultimately responsible forsetting the fair value and disclosure of investments in the financialstatements.

 

*Interest Income Recognition*

 

Interest income, adjusted for amortization of premiums and acquisitioncosts and for the accretion of discounts, is recorded on the accrual basis tothe extent that such amounts are expected to be collected. The Company stopsaccruing interest on its investments when it is determined that interest is nolonger collectible.  At December 31,2007, two Non-Control/Non-Affiliate investments were on non-accrual with anaggregate cost basis of approximately $9.0 million, or about 2% of the costbasis of all investments in the Company’s portfolio as compared to September30, 2007, in which one Non-Control/Non-Affiliate investment was on non-accrualwith a cost basis of approximately $2.2 million at September 30, 2007, or lessthan 1% of the cost basis of all investments in the Company’s portfolio.  Conditional interest, or a success fee, isrecorded upon full repayment of a loan investment.

 

*Paid in Kind Interest*

* *

The Company seeksto avoid PIK interest, however, the Company has one loan in its portfolio thatcontains a PIK provision. A PIK provision requires the borrower to accrue apayment to the Company but the borrower does not have to pay that interestuntil the loan is paid in full. The PIK interest is added to the principalbalance of the loan and recorded as income to the Company even though the cashhas not been received.  To maintain theCompany’s status as a RIC (as discussed in Note 9), this non-cash source ofincome must be paid out to stockholders in the form of cash dividends, eventhough the Company has not yet collected the cash. The Company recorded PIKinterest income for the three months ended December 31, 2007 of $13,926 ininterest from investments on the consolidated statement of operations. Therewere no PIK loans in the Company’s portfolio during the three months endedDecember 31, 2006.

 

*Services Provided to PortfolioCompanies*

 

The 1940 Act requiresthat a business development company make available managerial assistance to itsportfolio companies by providing significant guidance and counsel concerningthe management, operations, or business objectives and policies of therespective portfolio company.  TheCompany provides these and other services to its portfolio companies throughits Adviser.  Currently, neither the Companynor the Adviser charges a fee for managerial assistance.

 

The Adviserreceives fees for other services it provides to the Company’s portfoliocompanies.  These other fees aretypically non-recurring, are recognized as revenue when earned and aregenerally paid directly to the Adviser by the borrower or potential borrowerupon closing of the investment.  Theservices the Adviser provides to portfolio companies vary by investment, butgenerally include a broad array of services, such as investment bankingservices, arranging bank and equity financing, structuring financing frommultiple lenders and investors, reviewing existing credit facilities,restructuring existing investments, raising equity and debt capital, turnaroundmanagement, merger and acquisition services and recruiting new managementpersonnel.  Effective April 1, 2007, whenthe Adviser receives fees for these services, 50% of certain of those fees arevoluntarily credited against the base management fee that the Company pays toits Adviser.  Prior to April 1, 2007,100% of such fees were credited against the base management fee.

 

The Adviser alsoreceives fees for monitoring and reviewing portfolio company investments.  These fees are recurring and are generallypaid annually or quarterly in advance to the Adviser throughout the life of theinvestment.  Fees of this nature arerecorded as revenue by the Adviser when earned and are not credited against thebase management fee.

 

The Company mayreceive fees for the origination and closing services it provides to portfoliocompanies through its Adviser. These fees are paid directly to the Company andare recognized as revenue upon closing of the originated investment and arereported as fee income in the consolidated statements of operations.

 

*Realized Gain or Loss andUnrealized Appreciation or Depreciation of Portfolio Investments*

* *

Realized gain or loss isrecognized when an investment is disposed of and is computed as the differencebetween the Company’s cost basis in the investment at the disposition date andthe net proceeds received from such disposition.  Unrealized appreciation or depreciationdisplays the difference between the fair market value of the investment and thecost basis of such investment.

 

*Deferred Finance Costs*

* *

Costs associatedwith the Company’s line of credit facility with Deutsche Bank AG are deferredand amortized over the life of the credit facility, generally for a period ofone year.

 

22

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*Federal Income Taxes*

* *

The Company intends to continue to qualify fortreatment as a RIC under subchapter M of the Code. As a RIC, the Company willnot be subject to federal income tax on the portion of its taxable income andgains distributed to stockholders. To qualify as a RIC, the Company is requiredto distribute at least 90% of its investment company taxable income, as definedby the Code. The Company intends to distribute at least 90% of its ordinaryincome, and as a result, no income tax provisions have been recorded. TheCompany may, but does not intend to, pay out a return of capital.

 

In June 2006, the Financial Accounting Standards Board(“FASB”) issued FASB Interpretation No. 48, “*Accounting for Uncertainty in Income Taxes—an interpretation of FASBStatement No. 109”,* (“FIN 48”), which clarifies the accountingfor uncertainty in income taxes recognized in an enterprise’s financialstatements in accordance with SFAS No. 109, “*Accounting for Income Taxes*.” FIN 48 is effective as of thebeginning of an entity’s first fiscal year that begins after December 15,2006. The Company adopted this Interpretation on October 1, 2007. Theadoption of FIN 48 did not have a material impact on the Company’s consolidatedfinancial statements.

 

*Dividends*

 

Distributions to stockholders are recorded on the recorddate. The Company is required to pay out at least 90% of its ordinary incomeand short-term capital gains for each taxable year as a dividend to itsstockholders in order to maintain its status as a RIC under Subtitle A, Chapter1 of Subchapter M of the Code. It is the policy of the Company to pay out as adividend up to 100% of those amounts. The amount to be paid out as a dividendis determined by the Board of Directors each quarter and is based on the annualearnings estimated by the management of the Company. Based on that estimate, adividend is declared each quarter and is paid out monthly over the course ofthe respective quarter. At year-end the Company may pay a bonus dividend, inaddition to the monthly dividends, to ensure that it has paid out at least 90%of its ordinary income and short-term capital gains for the year. The Company mayretain long-term capital gains, if any, and not pay them out as dividends.  If the Company decides to retain long-termcapital gains, the portion of the retained capital gains will be subject to 35%tax.

 

*Recent Accounting Pronouncements*

* *

In September 2006, theFASB issued SFAS No. 157, *“Fair Value Measurements”*(“SFAS No. 157”).  SFAS No. 157 definesfair value, establishes a framework for measuring fair value in accordance withGAAP, and expands disclosures about fair value measurements.  SFAS No. 157 applies broadly to securitiesand other types of assets and liabilities. SFAS No. 157 is effective for financial statements issued for fiscal yearsbeginning after November 15, 2007 and interim periods within that fiscal year.  The Company will be required to adopt SFASNo. 157 on October 1, 2008 and is currently evaluating the impact of thispronouncement on its consolidated financial statements.

 

In February2007, the FASB issued SFAS No. 159, *“The Fair Value Option forFinancial Assets and Financial Liabilities — Including an Amendment ofFASB Statement No. 115”* which is effective for fiscal yearsbeginning after November 15, 2007. This pronouncement permits an entity tochoose to measure many financial instruments and certain other items at fairvalue at specified election dates. Subsequent unrealized gains and losses onitems for which the fair value option has been elected will be reported inearnings. The Company is currently evaluating the potential impact of this pronouncementon its consolidated financial statements.

 

In November2007, the SEC issued Staff Accounting Bulletin No. 109, *“WrittenLoan Commitments Recorded at Fair Value Through Earnings”* (“SAB109”)*.* SAB 109 providesguidance on the accounting for written loan commitments recorded at fair valueunder GAAP. Specifically, SAB 109 revises the Staff's views on incorporatingexpected net future cash flows related to loan servicing activities in the fairvalue measurement of a written loan commitment.  SAB 109, which supersedes  SAB  105,  “*Application of  Accounting  Principles  to  Loan Commitments”*,requires  the  expected  net  future  cash flows  related to the associated  servicing of the loan be includedin the measurement of all written loan commitments that are accounted for atfair value through earnings. SAB 109 is effective in fiscal quarters beginningafter December 15, 2007. The Company is currently evaluating the impact of thispronouncement on its consolidated financial statements.

 

In December 2007,the FASB issued SFAS No. 141(R) *“Business Combinations”*(“SFAS No. 141(R)”). SFAS No. 141(R) establishes principles and requirementsfor how an acquirer recognizes and measures in its financial statements theidentifiable assets acquired, the liabilities assumed, any noncontrollinginterest in the acquiree and the goodwill acquired. SFAS No. 141(R) alsoestablishes disclosure requirements to enable the evaluation of the nature andfinancial effects of the business combination. SFAS No. 141(R) is effective asof the beginning of an entity’s fiscal year that begins after December 15,2008.  The Company is required to adoptSFAS No. 141 (R) on October 1, 2009 and is currently evaluating the impact ofthis pronouncement on its consolidated financial statements.

 

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In December2007, the FASB issued SFAS No. 160, “*Noncontrolling Interest in Consolidated Financial Statements”* (“SFAS No. 160”)*.*SFAS No. 160 amends Accounting Research Bulletin 51to establish accounting and reporting standards for the noncontrolling(minority) interest in a subsidiary and for the deconsolidation of asubsidiary. It clarifies that a noncontrolling interest in a subsidiary is anownership interest in the consolidated entity that should be reported as equityin the consolidated financial statements. SFAS No. 160 is effective for interim periods beginning on or afterDecember 15, 2008.  The Company is requiredto adopt SFAS No. 160 on October 1, 2009 and is currently evaluating the impactof this pronouncement on its consolidated financial statements.

 

NOTE 3. INVESTMENTS

 

*Non-Control/Non-AffiliateInvestments*

 

At December 31, 2007 andSeptember 30, 2007, the Company held investments in Non-Control/Non-Affiliateof approximately $423.9 million and $354.8 million, at cost, respectively.

 

*Control Investments*

 

At December 31, 2007, theCompany had one control investment in BERTL, Inc. (“BERTL”).  The Company originally purchased a past duedebt instrument in MCA Communications LLC, and the Company accepted a deed inlieu of foreclosure in satisfaction of BERTL’s obligations under the debtinstrument on September 28, 2007.  BERTLis a web-based evaluator of digital imaging products.  The investment in BERTL consists of a line ofcredit facility with a cost basis and fair value of $613,313 and also commonstock with a cost basis of $423,548 and a fair value of $332,115.  The Company’s investment in BERTL’s commonstock had a cost basis and fair value of $923,548 at September 30, 2007.

 

Investments at fairvalue consisted of the following industry classifications as of December 31,2007 and September 30, 2007:

 

 
| ** **                                     | ** ** | **December 31, 2007** | ** **  | **September 30, 2007** | ** ** |
|------------------------------------------------|------------|-----------------------|-------------|------------------------|------------|
| ** **                                     | ** ** | ** **            | ** **  | **Percentage of**      | ** ** | ** ** | ** ** | **Percentage of** | ** ** |
| ** **                                     | ** ** | ** **            | ** **  | **Total**              | ** ** | **Net** | ** ** | ** ** | ** ** | **Total** | ** ** | **Net** | ** ** |
| **Industry  Classification**                   | ** ** | **Fair Value**        | ** **  | **Investments**        | ** ** | **Assets** | ** ** | **Fair Value** | ** ** | **Investments** | ** ** | **Assets** | ** ** |
|                                           |       |                  |        |                   |       |   |   |   |   |   |   |   |   |
| Aerospace & Defense                        |       | $                     | 4,627,453   |                   | 1.1        | % | 1.7 | % | $ | 4,615,750 |   | 1.3 | % | 2.1 | % |
| Automobile                                     |       | 6,008,750             |        | 1.5                    | %          | 2.3 | % | 6,245,938 |   | 1.8 | % | 2.8 | % |
| Broadcast (TV &  Radio)                    |       | 51,077,578            |        | 12.4                   | %          | 19.2 | % | 41,934,377 |   | 12.0 | % | 19.0 | % |
| Buildings and Real  Estate                     |       | 14,500,000            |        | 3.5                    | %          | 5.5 | % | — |   | — |   | — |   |
| Cargo Transport                                |       | 15,585,791            |        | 3.8                    | %          | 5.9 | % | 15,685,197 |   | 4.5 | % | 7.1 | % |
| Chemicals, Plastics  & Rubber              |       | 28,505,514            |        | 6.9                    | %          | 10.7 | % | 25,110,192 |   | 7.2 | % | 11.4 | % |
| Diversified/Conglomerate Manufacturing         |       | 3,795,450             |        | 0.9                    | %          | 1.4 | % | 3,710,700 |   | 1.1 | % | 1.7 | % |
| Electronics                                    |       | 30,908,487            |        | 7.5                    | %          | 11.6 | % | 31,351,318 |   | 9.0 | % | 14.2 | % |
| Farming &  Agriculture                     |       | 11,549,864            |        | 2.8                    | %          | 4.3 | % | 11,537,833 |   | 3.3 | % | 5.2 | % |
| Finance                                        |       | 2,420,375             |        | 0.6                    | %          | 0.9 | % | 2,460,125 |   | 0.7 | % | 1.1 | % |
| Healthcare, Education  & Childcare         |       | 63,800,564            |        | 15.3                   | %          | 24.0 | % | 36,927,299 |   | 10.5 | % | 16.7 | % |
| Home & Office  Furnishings                 |       | 16,656,063            |        | 4.0                    | %          | 6.3 | % | 17,057,109 |   | 4.9 | % | 7.7 | % |
| Leisure, amusement, movies & entertainment |       | 8,793,063             |        | 2.1                    | %          | 3.3 | % | 9,508,750 |   | 2.7 | % | 4.3 | % |
| Machinery                                      |       | 9,871,850             |        | 2.4                    | %          | 3.7 | % | 9,883,350 |   | 2.8 | % | 4.5 | % |
| Mining, Steel, Iron & Non-precious Metals  |       | 26,981,688            |        | 6.5                    | %          | 10.1 | % | 27,057,277 |   | 7.7 | % | 12.2 | % |
| Personal & Non-durable Consumer Products   |       | 8,831,925             |        | 2.1                    | %          | 3.3 | % | 8,977,500 |   | 2.6 | % | 4.1 | % |
| Printing &  Publishing                     |       | 74,561,253            |        | 18.0                   | %          | 28.0 | % | 72,190,583 |   | 20.6 | % | 32.7 | % |
| Retail Stores                                  |       | 24,700,000            |        | 6.0                    | %          | 9.3 | % | 14,986,500 |   | 4.3 | % | 6.8 | % |
| Textiles & Leather                         |       | 10,482,022            |        | 2.6                    | %          | 3.9 | % | 10,604,732 |   | 3.0 | % | 4.8 | % |
| **Total**                                      |       | $                     | 413,657,690 |                   | 100.0      | % |   |   | $ | 349,844,530 |   | 100.0 | % |   |   |

 

 

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** **

The investments at fairvalue were included in the following geographic regions of the United States atDecember 31, 2007 and September 30, 2007:

 

 
| ** **             | ** ** | **December 31, 2007** | ** **  | **September 30, 2007** | ** ** |
|------------------------|------------|-----------------------|-------------|------------------------|------------|
| ** **             | ** ** | ** **            | ** **  | **Percentage of**      | ** ** | ** ** | ** ** | **Percentage of** | ** ** |
| ** **             | ** ** | ** **            | ** **  | **Total**              | ** ** | **Net** | ** ** | ** ** | ** ** | **Total** | ** ** | **Net** | ** ** |
| **Geographic  Region** | ** ** | **Fair Value**        | ** **  | **Investments**        | ** ** | **Assets** | ** ** | **Fair Value** | ** ** | **Investments** | ** ** | **Assets** | ** ** |
|                   | ** ** | ** **            |        |                   |       |   |   |   |   |   |   |   |   |
| Midwest                |       | $                     | 214,799,373 |                   | 51.9       | % | 80.7 | % | $ | 152,927,681 |   | 43.7 | % | 69.2 | % |
| West                   |       | 69,814,760            |        | 16.9                   | %          | 26.2 | % | 70,842,472 |   | 20.2 | % | 32.1 | % |
| Mid-Atlantic           |       | 56,751,553            |        | 13.7                   | %          | 21.3 | % | 56,865,802 |   | 16.3 | % | 25.7 | % |
| Southeast              |       | 48,711,624            |        | 11.8                   | %          | 18.3 | % | 44,488,416 |   | 12.7 | % | 20.1 | % |
| Northeast              |       | 16,462,800            |        | 4.0                    | %          | 6.2 | % | 17,331,801 |   | 5.0 | % | 7.8 | % |
| US Territory           |       | 7,117,580             |        | 1.7                    | %          | 2.7 | % | 7,388,358 |   | 2.1 | % | 3.3 | % |
| ** **             |       | $                     | 413,657,690 |                   | 100.0      | % | ** ** |   | $ | 349,844,530 |   | 100.0 | % |   |   |

 

 

The geographic regiondepicts the location of the headquarters for the Company’s portfoliocompanies.  A portfolio company may havea number of other business locations in other geographic regions.

 

*Investment Principal Repayment*

 

The following tablesummarizes the contractual principal repayment and maturity of the Company’sinvestment portfolio by fiscal year, assuming no voluntary prepayments:

 

| **Fiscal  Year Ended September 30,** | ** ** | **Amount**  | ** **  |
|--------------------------------------|------------|-------------|-------------|
|                                 |       |        |        |
| 2008                                 |       | $           | 18,231,989  |   |
| 2009                                 |       | 28,519,183  |        |
| 2010                                 |       | 39,747,593  |        |
| 2011                                 |       | 103,631,619 |        |
| 2012                                 |       | 94,196,096  |        |
| Thereafter                           |       | 139,865,373 |        |
| **Total Contractual Repayments**     |       | $           | 424,191,853 |   |
|                                 |       |        |        |
| Investments in Equity  Securities    |       | $           | 778,347     |   |
| **Total**                            |       | $           | 424,970,200 |   |

 

 

NOTE 4. RELATED PARTYTRANSACTIONS

 

*Loans to Employees*

* *

The Company providedloans to employees of the Adviser for the exercise of options under the Amendedand Restated 2001 Equity Incentive Plan (the “2001 Plan”), which has since beenterminated and is no longer in operation. The loans require the quarterly payment of interest at the market ratein effect at the date of issue, have varying terms not exceeding ten years andhave been recorded as a reduction of net assets.  The loans are evidenced by full recoursenotes that are due upon maturity or 60 days following termination ofemployment, and the shares of common stock purchased with the proceeds of theloan are posted as collateral.  No newloans were issued during the three months ended December 31, 2007 or December31, 2006 and the Company received $6,326 and $152 of principal repaymentsduring the three months ended December 31, 2007 and December 31, 2006,respectively.  The Company recognizedinterest income from all employee stock option loans of $118,176, for the threemonths ended December 31, 2007, as compared to $138,191 for the three monthsended December 31, 2006.

 

*Investment Advisory andManagement and Administration Agreements*

* *

The Company isexternally managed by the Adviser, which is controlled by our chairman andchief executive officer, under a contractual investment advisoryagreement.  On October 1, 2006, theCompany entered into the investment advisory agreement (the “AdvisoryAgreement”).

 

 

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*Terms of the Advisory Agreement*

* *

Under the AdvisoryAgreement, the Company pays the Adviser an annual base management fee of 2% ofits average gross assets, which is defined as total assets less cash and cashequivalents pledged to creditors calculated as of the end of the two mostrecently completed fiscal quarters and also consists of a two-part incentivefee.

 

The first part of theincentive fee is an income-based incentive fee which rewards the Adviser if theCompany’s quarterly net investment income (before giving effect to any incentivefee) exceeds 1.75% of the Company’s net assets (the “hurdle rate”). The Companypays the Adviser an income incentive fee with respect to its pre-incentive feenet investment income in each calendar quarter as follows:

 

·    noincentive fee in any calendar quarter in which its pre-incentive fee netinvestment income does not exceed the hurdle rate (7% annualized);

 

·    100%of pre-incentive fee net investment income with respect to that portion of suchpre-incentive fee net investment income, if any, that exceeds the hurdle ratebut is less than 2.1875% in any calendar quarter (8.75% annualized); and

 

·    20%of the amount of pre-incentive fee net investment income, if any, that exceeds2.1875% in any calendar quarter (8.75% annualized).

 

The second part of the incentivefee is a capital gains incentive fee that is determined and payable in arrearsas of the end of each fiscal year (or upon termination of the AdvisoryAgreement, as of the termination date) and equals 20% of the Company’s realizedcapital gains as of the end of the fiscal year. In determining the capitalgains incentive fee payable to the Adviser, the Company calculates thecumulative aggregate realized capital gains and cumulative aggregate realizedcapital losses since the Company’s inception, and the aggregate unrealizedcapital depreciation as of the date of the calculation, as applicable, withrespect to each of the investments in its portfolio.

 

The Adviser’s board of directorsvoluntarily waived, for the three months ended December 31, 2007 and December31, 2006, the annual 2.0% base management fee to 0.5% for senior syndicatedloan participations and also waived the entire incentive fee for the threemonths ended December 31, 2007 and a portion of the incentive fee due for thethree months ended December 31, 2006.

 

In addition to the basemanagement and incentive fees under the Advisory Agreement, certain feesreceived by the Adviser from the Company’s portfolio companies are creditedagainst the investment advisory fee. Effective April 1, 2007, 50% of certain of the fees received by theAdviser are voluntarily credited against the base management fee.  In addition, the Company will continue to payits direct expenses including, but not limited to, directors’ fees, legal andaccounting fees, stockholder related expenses, and directors and officersinsurance under the Advisory Agreement.

 

For the three monthsended December 31, 2007, the Company recorded a base management fee of$577,920, after reductions for loan servicing fees paid to the Adviser of$1,381,307, less a credit of $821,838 for fees received by the Adviser and a$103,440 fee reduction for the waiver of the 2% fee on senior syndicated loansto 0.5%, for a net base management fee credit of $347,358. For the three monthsended December 31, 2006, the Company recorded a base management fee of $476,849,after reductions for loan servicing fees paid to the Adviser of $719,152, lessa credit of $311,000 for fees received by the Adviser and a $78,417 feereduction for the waiver of the 2% fee on senior syndicated loans to 0.5%, fora net base management fee of $87,432 for the three months ended December 31,2006.  The Company also recorded a grossincentive fee of $1,460,657, offset by a credit from a full voluntary waiverissued by the Adviser’s board of directors of $1,460,657, for the three monthsended December 31, 2007, as compared to a gross incentive fee of $1,148,483,offset by a credit from a voluntary waiver issued by the Adviser’s board ofdirectors of $568,944, for a net incentive fee of $579,489, for the threemonths ended December 31, 2006.  As of December31, 2007, the Company was owed $347,358 of base management fee credits due fromthe Adviser, presented in the net fees due to Adviser in the accompanyingconsolidated statements of assets and liabilities.  The credits to the base management fee andincentive fee are reflected on the consolidated statement of operations ascredits to base management and incentive fees. Overall, the base management fee due to the Adviser cannot exceed 2% oftotal assets (as reduced by cash and cash equivalents pledged to creditors)during any given fiscal year.

 

*Loan Servicing and PortfolioCompany Fees*

* *

The Adviser alsoservices the loans held by Business Loan, in return for which it receives a 1.5%annual fee based on the monthly aggregate outstanding balance of the loanspledged under the Company’s line of credit. Since the Company owns these loans, all loan servicing fees paid to theAdviser are treated as reductions directly against the 2% base management fee underthe Advisory Agreement.  Effective inApril 2006, the Adviser’s board of directors voluntarily reduced the annualservicing fee rate on these loans to 0.5%.For thethree months ended December 31, 2007 and 2006, these loan servicing fees totaled$1,381,307 and $719,152, respectively, all of which were deducted against the2% base management fee in order to derive the base management fee which is 

 

 

26

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presented as the lineitem base management fee in the consolidated statements of operations.  At December 31, 2007, the Company owed $358,402of unpaid loan servicing fees to the Adviser, which are netted and recorded infees due to Adviser.  At September 30,2007, the Company owed $267,427 in loan servicing fees to the Adviser, recordedin fees due to Adviser in the consolidated statements of assets andliabilities.  Under the AdvisoryAgreement, the Adviser also provides managerial assistance and other servicesto the Company’s portfolio companies and may receive fees for services otherthan managerial assistance services.

 

*Administration Agreement*

* *

On October 1, 2006, theCompany entered into an administration agreement (the “AdministrationAgreement”) with Gladstone Administration, LLC (the “Administrator”), awholly-owned subsidiary of the Adviser.  Underthe Administration Agreement, the Company pays separately for administrativeservices.  The Administration Agreementprovides for payments equal to the Company’s allocable portion of theAdministrator’s overhead expenses in performing its obligations under theAdministration Agreement, including, but not limited to, rent for employees ofthe Administrator, and the allocable portion of salaries and benefits expensesof the Company’s chief financial officer, controller, chief compliance officer,treasurer and their respective staffs. The Company recorded an administration fee of $211,675 and $126,085,respectively, for the three months ended December 31, 2007 and December 31,2006. As of December 31, 2007 and September 30, 2007, $211,675 and $237,510,respectively, was unpaid and included in the administration fee due toAdministrator in the accompanying consolidated statements of assets andliabilities.

 

NOTE 5. LINE OF CREDIT

 

Through BusinessLoan, the Company has a $220 million revolving credit facility (the “DBFacility”) with Deutsche Bank AG, as administrative agent, pursuant to whichBusiness Loan pledges the loans it holds to secure future advances by certaininstitutional lenders. The interest rate charged on the advances under the DB Facilityis based on the Commercial Paper (“CP”) rate which is equivalent to theweighted average per annum rates paid by the DB Facility’s CP lenders inrespect of CP notes issued by the CP lender during such period.  Business Loan also has the ability to borrowat an alternative rate from the committed lenders if CP lenders are unable tofund advances.  The alternative rate isthe London Interbank Offered Rate (“LIBOR”), or if LIBOR is unavailable, thePrime Rate or the Federal Funds Rate, plus 1.0%. The DB Facility matures on May23, 2008.  As of December 31, 2007, theoutstanding principal balance under the DB Facility was $161,831,000 at astated interest rate of approximately 5.36%, plus a 0.95% program fee.  Available borrowings are subject to variousconstraints imposed under the credit agreement, based on the aggregate loanbalance pledged by Business Loan, which varies as loans are added and repaid,regardless of whether such repayments are early prepayment or are made ascontractually required.  At December 31,2007, the remaining borrowing capacity available under the DB Facility was approximately$58.2 million.  The weighted averageborrowings outstanding under the DB Facility for the three months endedDecember 31, 2007 and 2006 were $145.4 million and $64.3 million, respectively,at a weighted average annual interest cost of 6.68% and 7.33%, respectively,which was computed by using the annual stated interest rate plus commitment andother fees plus the amortization of deferred financing fees divided by theweighted average debt outstanding.

 

The DB Facilitycontains covenants that require Business Loan to maintain its status as aseparate entity; prohibit certain significant corporate transactions (such asmergers, consolidations, liquidations or dissolutions); and restrict materialchanges to the Company’s credit and collection policies. The DB Facility alsorestricts some of the terms and provisions (including interest rates, terms tomaturity and payments schedules) and limits the borrower and industryconcentrations of loans that are eligible to secure advances.  As of December 31, 2007, Business Loan was incompliance with all of the facility covenants.

 

The administrativeagent also requires that any interest or principal payments on pledged loans beremitted directly by the borrower into a lockbox account with the Bank of NewYork Mellon as custodian.  Deutsche BankAG is also the trustee of the account and once a month remits the collectedfunds to the Company. At December 31, 2007, the amount due from custodian was$4,816,186 and at September 30, 2007, the amount due from custodian was$3,230,385.

 

The Adviser alsoservices the loans pledged under the DB Facility.  As a condition to this servicing arrangement,the Company executed a performance guaranty pursuant to which it guaranteedthat the Adviser would comply fully with all of its obligations under the DBFacility.  The performance guarantyrequires that the Company maintain a minimum net worth of $100 million and 75%of equity issuances after May 2003 and maintain “asset coverage” with respectto “senior securities representing indebtedness” of at least 200%, inaccordance with Section 18 of the 1940 Act.  As of December 31, 2007, the Company was incompliance with all covenants under the performance guaranty.

 

 

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NOTE 6. INTEREST RATECAP AGREEMENT

 

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

 

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

 

In February 2004, theCompany entered into an interest rate cap agreement with a notional amount of$35.0 million at a cost of $304,000.  Theinterest rate cap agreement’s current notional amount is $5.7 million and ithas a current fair market value of $1,761 which is recorded in other assets onthe Company’s consolidated balance sheet at December 31, 2007.  At September 30, 2007, the interest rate capagreement had a fair market value of $12,314. The Company records changes in the fair market value of the interestrate cap agreement monthly based on the current market valuation at month endas unrealized depreciation or appreciation on derivative on the Company’sconsolidated statement of operations. The interest rate cap agreement expiresin February 2009. The agreement provides that the Company’s floating interestrate or cost of funds on a portion of the portfolio’s borrowings will be cappedat 5% when the LIBOR rate is in excess of 5%. During the three months ended December 31, 2007, the Company recorded$5,606, as compared to $12,554 for the three months ended December 31, 2006, ofincome from the interest rate cap agreement, recorded as a realized gain on thesettlement of derivative on the Company’s consolidated statements ofoperations.

 

NOTE 7.  COMMON STOCK TRANSACTIONS

 

At December 31, 2006 andDecember 31, 2007, 50,000,000 shares of $0.001 par value common stock wereauthorized and 12,249,683 and 17,637,574 shares were outstanding, respectively.

 

Transactions in commonstock were as follows:

 

| ** **                                            | ** ** | **Common Stock** | ** ** |
|-------------------------------------------------------|------------|------------------|------------|
| ** **                                            | ** ** | **Shares**       | ** ** | **Amount** | ** ** |
| Balance at September  30, 2006                        |       | 12,305,008       |       | $ | 12,305 |   |
| Issuance of Common  Stock Under Stock Option Plan     |       | 5,000            |       | 5 |   |
| Shares surrendered for  settlement of withholding tax |       | (60,325          | )          | (60 | ) |
| Balance at December 31,  2006                         |       | 12,249,683       |       | $ | 12,250 |   |
|                                                  |       |             |       |   |   |
| Balance at September  30, 2007                        |       | 14,762,574       |       | $ | 14,763 |   |
| Issuance of Common  Stock Under Shelf Offering        |       | 2,875,000        |       | 2,875 |   |
| Balance at December 31,  2007                         |       | 17,637,574       |       | $ | 17,638 |   |

 

 

*Offeringsof Common Stock*

 

On October 19, 2007, theCompany completed an offering of 2,500,000 shares of its common stock, at aprice of $18.70 per share, less an underwriter’s discount of $1.03 per share,under a shelf registration statement on Form N-2 (File No. 333-143027), andpursuant to the terms set forth in a prospectus dated July 5, 2007, assupplemented by a final prospectus supplement dated October 15, 2007. The underwriterexercised its over-allotment option and the Company closed on an additional375,000 shares of common stock on November 19, 2007  Net proceeds of the offering, after offeringexpenses, were approximately $50.5 million and were used to repay outstandingborrowings under the Company’s line of credit.

 

 

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NOTE 8. INCREASE IN NETASSETS PER SHARE RESULTING FROM OPERATIONS

 

The following table setsforth the computation of basic and diluted net increase in net assets per shareresulting from operations for the three months ended December 31, 2007 and December31, 2006:

 

| ** **                                                                                      | ** ** | **Three Months Ended December 31,** | ** ** |
|-------------------------------------------------------------------------------------------------|------------|-------------------------------------|------------|
| ** **                                                                                      | ** ** | **2007**                            | ** ** | **2006** | ** ** |
|                                                                                            |       |                                |       |   |   |
| Numerator for basic and diluted net increase in net  assets resulting from operations per share |       | $                                   | 1,900,497  |   | $ | 4,163,603 |   |
|                                                                                            |       |                                |       |   |   |
| Denominator for basic  and diluted shares                                                       |       | 16,953,703                          |       | 12,294,340 |   |
|                                                                                            |       |                                |       |   |   |
| Basic and diluted net increase in net assets resulting  from operations per share               |       | $                                   | 0.11       |   | $ | 0.34 |   |

 

 

NOTE 9. DIVIDENDS

 

***Dividends and Distributions***

** **

The Company is requiredto pay out as a dividend 90% of its ordinary income and short-term capitalgains for each taxable year in order to maintain its status as a RIC underSubtitle A, Chapter 1 of Subchapter M of the Code.  It is the policy of the Company to pay out asa dividend up to 100% of those amounts. The amount to be paid out as a dividend is determined by the Board ofDirectors each quarter and is based on the annual earnings estimated by themanagement of the Company.  Based on thatestimate, three monthly dividends are declared each quarter.  At year-end the Company may pay a bonusdividend, in addition to the monthly dividends, to ensure that it has paid outat least 90% of its ordinary income and realized net short-term capital gainsfor the year.  Long-term capital gainsare composed of success fees, prepayment fees and gains from the sale ofsecurities held for one year or more. The Company may decide to retainlong-term capital gains from the sale of securities, if any, and not pay themout as dividends, however, the Board of Directors may decide to declare and payout capital gains during any fiscal year. If the Company decides to retain long-term capital gains, the portion ofthe retained capital gains will be subject to 35% tax.  The tax characteristics of all dividends willbe reported to stockholders on Form 1099 at the end of each calendar year.  The following table lists the per sharedividends paid for the three months ended December 31, 2007 and 2006:

 

| **Fiscal  Year** | ** ** | **Record Date**   | ** ** | **Payment Date**  | ** ** | **Dividend per Share** | ** ** |
|------------------|------------|-------------------|------------|-------------------|------------|------------------------|------------|
| 2008             |       | December 20, 2007 |       | December 31, 2007 |       | $                      | 0.14       |   |
|             |       | November 21, 2007 |       | November 30, 2007 |       | $                      | 0.14       |   |
|             |       | October 23, 2007  |       | October 31, 2007  |       | $                      | 0.14       |   |
|             |       |              |       | Total             |       | $                      | 0.42       |   |
|             |       |              |       |              |       |                   |       |
| 2007             |       | December 20, 2006 |       | December 29, 2006 |       | $                      | 0.14       |   |
|             |       | November 21, 2006 |       | November 30, 2006 |       | $                      | 0.14       |   |
|             |       | October 23, 2006  |       | October 31, 2006  |       | $                      | 0.14       |   |
|             |       |              |       | Total             |       | $                      | 0.42       |   |

 

***Section19(a) Disclosure***

** **

The Company’s Board ofDirectors estimates the source of the distributions at the time of theirdeclaration as required by Section 19(a) of the 1940 Act.  On a monthly basis, if required underSection 19(a), the Company posts a Section 19(a) notice through theDepository Trust Company's Legal Notice System (“LENS”) and also sends to itsregistered stockholders a written Section 19(a) notice along with thepayment of dividends for any payment which includes a dividend estimated to bepaid from any other source other than net investment income.  The estimates of the source of thedistribution are interim estimates based on GAAP that are subject torevision, and the exact character of the distributions for tax purposes cannotbe determined until the final books and records of the Company are finalizedfor the calendar year.  Following thecalendar year end, after definitive information has been determined by theCompany, if the Company has made distributions of taxable income (or return ofcapital), the Company will deliver a Form 1099-DIV to its stockholdersspecifying such amount and the tax characterization of such amount.  Therefore, these estimates are made solely inorder to comply with the requirements of Section 19(a) of the 1940 Act andshould not be relied upon for tax reporting or any other purposes and coulddiffer significantly from the actual character of distributions for taxpurposes.

 

 

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The following GAAPestimates were made by the Board of Directors during the quarter ended December31, 2007:

 

| **Month Ended**   | ** ** | **Ordinary Income** | ** ** | **Return of Capital** | ** ** | **Total Dividend** | ** ** |
|-------------------|------------|---------------------|------------|-----------------------|------------|--------------------|------------|
|              |       |                |       |                  |       |               |       |
| December 31, 2007 |       | $                   | 0.096      |                  | $          | 0.044              |       | $ | 0.140 |   |
| November 30, 2007 |       | 0.140               |       | —                |       | 0.140              |       |
| October 31, 2007  |       | 0.140               |       | —                |       | 0.140              |       |
|                   |            |                     |            |                       |            |                    |            |  |  |  |

 

 

Because the Board ofDirectors declares dividends at the beginning of a quarter, it is difficult toestimate how much of the Company’s monthly dividends and distributions, basedon GAAP, will come from ordinary income, capital gains, and returns ofcapital.  Subsequent to the quarter endedDecember 31, 2007, the following corrections were made to the above listedestimates for that quarter:

 

| **Month  Ended**  | ** ** | **Ordinary Income** | ** ** | **Return of Capital** | ** ** | **Total Dividend** | ** ** |
|-------------------|------------|---------------------|------------|-----------------------|------------|--------------------|------------|
|              |       |                |       |                  |       |               |       |
| December 31, 2007 |       | $                   | 0.125      |                  | $          | 0.015              |       | $ | 0.140 |   |
| November 30, 2007 |       | 0.137               |       | 0.003                 |       | 0.140              |       |
| October 31, 2007  |       | 0.140               |       | —                |       | 0.140              |       |
|                   |            |                     |            |                       |            |                    |            |  |  |  |

 

 

For dividends declaredsubsequent to quarter end, the following estimates, based on GAAP, have beenmade pursuant to Section 19(a) of the 1940 Act:

 

| **Month  Ended**  | ** ** | **Ordinary Income** | ** ** | **Return of Capital** | ** ** | **Total Dividend** | ** ** |
|-------------------|------------|---------------------|------------|-----------------------|------------|--------------------|------------|
|              |       |                |       |                  |       |               |       |
| March 31, 2008    |       | $                   | 0.114      |                  | $          | 0.026              |       | $ | 0.140 |   |
| February 29, 2008 |       | 0.140               |       | —                |       | 0.140              |       |
| January 31, 2008  |       | 0.140               |       | —                |       | 0.140              |       |
|                   |            |                     |            |                       |            |                    |            |  |  |  |

 

 

NOTE 10. CONTRACTUALOBLIGATIONS

 

As of December 31, 2007,the Company was a party to signed and non-binding term sheets for five loanoriginations for an aggregate of $45.4 million. The Company expects to fund these potential investments as follows:

 
| ** **                   | ** ** | ** ** | ** ** | **Payment Due by Period** | ** ** |
|------------------------------|------------|------------|------------|---------------------------|------------|
| **Contractual  Obligations** | ** ** | **Total**  | ** ** | **Less than 1 Year**      | ** ** | **1-3 Years** | ** ** | **3-5 Years** | ** ** | **More than  5 Years** | ** ** |
|                         |       |       |       |                      |       |   |   |   |   |   |   |
| Investments                  |       | $          | 45,400,000 |                      | 45,400,000 |   | — |   | — |   | — |   |
| Total                        |       | $          | 45,400,000 |                      | $          | 45,400,000 |   | $ | — |   | $ | — |   | $ | — |   |
|                              |            |            |            |                           |            |  |  |  |  |  |  |  |  |  |  |  |

 

 

All prospective investmentsare subject to, among other things, the satisfactory completion of theCompany’s due diligence investigation of each borrower, acceptance of terms andstructure and receipt of necessary consents. With respect to each prospectiveloan, the Company will only agree to provide the loan if, among other things,the results of its due diligence investigations are satisfactory, the terms andconditions of the loan are acceptable and all necessary consents are received.The Company has initiated its due diligence investigations of the potentialborrowers, however there can be no guarantee that facts will not be discoveredin the course of completing the due diligence that would render a particularinvestment imprudent or that any of these investments will actually be made.

 

As of February 1, 2008,the Company funded $13.9 million out of the above mentioned investments.

 

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NOTE11. SUBSEQUENT EVENTS

 

*Dividends*

 

In January 2008, the Company’s Board of Directors declared thefollowing monthly cash dividends:

 

| **Fiscal  Year** | ** ** | **Record Date**   | ** ** | **Payment Date**  | ** ** | **Dividend per Share** | ** ** |
|------------------|------------|-------------------|------------|-------------------|------------|------------------------|------------|
| 2008             |       | January 23, 2008  |       | January 31, 2008  |       | $                      | 0.14       |   |
|             |       | February 21, 2008 |       | February 29, 2008 |       | $                      | 0.14       |   |
|             |       | March 21, 2008    |       | March 31, 2008    |       | $                      | 0.14       |   |

** **

*InvestmentActivity*

 

Subsequent to December 31, 2007, the Company funded one investmentfor an aggregate amount of $13.9 million and also approximately $0.7 million ofrevolver draws to existing portfolio companies. The Company also received approximately $0.7 million of scheduled loanrepayments.

 

On January 30, 2008, the Company offered at public sale certainassets of U.S. Healthcare Communications, LLC consisting generally of all thefixtures and all tangible and intangible personal property.  The Company acquired these assets in thesale, through a newly formed subsidiary, and will continue the business of U.S.Healthcare Communications, LLC under its control.

 

*Offeringsof Common Stock*

 

On February 5, 2008, the Company completed an offering of3,000,000 shares of its common stock, at a price of $17.00 per share, lessunderwriters’ discounts of $0.935 per share, under a shelf registrationstatement on Form N-2 (File No. 333-143027), and pursuant to the terms setforth in a prospectus dated January 23, 2008, as supplemented by a finalprospectus supplement dated January 30, 2008. Net proceeds of the offering, after deducting underwriting discounts andestimated offering expenses, were approximately $47.8 million, all of whichwere used to repay a portion of the Company’s outstanding borrowings under theline of credit.  The underwriters havebeen granted an option, exercisable for 30 days, to purchase up to 450,000additional shares of common stock to cover over-allotments, if any.

 

 

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** **

**ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSISOF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.**

 

**All statements contained herein, other thanhistorical facts, may constitute “forward-looking statements.” These statementsmay relate to, among other things, future events or our future performance orfinancial condition. In some cases, you can identify forward-looking statementsby terminology such as “may,” “might,” “believe,” “will,” “provided,”“anticipate,” “future,” “could,” “growth,” “plan,” “intend,” “expect,”“should,” “would,” “if,” “seek,” “possible,” “potential,” “likely” or thenegative of such terms or comparable terminology. These forward-lookingstatements involve known and unknown risks, uncertainties and other factorsthat may cause our actual results, levels of activity, performance orachievements to be materially different from any future results, levels ofactivity, performance or achievements expressed or implied by suchforward-looking statements. Such factors include, among others: (1) adversechanges in interest rates; (2) our failure or inability to establish ormaintain referral arrangements with leveraged buyout funds and venture capitalfunds to generate loan opportunities; (3) the loss of one or more of ourexecutive officers, in particular David Gladstone, Terry Lee Brubaker, orGeorge Stelljes III; (4) our inability to extend, refinance or maintain ourcredit facility on terms reasonably acceptable to us, if at all, in futureequity capital resources; (5) our inability to successfully securitize our loanportfolio on terms reasonably acceptable to us, if at all; (6) the decision ofour competitors to aggressively seek to make senior and subordinated loans tosmall and medium-sized businesses on terms more favorable than we intend to provide;and (7) those factors listed under the caption “Risk Factors” of the Prospectusdated January 23, 2008 as filed with the Securities and Exchange Commission on January23, 2008. We caution readers not to place undue reliance on any suchforward-looking statements, which speak only as of the date made. We undertakeno obligation to publicly update or revise any forward-looking statements,whether as a result of new information, future events or otherwise, after thedate of this Form 10-Q**.

 

*Thefollowing analysis of our financial condition and results of operations shouldbe read in conjunction with our consolidated financial statements and the notesthereto contained elsewhere in this report and our annual report on Form10-K for the fiscal year ended September 30, 2007**.*

 

**OVERVIEW**

 

We were incorporatedunder the General Corporation Laws of the State of Maryland on May 30, 2001.Our investment objectives are to achieve a high level of current income byinvesting in debt securities, consisting primarily of senior notes, second liennotes, and senior subordinated notes of established private businesses that arebacked by leveraged buyout funds, venture capital funds or others, with aparticular emphasis on second lien and senior subordinated notes.  In addition, we may acquire existing loans,which meet this profile, from leveraged buyout funds, venture capital funds andothers. We also seek to provide our stockholders with long-term capital growththrough the appreciation in the value of warrants, or other equity instrumentsthat we may receive when we extend loans. We operate as a closed-end,non-diversified management investment company, and have elected to be treatedas a business development company under the Investment Company Act of 1940, asamended (the “1940 Act”).

 

We seek out small andmedium-sized businesses that meet certain criteria, including some but not allof the following: the potential for growth in cash flow, adequate assetsfor loan collateral, experienced management teams with a significant ownershipinterest in the borrower, profitable operations based on the borrower’s cashflow, reasonable capitalization of the borrower (usually by leveraged buyoutfunds or venture capital funds) and the potential to realize appreciation andgain liquidity in our equity position, if any. We anticipate that liquidity inour equity position will be achieved through a merger or acquisition of theborrower, a public offering of the borrower’s stock or by exercising our rightto require the borrower to repurchase our warrants, though there can be noassurance that we will always have these rights. We lend to borrowers that needfunds to finance growth, restructure their balance sheets or effect a change ofcontrol.

 

Our loans typically rangefrom $5 million to $15 million, although this investment size may varyproportionately as the size of our capital base changes, generally mature in nomore than seven years and accrue interest at fixed or variable rates. Some ofour loans may contain a provision that calls for some portion of the interestpayments to be deferred and added to the principal balance so that the interestis paid, together with the principal, at maturity. This form of deferred interestis often called “paid in kind” (“PIK”) interest, and, when earned, we recordPIK interest as interest income and add the PIK interest to the principalbalance of the loans. We seek to avoid PIK interest with all potentialinvestments under review.

 

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Because the majority ofour portfolio loans consist of term debt of private companies who typicallycannot or will not expend the resources to have their debt securities rated bya credit rating agency, we expect that most of the debt securities we acquirewill be unrated. We cannot accurately predict what ratings these loans mightreceive if they were in fact rated, and thus cannot determine whether or notthey could be considered “investment grade” quality.

 

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

 

Original issue discounts(“OID”) arise when we extend a loan and receive an equity interest in theborrower at the same time.  To the extentthat the price paid for the equity is not at market value, we must allocatepart of the price paid for the loan, to the value of the equity.  Then the amount allocated to the equity, theOID, must be amortized over the life of the loan.  As with PIK interest, the amortization of OIDalso produces income that must be recognized for purposes of satisfying thedistribution requirements for a regulated investment company (“RIC”) underSubchapter M of the Internal Revenue Code of 1986, as amended (the “Code”),whereas the cash is received, if at all, when the equity instrument is sold.  We seek to avoid OID and to date do not holdany investments with OID.

 

Our Adviser receives feesfor other services it provides to our portfolio companies. These other fees aretypically non-recurring, are recognized as revenue when earned and aregenerally paid directly to our Adviser by the borrower or potential borrowerupon closing of the investment. The services our Adviser provides to portfoliocompanies vary by investment, but generally include a broad array of services,such as investment banking services, arranging bank and equity financing,structuring financing from multiple lenders and investors, reviewing existingcredit facilities, restructuring existing investments, raising equity and debtcapital, turnaround management, merger and acquisition services and recruitingnew management personnel. When our Adviser receives fees for these services,50% of certain of those fees are voluntarily credited against the basemanagement fee that we pay to our Adviser.

 

Our Adviser also receivesfees for monitoring and reviewing portfolio company investments. These fees arerecurring and are generally paid annually or quarterly in advance to ourAdviser throughout the life of the investment. Fees of this nature are recordedas revenue by our Adviser when earned and are not credited against the basemanagement fee.

 

We may receive fees forthe origination and closing services we provide to portfolio companies throughour Adviser. These fees are paid directly to us and are recognized as revenueupon closing of the originated investment and are reported as fee income in theconsolidated statements of operations.

 

Prior to making aninvestment, we ordinarily enter into a non-binding term sheet with thepotential borrower. These non-binding term sheets are generally subject to anumber of conditions including, but not limited to, the satisfactory completionof our due diligence investigations of the potential borrower’s business,reaching agreement on the legal documentation for the loan, and the receipt ofall necessary consents. Upon execution of the non-binding term sheet, thepotential borrower generally pays the Adviser a non-refundable fee for itsservices rendered through the date of the non-binding term sheet. These feesare received by the Adviser and are offset against the base management feepayable to the Adviser, which has the effect of reducing our expenses to theextent of any such fees received by the Adviser.

 

In the event that weexpend significant effort in considering and negotiating a potential investmentthat ultimately is not consummated, we generally will seek reimbursement fromthe proposed borrower for our reasonable expenses incurred in connection withthe transaction, including legal fees.  Anyamounts collected for expenses incurred by the Adviser in connection withunconsummated investments will be reimbursed to the Adviser.  Amounts collected for these expenses incurredby us will be reimbursed to us and will be recognized in the period in whichsuch reimbursement is received, however, there can be no guarantee that we willbe successful in collecting any such reimbursements.

 

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During the three monthsended December 31, 2007, we extended, directly or through participations,approximately $58.0 million of new loan originations, including a common equitywarrant, to a total of 5 companies and also increased our investments inexisting portfolio companies through revolver draws or the additions of newterm notes in the aggregate of $15.3 million, for total new investments of$73.3 million. During the three months ended December 31, 2007, no investmentsrepaid in full, however, we experienced contractual amortization, revolverrepayments and some unscheduled partial repayments, for total principalrepayments of approximately $4.0 million. Since our initial public offering in August 2001, we have made 241different loans to, or investments in, 125 companies for a total ofapproximately $845.2 million, before giving effect to principal repayments oninvestments and divestitures.

 

**Our Adviser and Administrator**

 

Our Adviser is led by a management team which has extensiveexperience in our lines of business. Our Adviser is controlled by DavidGladstone, our chairman and chief executive officer. Mr. Gladstone is alsothe chairman and chief executive officer of our Adviser. Terry Lee Brubaker,our vice chairman, chief operating officer, secretary and director, is a memberof the board of directors of our Adviser and its vice chairman and chiefoperating officer. George Stelljes III, our president, chief investmentofficer and director, is a member of the board of directors of our Adviser andits president and chief investment officer. Harry Brill, our chief financialofficer, is also the chief financial officer of our Adviser. Our Adviser alsohas a wholly-owned subsidiary, Gladstone Administration, LLC (the“Administrator”), which employs our chief financial officer, chief complianceofficer, controller, treasurer and their respective staffs.

 

Our Adviser and Administrator also provide investment advisory andadministrative services to our affiliates, Gladstone Commercial Corporation, apublicly traded real estate investment trust; Gladstone Investment Corporation,a publicly traded business development company; and Gladstone Land Corporation,a private agricultural real estate company. All of our executive officers serveas either directors or executive officers, or both, of our Adviser, ourAdministrator, Gladstone Commercial Corporation and Gladstone InvestmentCorporation. In the future, our Adviser may provide investment advisory andadministrative services to other funds, both public and private, of which it isthe sponsor.

 

We have been externally managed by our Adviser pursuant to aninvestment advisory and management agreement. Our Adviser was organized as acorporation under the laws of the State of Delaware on July 2, 2002, andis a registered investment adviser under the Investment Advisers Act of 1940,as amended. Our Adviser is headquartered in McLean, Virginia, a suburb ofWashington D.C., and also has offices in New York, New Jersey, Pennsylvania,Illinois, Texas and Washington.

 

**Investment Advisory andManagement Agreement**

 

The Company is externallymanaged by the Adviser pursuant to an investment advisory and managementagreement (the “Advisory Agreement”), under which our Adviser has directly employed all of our personnel and paid ourpayroll, benefits, and general expenses directly and we pay our directexpenses including, but not limited to, directors’ fees, legal and accountingfees, stockholder related expenses, and directors and officers insurance.

 

Under the AdvisoryAgreement, we pay the Adviser an annual base management fee of 2% of ouraverage gross assets, which is defined as total assets less cash and cashequivalents pledged to creditors calculated as of the end of the two mostrecently completed fiscal quarters and also consists of a two-part incentivefee.

 

The first part of theincentive fee is an income-based incentive fee which rewards the Adviser if ourquarterly net investment income (before giving effect to any incentive fee)exceeds 1.75% of our net assets (the “hurdle rate”). We will pay the Adviser anincome incentive fee with respect to our pre-incentive fee net investmentincome in each calendar quarter as follows:

 

·    noincentive fee in any calendar quarter in which our pre-incentive fee netinvestment income does not exceed the hurdle rate (7% annualized);

 

·    100%of our pre-incentive fee net investment income with respect to that portion ofsuch pre-incentive fee net investment income, if any, that exceeds the hurdlerate but is less than 2.1875% in any calendar quarter (8.75% annualized); and

 

·    20%of the amount of our pre-incentive fee net investment income, if any, thatexceeds 2.1875% in any calendar quarter (8.75% annualized).

 

The second part ofthe incentive fee is a capital gains incentive fee that will be determined andpayable in arrears as of the end of each fiscal year (or upon termination ofthe Advisory Agreement, as of the termination date) and will equal 20% of ourrealized capital gains as of the end of the fiscal year. In determining thecapital gains incentive fee payable to the Adviser, we will calculate the 

 

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cumulativeaggregate realized capital gains and cumulative aggregate realized capitallosses since our inception, and the aggregate unrealized capital depreciationas of the date of the calculation, as applicable, with respect to each of theinvestments in our portfolio.

 

The Adviser’s board of directorsvoluntarily waived, for the three months ended December 31, 2007 and December31, 2006, the annual 2.0% base management fee to 0.5% for senior syndicatedloan participations and also waived the entire fee and a portion of theincentive fees due, respectively in the periods.

 

The Adviserservices our loan portfolio pursuant to a loan servicing agreement withGladstone Business Loan, LLC (“Business Loan”) in return for a 1.5% annual fee,based on the monthly aggregate outstanding loan balance of the loans pledgedunder our credit facility.  Effective inApril 2006, the Adviser’s board of directors voted to reduce the portion of the1.5% annual fee to 0.5% for senior syndicated loans.  This fee directly reduces the amount of feepayable under the Advisory Agreement.

 

In addition to the basemanagement and incentive fees under the Advisory Agreement, certain feesreceived by the Adviser from the Company’s portfolio companies are creditedagainst the investment advisory fee. Effective April 1, 2007, 50% of certain of the fees received by theAdviser are voluntarily credited against the base management fee.  In addition, the Company will continue to payits direct expenses including, but not limited to, directors’ fees, legal andaccounting fees, stockholder related expenses, and directors and officersinsurance under the Advisory Agreement.

 

**AdministrationAgreement**

 

Under the administrationagreement we have with our Administrator (the “Administration Agreement”), wepay separately for administrative services. The Administration Agreementprovides for payments equal to our allocable portion of the Administrator’soverhead expenses in performing its obligations under the AdministrationAgreement including, but not limited to, rent for employees of the Administrator,and our allocable portion of the salaries and benefits expenses of our chieffinancial officer, controller, chief compliance officer, treasurer and theirrespective staffs.  Our allocable portionof expenses is derived by multiplying our Administrator’s total expenses by thepercentage of our average total assets (the total assets at the beginning andend of each quarter) in comparison to the average total assets of all companiesmanaged by our Adviser.

 

**Off-Balance Sheet Arrangements**

 

We do not have anysignificant off-balance sheet arrangements as defined in Item 303(a)(4)(ii) ofSecurities and Exchange Commission (“SEC”) Regulation S-K as of December 31,2007.

 

**Recent Accounting Pronouncements**

 

In June 2006, the FASBissued FASB Interpretation No. 48, *“Accounting forUncertainty in Income Taxes—an interpretation of FASB Statement No. 109,”*which clarifies the accounting for uncertainty in income taxes recognized in anenterprise’s financial statements in accordance with SFAS No. 109, *“Accounting for Income Taxes.”* This Statement is effectiveas of the beginning of an entity’s first fiscal year that begins afterDecember 15, 2006. We adopted this Interpretation on October 1, 2007.The adoption did not have a material impact on the consolidated financialstatements.

 

In September 2006, theFASB issued SFAS No. 157, *“Fair Value Measurements”*(“SFAS No. 157”).  SFAS No. 157 definesfair value, establishes a framework for measuring fair value in accordance withGAAP, and expands disclosures about fair value measurements.  SFAS No. 157 applies broadly to securitiesand other types of assets and liabilities. SFAS No. 157 is effective for financial statements issued for fiscalyears beginning after November 15, 2007 and interim periods within that fiscalyear.  We will be required to adopt SFASNo. 157 on October 1, 2008 and are currently evaluating the impact of thispronouncement on the consolidated financial statements.

 

In February 2007, the FASB issued SFAS No. 159, *“The Fair Value Option for Financial Assets and FinancialLiabilities — Including an Amendment of FASB Statement No. 115,”*which is effective for fiscal years beginning after November 15, 2007.This pronouncement permits an entity to choose to measure many financialinstruments and certain other items at fair value at specified election dates.Subsequent unrealized gains and losses on items for which the fair value optionhas been elected will be reported in earnings. We will berequired to adopt SFAS No. 159 on October 1, 2008 and are currently evaluating the potential impact of thispronouncement on the consolidated financial statements.

 

In November 2007, the SEC issued Staff Accounting Bulletin No.109, *“Written Loan Commitments Recorded at Fair ValueThrough Earnings”* (“SAB 109”)*.*SAB 109 provides guidance on the accounting for written loan commitmentsrecorded at fair value under GAAP. Specifically, SAB 109 revises the Staff'sviews on incorporating expected net future cash flows related to loan servicingactivities in the fair value measurement of a written loan commitment. SAB 109, which  supersedes  SAB  105,  “*Application  of  Accounting Principles  to  Loan Commitments”*, requires the  expected  net  future  cash  flows  relatedto the associated  servicing of 

 

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the loan beincluded in the measurement of all written loan commitments that are accountingfor at fair value through earnings. SAB 109 is effective in fiscal quartersbeginning after December 15, 2007. We are currently evaluating the impact ofthis pronouncement on the consolidated financial statements.

 

In December 2007,the FASB issued SFAS No. 141(R) *“Business Combinations”*(“SFAS No. 141(R)”). SFAS No. 141(R) establishes principles and requirementsfor how an acquirer recognizes and measures in its financial statements theidentifiable assets acquired, the liabilities assumed, any noncontrollinginterest in the acquiree and the goodwill acquired. SFAS No. 141(R) alsoestablishes disclosure requirements to enable the evaluation of the nature andfinancial effects of the business combination. SFAS No. 141(R) is effective asof the beginning of an entity’s fiscal year that begins after December 15,2008.  We will be required to adopt SFASNo. 141(R) on October 1, 2009 and are currently evaluating the impact of thispronouncement on the consolidated financial statements.

 

In December2007, the FASB issued SFAS No. 160, “*Noncontrolling Interest in Consolidated Financial Statements”* (“SFAS No. 160”)*.*SFAS No. 160 amends Accounting Research Bulletin 51to establish accounting and reporting standards for the noncontrolling(minority) interest in a subsidiary and for the deconsolidation of asubsidiary. It clarifies that a noncontrolling interest in a subsidiary is anownership interest in the consolidated entity that should be reported as equityin the consolidated financial statements. SFAS No. 160 is effective for fiscal years, and interim periods withinthose fiscal years, beginning on or after December 15, 2008.  We will be required to adopt SFAS No. 160 onOctober 1, 2009 and are currently evaluating the impact of this pronouncementon the consolidated financial statements.

 

**CriticalAccounting Policies**

 

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

 

***InvestmentValuation***

* *

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

 

*General Valuation Policy:* Usingprocedures established by our Board of Directors, we value our investmentportfolio each quarter. We carry our investments at fair value, as determinedin good faith by or under the direction of our Board of Directors. Securitiesthat are publicly traded, if any, are valued at the closing price of theexchange or securities market on which they are listed on the valuation date.Securities that are not traded on a public exchange or securities market, butfor which a limited market exists, are valued at the indicative bid priceoffered by the respective originating syndication agent’s desk on or near thevaluation date.

 

Debt and equitysecurities that are not publicly traded and for which a limited market does notexist are valued at fair value as determined in good faith by or under thedirection of our Board of Directors. In making the good faith determination ofthe value of these securities, we start with the cost basis of the security,which includes PIK interest, if any. We then apply the methods set out below in“—Valuation Methods.” Members of our Adviser’s portfolio management teamprepare the valuations of our investments in portfolio companies using the mostrecent portfolio company financial statements and forecasts. These individualsalso consult with portfolio company senior management and ownership to obtainfurther updates on the portfolio company’s performance, including informationsuch as industry trends, new product development, and other operational issues.Due to the uncertainty inherent in the valuation process, such estimates offair 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 otherevents that may occur over the life of the investments may cause the gains orlosses ultimately realized on these investments to be different than thevaluations currently assigned. There is no single standard for determining fairvalue in good faith, as fair value depends upon circumstances of eachindividual case. In general, fair value is the amount that we might reasonablyexpect to receive upon the current sale of the security.

 

At December 31, 2007, we engaged Standard & Poor’sSecurities Evaluations, Inc. (“SPSE”) to submit opinions of value for ourdebt securities that are issued by portfolio companies where we have no equity,or equity-like securities. In addition, securities that are not traded on apublic exchange or securities market, but for which a limited market exists andthat have not been rated by a nationally recognized statistical ratingorganization (“NRSRO”) (such as certain participations in syndicated loans) arealso submitted to SPSE for opinions of value, along with the indicative bidprice offered by the syndication agent’s desk on or near the valuation date. Wesubmit non-NRSRO rated securities to SPSE as part of our Board’s furtherconsideration of whether market quotations are readily 

 

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available, valid and reliable and, if there are discrepancies betweenthe indicative bid price offered by the syndication agent’s desk and theopinion of value from SPSE, we determine whether it is more appropriate for thealternative method of valuation prescribed by the 1940 Act—fair value asdetermined in good faith by the Board of Directors—to be implemented. Werequest that SPSE also evaluate and assign values to success fees (conditionalinterest included in some debt securities) when we determine that theprobability of receiving a success fee on a given loan is above 6-8%, a thresholdof significance. We may also submit PIK interest to SPSE for valuation when itis determined the PIK interest is likely to be received. SPSE will onlyevaluate the debt portion of our investments for which we specifically requestevaluation, and may decline to make requested evaluations for any reason at itssole discretion. Upon completing our collection of data with respect to theinvestments (including the information described under “—Credit Information,”the risk ratings of the loans described under “—Loan Grading and Risk Rating”and the factors described under “—Valuation Methods”), this valuation data isforwarded to SPSE for review and analysis. SPSE makes its independentassessment of the data that we have assembled and assesses its independent datato form an opinion as to what they consider to be the market values for thesecurities. With regard to its work, SPSE has issued the following paragraph:

 

SPSE provides evaluated price opinions which arereflective of what SPSE believes the bid side of the market would be for eachloan after careful review and analysis of descriptive, market and creditinformation. Each price reflects SPSE’s best judgment based upon carefulexamination of a variety of market factors. Because of fluctuation in the marketand in other factors beyond its control, SPSE cannot guarantee theseevaluations. The evaluations reflect the market prices, or estimates thereof,on the date specified. The prices are based on comparable market prices forsimilar securities. Market information has been obtained from reputablesecondary market sources. Although these sources are considered reliable, SPSEcannot guarantee their accuracy.

 

SPSE opinions of value of our debt securities that are issued byportfolio companies where we have no equity or equity-like securities aresubmitted to our Board of Directors along with our Adviser’s supplementalassessment and recommendation regarding valuation of each of these investments.Our Adviser generally accepts the opinion of value given by SPSE, however, incertain limited circumstances, such as when our Adviser may learn newinformation regarding an investment between the time of submission to SPSE andthe date of the Board assessment, our Adviser’s conclusions as to value maydiffer from the opinion of value delivered by SPSE. Our Board of Directors thenreviews whether our Adviser has followed its established procedures fordeterminations of fair value, and votes to accept or reject the recommendedvaluation of our investment portfolio. Our Adviser and our managementrecommended, and the Board of Directors voted to accept, the opinions of valuedelivered by SPSE on the loans in our portfolio as denoted on the ConsolidatedSchedule of Investments as of December 31, 2007 and September 30, 2007,included in our consolidated financial statements.

 

Because there is a delay between when we close an investment and whenthe investment can be evaluated by SPSE, new loans are not valued immediatelyby SPSE; rather, management makes its own determination about the value ofthese investments in accordance with our valuation policy. Because SPSE doesnot provide values for equity securities, our Adviser determines therecommended fair value of these investments using valuation policies approvedby our Board of Directors.

 

*Credit Information:*  Our Adviser monitors a wide variety of keycredit statistics that provide information regarding our portfolio companies tohelp us assess credit quality and portfolio performance. We and our Adviserparticipate in the periodic board meetings of our portfolio companies in whichwe hold control investments and also require them to provide annual audited andmonthly unaudited financial statements. Using these statements and boarddiscussions, our Adviser calculates and evaluates the credit statistics.

 

*Loan Grading and Risk Rating:*  As part of our valuation procedures we riskrate all of our investments in debt securities. For syndicated loans that havebeen rated by a NRSRO (as defined in Rule 2a-7 under the 1940 Act), we usethe NRSRO’s risk rating for such security. For all other debt securities, weuse a proprietary risk rating system. Our risk rating system uses a scale of 0to 10, with 10 being the lowest probability of default. This system is used toestimate the probability of default on debt securities and the probability ofloss if there is a default. These types of systems are referred to as riskrating systems and are used by banks and rating agencies. The risk ratingsystem covers both qualitative and quantitative aspects of the business and thesecurities we hold.

 

For the debt securities for which we do not use a third-party NRSROrisk rating, we seek to have our risk rating system mirror the risk ratingsystems of major risk rating organizations, such as those provided by a NRSRO.While we seek to mirror the NRSRO systems, we cannot provide any assurance thatour risk rating system will provide the same risk rating as a NRSRO for thesesecurities. The following chart is an estimate of the relationship of our riskrating system to the designations used by two NRSROs as they risk rate debtsecurities of major companies. Because our system rates debt securities ofcompanies that are unrated by any NRSRO, there can be no assurance that thecorrelation to the NRSRO set out below is accurate. We believe our risk ratingwould be significantly higher than a typical NRSRO risk rating because the riskrating of the typical NRSRO is designed for larger businesses. However, ourrisk rating has been designed to risk rate the securities of smaller businessesthat are not rated by a typical NRSRO. Therefore, when we use our risk ratingon larger business securities, the risk rating is higher than a typical NRSROrating. The primary difference between our risk rating and the rating of atypical NRSRO is that our risk rating uses more quantitative determinants andincludes qualitative 

 

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determinants that we believe are not used in the NRSRO rating. It isour understanding that most debt securities of medium-sized companies do notexceed the grade of BBB on a NRSRO scale, so there would be no debt securitiesin the middle market that would meet the definition of AAA, AA or A. Therefore,our scale begins with the designation 10 as the best risk rating which may beequivalent to a BBB from a NRSRO, however, no assurance can be given that a 10on our scale is equal to a BBB on a NRSRO scale.

 
| **Company’s  System** | ** ** | **First  NRSRO** | ** ** | **Second  NRSRO** | ** ** | **Gladstone Capital’s Description(a)**                                                          | ** ** |
|----------------------------|------------|------------------|------------|-------------------|------------|------------------------------------------------------------------------------------------------------|------------|
| **>10**                 |       | Baa2             |       | BBB               |       | Probability of Default  (PD during the next ten years is 4% and the Expected Loss (EL) is 1% or less |       |
| **10**                     |       | Baa3             |       | BBB-              |       | PD is 5% and the EL is  1% to 2%                                                                     |       |
| **9**                      |       | Ba1              |       | BB+               |       | PD is 10% and the EL is  2% to 3%                                                                    |       |
| **8**                      |       | Ba2              |       | BB                |       | PD is 16% and the EL is  3% to 4%                                                                    |       |
| **7**                      |       | Ba3              |       | BB-               |       | PD is 17.8% and the EL  is 4% to 5%                                                                  |       |
| **6**                      |       | B1               |       | B+                |       | PD is 22% and the EL is  5% to 6.5%                                                                  |       |
| **5**                      |       | B2               |       | B                 |       | PD is 25% and the EL is  6.5% to 8%                                                                  |       |
| **4**                      |       | B3               |       | B-                |       | PD is 27% and the EL is  8% to 10%                                                                   |       |
| **3**                      |       | Caa1             |       | CCC+              |       | PD is 30% and the EL is  10% 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 forth are for a ten year term debt security.  If a debt security is less than ten years,then the probability of default is adjusted to a lower percentage for theshorter period, which may move the security higher on our risk rating scale.*

* *

The above scale gives anindication of the probability of default and the magnitude of the loss if thereis a default.  Our policy is to stopaccruing interest on an investment if we determine that interest is no longercollectible.  At December 31, 2007, twoinvestments were on non-accrual and one investment was on non-accrual atSeptember 30, 2007.  Additionally, we donot risk rate our equity securities.

 

The following table liststhe risk ratings for all non-syndicated loans in our portfolio at December 31,2007 and September 30, 2007, representing approximately 82% and 79%,respectively, of all loans in our portfolio at the end of each period:

 

| **Rating**       | ** ** | **Dec. 31,  2007** | ** ** | **Sept.  30, 2007** |
|------------------|------------|--------------------|------------|---------------------|
| Average          |       | **7.3**            | ** ** | **7.3**             |
| Weighted Average |       | **7.0**            | ** ** | **7.1**             |
| Highest          |       | **9.0**            | ** ** | **9.0**             |
| Lowest           |       | **5.0**            | ** ** | **4.0**             |

 

The following table liststhe risk ratings for syndicated loans in our portfolio that were not rated byan NRSRO at December 31, 2007 and September 30, 2007, representingapproximately 4% of all loans in our portfolio at the end of each period:

 

| **Rating**       | ** ** | **Dec. 31,  2007** | ** ** | **Sept.  30, 2007** |
|------------------|------------|--------------------|------------|---------------------|
| Average          |       | **6.3**            | ** ** | **6.0**             |
| Weighted Average |       | **6.1**            | ** ** | **6.0**             |
| Highest          |       | **7.0**            | ** ** | **6.0**             |
| Lowest           |       | **6.0**            | ** ** | **6.0**             |

 

For syndicated loans thatare currently rated by an NRSRO, we risk rate such loans in accordance with therisk rating systems of major risk rating organizations, such as those providedby an NRSRO. The following table lists the risk ratings for all syndicatedloans in our portfolio that were rated by an NRSRO at December 31, 2007 andSeptember 30, 2007, representing approximately 14% and 17%, respectively, ofall loans in our portfolio at the end of each period:

 

| **Rating**       | ** ** | **Dec. 31,  2007** | ** ** | **Sept.  30, 2007** |
|------------------|------------|--------------------|------------|---------------------|
| Average          |       | **CCC+/Caa1**      | ** ** | **CCC+/Caa1**       |
| Weighted Average |       | **CCC+/Caa1**      | ** ** | **CCC+/Caa1**       |
| Highest          |       | **B/B3**           | ** ** | **B/B3**            |
| Lowest           |       | **CCC/Caa2**       | ** ** | **CCC/Caa2**        |

 

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*Valuation Methods:*  We determine the value of publicly-tradeddebt securities based on the closing price for the security on the exchange orsecurities market on which it is listed on the valuation date. We value debtsecurities that are not publicly traded, but for which a limited market for thesecurity exists, such as certain participations in syndicated loans, at theindicative bid price offered by the respective originating syndication agent’strading desk on or near the valuation date. At December 31, 2007, none ofthe debt securities in our portfolio were publicly traded and there was alimited market for 29 debt securities in our portfolio.  At September 30, 2007, none of the debtsecurities in our portfolio were publicly traded and there was a limited marketfor 28 debt securities in our portfolio.

 

Debt securities that are issued by portfolio companies where we have anequity, or equity-like interest that are not publicly traded and for whichthere is no market are valued at cost, if there is adequate total enterprisevalue determined when valuing our equity holdings in the borrower. Fair valuesare discounted for any shortfall of total enterprise value over the total debtoutstanding for the borrower.

 

For securities that are not publicly traded and that are issued byportfolio companies for which there is no market, we determine the value of thesecurity as if we currently intended to sell the security and consider some orall of the following factors:

 

·      the risk rating of the security;

 

·      the cost basis and the type of thesecurity;

 

·      the nature and realizable value of thecollateral;

 

·      the portfolio company’s ability to makepayments and discounted cash flow;

 

·      reports from portfolio company senior managementand board meetings;

 

·      reported values of similar securities ofthe portfolio company or comparable companies; and

 

·      changes in the economy affecting theportfolio company.

 

We value convertible debt, equity, success or exit fees or other equity-likesecurities for which there is a market based on the market prices for suchsecurities, even if that market is not robust. At December 31, 2007 andSeptember 30, 2007, there was no market for any of the equity securitieswe owned. To value convertible debt, equity, success or exit fees or otherequity-like securities for which no market exists, we use the same informationwe would use for a debt security valuation described above, except risk rating,as well as standard valuation techniques used by major valuation firms to valuethe equity securities of private companies. These valuation techniques alsoinclude discounted cash flow of the expected sale price in the future,valuation of the securities based on recent sales to third parties in comparabletransactions, or a review of similar companies that are publicly traded and themarket multiple of their equity securities. In gathering the sales to thirdparties of similar securities, we may reference industry statistics and useoutside experts. At December 31, 2007 and September 30, 2007, we had $778,347and $1,069,672, respectively, invested, at cost, in equity securities comparedto our debt portfolio with a cost basis of $424,191,853 and $354,689,528,respectively.

 

At December 31, 2007, wehad total unrealized depreciation of $14,589,062, which was mainly comprised ofunrealized depreciation of $1,982,250, on the aggregate of our investments inLocalTel, Inc., unrealized depreciation of $1,833,600, on the aggregate of ourinvestments in Greatwide Logistics Services, Inc., and unrealized deprecationof $1,750,000 on our senior subordinated term debt investment in Visual EdgeTechnology, Inc.  Unrealized appreciationof $3,276,551 was primarily composed of unrealized appreciation of $2,997,551on our warrants in Finn Corporation.  Inthe aggregate, we recorded net unrealized depreciation of $11,312,511 on ourtotal investment portfolio as of December 31, 2007.

 

At September 30, 2007, wehad total unrealized depreciation of $9,107,156, which was mainly comprised ofunrealized depreciation of $1,425,000 on our senior subordinated term debtinvestment in Visual Edge Technology, Inc., unrealized depreciation of$1,236,100 on the aggregate of our investments in Greatwide Logistics Services,Inc., unrealized depreciation of $1,180,713, on the aggregate of ourinvestments in LocalTel, Inc. and unrealized depreciation of $456,750 on oursenior term debt investment in It’s Just Lunch International, LLC.  Unrealized appreciation of $3,192,486 wasprimarily composed of unrealized appreciation of $2,968,333 on our warrants inFinn Corporation.  In the aggregate, werecorded net unrealized depreciation of $5,914,670 on our total investmentportfolio as of September 30, 2007.

 

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***Tax Status***

* *

*Federal Income Taxes*

 

We intend tocontinue to qualify for treatment as a RIC under Subtitle A, Chapter 1 ofSubchapter M of the Code. As a RIC, we are not subject to federal income tax onthe portion of our taxable income and gains distributed to stockholders. Toqualify as a RIC, we are required to distribute to stockholders at least 90% ofour investment company taxable income, as defined by the Code.  We have a policy to pay out as a dividend upto 100% of that amount.

 

In an effort toavoid certain excise taxes imposed on RICs, we currently intend to distributeduring each calendar year, an amount at least equal to the sum of (1) 98% ofour ordinary income for the calendar year, (2) 98% of our capital gains inexcess of capital losses for the one-year period ending on October 31 of thecalendar year and (3) any ordinary income and net capital gains for precedingyears that were not distributed during such years.

 

***Revenue Recognition***

* *

*Interest Income Recognition*

 

Interest income isrecorded on the accrual basis to the extent that such amounts are expected tobe collected. We will stop accruing interest on investments and write off anypreviously accrued and uncollected interest when it is determined that interestis no longer collectible. Conditional interest or a success fee is recordedwhen earned upon full repayment of a loan investment.

 

*Paid in Kind Interest*

 

We may hold loansin our portfolio which contain a PIK interest provision. The PIK interest,computed at the contractual rate specified in each loan agreement, is added tothe principal balance of the loan and recorded as interest income. To maintainour status as a RIC, this non-cash source of income must be paid out tostockholders in the form of dividends, even though we have not yet collectedthe cash.

 

*Services Provided to Portfolio Companies*

 

As a business development company under the 1940 Act, we are requiredto make available significant managerial assistance to our portfolio companies.We provide these services through our Adviser, who provides these services onour behalf through its officers who are also our officers.  Currently, neither we nor our Adviser chargesa fee for managerial assistance, however, if our Adviser does receive fees forsuch managerial assistance, our Adviser will credit the managerial assistancefees to the base management fee due from us to our Adviser.

 

Our Adviser receives fees for the other services it provides to our portfoliocompanies.  These other fees aretypically non-recurring, are recognized as revenue when earned and aregenerally paid directly to our Adviser by the borrower or potential borrowerupon the closing of the investment. The services our Adviser provides to ourportfolio companies vary by investment, but generally include a broad array ofservices such as investment banking services, arranging bank and equityfinancing, structuring financing from multiple lenders and investors, reviewingexisting credit facilities, restructuring existing investments, raising equityand debt capital, turnaround management, merger and acquisition services andrecruiting new management personnel.  EffectiveApril 1, 2007, when our Adviser receives fees for these services, 50% ofcertain of those fees are voluntarily credited against the base management fee thatwe pay to our Adviser, whereas prior to such date fees were 100% credited.  Any services of this nature subsequent to theclosing would typically generate a separate fee at the time of completion.

 

Our Adviser also receives fees for monitoring and reviewing portfoliocompany investments.  These fees arerecurring and are generally paid annually or quarterly in advance to ourAdviser throughout the life of the investment. Fees of this nature are recorded as revenue by our Adviser when earnedand are not credited against the base management fee.

 

We may receive fees for the origination and closing services we provideto portfolio companies through our Adviser. These fees are paid directly to us and are recognized as revenue uponclosing of the originated investment and are reported as fee income in theconsolidated statements of operations

 

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** **

**RESULTS OF OPERATIONS**

 

*Comparison of theThree Months Ended December 31, 2007 to the Three Months Ended December 31,2006*

 

**InvestmentIncome**

 

Investment income for thethree months ended December 31, 2007 was $11,401,639, as compared to $8,233,718for the three months ended December 31, 2006.

 

Interest income from ourinvestments in debt securities of private companies was $11,138,978 for thethree months ended December 31, 2007, as compared with $7,898,600 for the threemonths ended December 31, 2006.  Thisincrease was based on the overall growth in the cost basis of investments,which exclude equity, with an average cost basis of approximately $389.4million for the three months ended December 31, 2007, as compare to an averagecost basis of $230.3 million for the three months ended December 31, 2006.  During the three months ended December 31,2007, we received a success fee of $346,000, as compared to the same period ofthe prior year, which contained a success fee of $1,200,000.

 

The annualized weightedaverage yield on our portfolio for the three months ended December 31, 2007 was11.0%. The annualized weighted average yield on our portfolio for the threemonths ended December 31, 2006 was 13.7%.  The decline in the portfolio yield is due totwo investments being on non-accrual during the three months ended December 31,2007 and none in the prior year period.

 

Interest income frominvested cash and cash equivalents for the three months ended December 31, 2007was $144,485, as compared to $37,269 for the three months ended December 31,2006. Interest income increased from the prior year due to the amount of cashthat was held in interest bearing accounts and the interest earned on ourcustodial account prior to disbursement.

 

For the three monthsended December 31, 2007 and December 31, 2006, we recorded $118,176 and $138,191,respectively, in interest income from loans to our employees in connection withthe exercise of employee stock options.  The decrease is due to the cancellation infull of one employee loan during the fourth quarter of the prior fiscal year.

 

For the three months endedDecember 31, 2007, we did not record any prepayment fees or other income, ascompared to $159,658 for the three months ended December 31, 2006.  The income for the prior year periodconsisted of prepayment penalty fees received upon the full repayment ofcertain loan investments ahead of contractual maturity and prepayment feesreceived upon the early unscheduled principal repayments which, in bothinstances, were based on a percentage of the outstanding principal amount ofthe loan at the date of prepayment.

 

**OperatingExpenses**

** **

Operating expenses, netof credits from the Adviser for fees earned and voluntary waivers to the basemanagement and incentive fees, for the three months ended December 31, 2007were $4,098,354, as compared to $3,070,792 for the three months ended December31, 2006. Operating expenses for the three months ended December 31, 2007reflected a significant increase in interest expense, loan servicing fees, andadministration fees.

 

Interest expense for thethree months ended December 31, 2007 was $2,356,315, as compared to $1,120,257for the three months ended December 31, 2006.  This increase is primarily a result ofincreased borrowings under our line of credit during the three months ended December31, 2007, which borrowings were partially used to finance our increasedinvestments, borrowings remaining outstanding for longer periods of time and anincrease in the interest rates on our borrowings.

 

Loan servicingfees of $1,381,307 were incurred for the three months ended December 31, 2007,as compared to $719,152 for the three months ended December 31, 2006.  These fees were incurred in connection with aloan servicing agreement between Business Loan and our Adviser, which is basedon the size of the portfolio.  Theaverage size of our investment portfolio, excluding equity investments andcontrol investments, was approximately $377.6 million for the three monthsended December 31, 2007 as compared to approximately $230.6 million for thethree months ended December 31, 2006.  Thesefees were reduced against the amount of the base management fee due to ourAdviser.

 

For the threemonths ended December 31, 2007, we incurred a base management fee of $577,920 ,after reductions for loan servicing fees received by our Adviser of $1,381,307,less credits for fees received by our Adviser of $821,838 and a $103,440 feereduction for the waiver of the 2% fee on senior syndicated loans to 0.5%, fora net base management fee credit of $347,358 as compared to the three monthsended December 31, 2006, in which we incurred a base management fee of $476,819after reductions for loan servicing fees received by our Adviser of $719,152,less credits for fees received by our Adviser of $311,000 and a $78,417 feereduction for the waiver of the 2% fee on senior syndicated loans to 0.5%, fora net base management fee of $87,432. The base management fee is computedquarterly as described under *“Investment Advisory andManagement Agreement.”* Effective April 1, 2007, the board of our 

 

 

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Adviser reducedthe amount of voluntary credit for fees received by our Adviser from 100% ofthe fees received to 50% of the fees received, therefore the three months endedDecember 31, 2007 reflects the reduced credit for fees received by our Adviser.The gross base management fee before the reduction for loan servicing fees forthe three months ended December 31, 2007 and December 31, 2006, was $1,959,227and $1,196,001, respectively, increased in the current period due to the growthof the investment portfolio as compared to the same period of the prior year.

 

We recorded agross incentive fee of $1,460,657, which was reduced by a voluntary waiverissued by our Adviser’s board of directors of $1,460,657, which resulted in noincentive fee, as compared to a gross incentive fee of $1,148,483, which wasreduced by a voluntary waiver issued by our Adviser’s board of directors of $568,944,which resulted in a net incentive fee of $579,489 for the three month endedDecember 31, 2006

 

We incurred anadministration fee of $211,675 for the three months ended December 31, 2007 ascompared to $126,085 for the three months ended December 31, 2006. The increaseis due to the addition of internal counsel in the administration staff.

 

Professional fees,consisting primarily of legal and audit fees, for the three months endedDecember 31, 2007 were $129,253, as compared to $110,920 for the three monthsended December 31, 2006.  The increase isdue to the recording of audit accruals and non reimbursable legal fees.

 

Amortization of deferredfinancing costs, in connection with our line of credit, was $73,799 for thethree months ended December 31, 2007 and $58,300 for the three months ended December31, 2006.  The increase is due to theamortization of additional fees incurred with our line of credit which were notin place during the prior year period.

 

Stockholder related costsfor the three months ended December 31, 2007 were $119,769, as compared to$63,728 for the three months ended December 31, 2006.  Stockholder related costs include suchrecurring items as transfer agent fees, NASDAQ listing fees, SEC filing fees,and the production of our annual report. These fees increased during the three months ended December 31, 2007 duethe increase over the prior year of the size and quantity of our annual reportand additional filing fees as compared to the prior year.

 

Directors’ fees were$54,250 for the three months ended December 31, 2007 and 2006 and consisted ofamortization of their annual stipend and meeting stipends.

 

Insurance expense for thethree months ended December 31, 2007 was $54,213, as compared to $62,694 forthe three months ended December 31, 2006. The decrease was primarily the resultof a decrease of our directors and officers insurance policy premiums.

 

Other expenses were $65,131for the three months ended December 31, 2007, as compared to $88,485 for thethree months ended December 31, 2006.  The expenses primarily represent directexpenses such as travel related specifically to our portfolio companies, loanevaluation services for our portfolio companies, press releases and backupservicer expenses.

 

**Net Realized Gain on Sale ofInvestments**

** **

During the three monthsended December 31, 2007, we were not repaid in full on any investments andtherefore did not realize any gains or losses, as compared to a realized netgain of $2,314 from the sale of a syndicate loan investment in the three monthsended December 31, 2006.

 

**Realized Gain on Settlement ofDerivative**

** **

During the three monthsended December 31, 2007, we received interest rate cap agreement payments of$5,606 as a result of the one month LIBOR having a downward trend, as opposedto an increasing trend in the three months ended December 31, 2006 in which wereceived payments of $12,554.  We receivepayments when the one month LIBOR is over 5% and continues to grow month overmonth, not when the one month LIBOR decreases.

 

**Net Unrealized Depreciation onDerivative**

 

During the three monthsended December 31, 2007, we recorded net unrealized depreciation of $10,553 dueto a decrease in the fair market value of our interest rate cap agreement, ascompared to unrealized depreciation of $9,812 during the three months ended December31, 2006.

 

**Net Unrealized Depreciation onInvestments**

 

For the three months endedDecember 31, 2007, we recorded net unrealized depreciation on investments of$5,397,841, as compared to net unrealized depreciation of $1,004,379, for thethree months ended December 31, 2006. The unrealized depreciation is mainly 

 

 

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attributable to the decreasein fair value on our portfolio, most notably in the following investments:  LocalTel, Inc., Greatwide Logistics Services,Inc., Visual Edge Technology, Inc., U.S. Healthcare Communications, LLC, andWestlake Hardware, Inc.

 

**NetIncrease in Net Assets from Operations**

 

Overall, we realized a net increase in net assets resulting from operationsof $1,900,497 for the three months ended December 31, 2007.  Based on a weighted-average of 16,953,703basic and diluted shares outstanding, our net increase in net assets fromoperations per weighted-average common share for the three months endedDecember 31, 2007 was $0.11, basic and diluted.

 

For the three months ended December 31,2006, werealized a net increase in net assets resulting from operations of $4,163,603.  Based on a weighted-average of 12,294,340basic and diluted shares outstanding, our net increase in net assets fromoperations per weighted-average common share for the three months ended December31, 2006 was $0.34 basic and diluted.

 

 

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**LIQUIDITY AND CAPITAL RESOURCES**

** **

**Operating Activities**

 

At December 31, 2007, wehad investments in debt securities of, or loans to, 61 private companies,totaling approximately $425.0 million (cost basis) of total assets.

 

During the three monthsended December 31, 2007 and December 31, 2006, the following investmentactivity occurred:

 

| ** **         | ** ** | ** **          | ** ** | ** **               | ** ** | **Net Gain/(Loss)** | ** ** |
|--------------------|------------|---------------------|------------|--------------------------|------------|---------------------|------------|
| **Quarter  Ended** | ** ** | **New Investments** | ** ** | **Principal Repayments** | ** ** | **on Disposal**     | ** ** |
|               |       |                |       |                     |       |                |       |
| December 31, 2007  |       | $                   | 73,340,781 |                     | $          | 4,046,711           |       | $ | — |   |
|               |       |                |       |                     |       |                |       |
| December 31, 2006  |       | $                   | 52,311,008 |                     | $          | 23,967,229          |       | $ | 2,314 |   |

 

 

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

 

| **Fiscal  Year Ended September 30,** | ** ** | **Amount**  | ** **  |
|--------------------------------------|------------|-------------|-------------|
|                                 |       |        |        |
| 2008                                 |       | $           | 18,231,989  |   |
| 2009                                 |       | 28,519,183  |        |
| 2010                                 |       | 39,747,593  |        |
| 2011                                 |       | 103,631,619 |        |
| 2012                                 |       | 94,196,096  |        |
| Thereafter                           |       | 139,865,373 |        |
| **Total Contractual Repayments**     |       | $           | 424,191,853 |   |
|                                 |       |        |        |
| Investments in Equity  Securities    |       | $           | 778,347     |   |
| **Total**                            |       | $           | 424,970,200 |   |

 

 

Net cash used in operating activities for the three months ended December31, 2007, consisting primarily of the items described in *“Results ofOperations”* and the investment activity described above, was$63,851,844 as compared to net cash used in operating activities of $23,250,821for the three months ended December 31, 2006.

 

**FinancingActivities**

 

Net cash provided by financing activities for the three monthsended December 31, 2007 was $60,544,135 and mainly consisted of an offering ofcommon stock for net proceeds of approximately $50.5 million, net borrowings onour line of credit of approximately $17.4 million, and approximately $7.4million for the payment of dividends.  Netcash provided by financing activities was $28,515,757 for the three monthsended December 31, 2006 and consisted primarily of net borrowings on our lineof credit of approximately $35.2 million and the payment of dividends ofapproximately $5.2 million.

 

**Dividends**

** **

In order toqualify as a RIC and to avoid corporate level tax on the income we distributeto our stockholders, we are required, under Subchapter M of the Code, todistribute at least 90% of our ordinary income and short-term capital gains toour stockholders on an annual basis. In accordance with these requirements, wedeclared and paid monthly cash dividends of $0.14 per common share for October,November and December 2007 and also October, November and December 2006.  In January 2008, our Board of Directorsdeclared a monthly dividend of $0.14 per common share for each of January,February, and March 2008.

 

 

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**Issuance of Equity**

** **

We anticipate borrowingfunds and issuing additional equity securities to obtain additional capital.During fiscal year 2007, we filed a registration statement on Form N-2 (File No. 333-143027) (the“Registration Statement”) with the SEC that permits us to issue, throughone or more transactions, up to an aggregate of $300 million insecurities, consisting of common stock, or debt securities, of which to date wehave issued $116.1 million in common stock, which leaves a remaining capacityof $183.9 million.

 

On October 19, 2007, wecompleted an offering of 2,500,000 shares of our common stock at a price of$18.70 per share, less an underwriting discount of $1.03 per share, under theRegistration Statement and as supplemented by a final prospectus supplementdated October 15, 2007.  On November 19,2007, the underwriter exercised its over-allotment option and we closed on anadditional 375,000 shares of common stock, at the same price.  Net proceeds of the offering, after offeringexpenses, were approximately $50.5 million and were used to repay a portion ofoutstanding borrowings under our line of credit.

 

On February 5, 2008, wecompleted an offering of 3,000,000 shares of our common stock at a price of$17.00 per share, less an underwriting discount of $0.935 per share, under theRegistration Statement and as supplemented by a final prospectus supplementdated January 30, 2008. Net proceeds of the offering, after deducting anunderwriting discount and estimated offering expenses, were approximately $47.8million and were used to repay a portion of outstanding borrowings under ourline of credit.

 

**Revolving Credit Facilities**

 

Through our wholly-ownedsubsidiary, Business Loan, we have a $220 million revolving credit facility(the “DB Facility”) with Deutsche Bank AG, as administrative agent, which isscheduled to mature on May 23, 2008. Pursuant to the DB Facility, Business Loan has pledged the loans itholds to secure future advances by certain institutional lenders.  The interest rate charged on the advancesunder the DB Facility is based on the Commercial Paper (“CP”) rate, which isequivalent to the weighted average per annum rates paid by the DB Facility’s CPlenders in respect of CP notes issued by the CP lender during such period.  Business Loan also has the ability to borrowat an alternative rate from the committed lenders if CP lenders are unable tofund advances.  The alternative rate isthe London Interbank Offered Rate (“LIBOR”), or if LIBOR is unavailable, thePrime Rate or the Federal Funds Rate plus 1.0%. As of December 31, 2007, theoutstanding principal balance under this credit facility was approximately$161.8 million at an interest rate of approximately 5.36% plus a 0.95% programfee.  Available borrowings are subject tovarious constraints imposed by Deutsche Bank AG, based on the aggregate loanbalance pledged by Business Loan, which varies as loans are added and repaid,regardless of whether such repayments are early prepayment or are made ascontractually required.  At December 31,2007, the remaining borrowing capacity available under the DB Facility wasapproximately $58.2 million.  In theevent that we are not able to renew or refinance the DB Facility once itmatures, this could have a material adverse impact on our liquidity and abilityto fund new investments.

 

The DB Facility containscovenants that require Business Loan to maintain its status as a separateentity; prohibit certain significant corporate transactions (such as mergers,consolidations, liquidations or dissolutions); and restrict material changes toour credit and collection policies.  Thefacility also restricts some of the terms and provisions (including interestrates, terms to maturity and payments schedules) and limits the borrower andindustry concentrations of loans that are eligible to secure advances.  As of December 31, 2007, Business Loanwas in compliance with all of the facility covenants.  We currently intend to securitize the loansheld by Business Loan and if we are able to do so, we will use the proceedsfrom the securitization to pay down any amounts then outstanding under therevolving credit facility.

 

The administrative agentalso requires that any interest or principal payments on pledged loans beremitted directly by the borrower into a lockbox account with the Bank of NewYork Mellon as custodian.  Deutsche BankAG is also the trustee of the account and once a month remits the collectedfunds to us. For the three months ended December 31, 2007, the amount due fromcustodian increased by $1,585,801 as compared to September 30, 2007.

 

Our Adviser services theloans pledged under the DB Facility.  Asa condition to this servicing arrangement, we executed a performance guarantypursuant to which we guaranteed that our Adviser would comply fully with all ofits obligations under the facility. The performance guaranty requires us tomaintain a minimum net worth of $100 million plus 75% of equity issued afterMay 2003 and to maintain “asset coverage” with respect to “senior securities representingindebtedness” of at least 200%, in accordance with Section 18 of the 1940Act.  As of December 31, 2007, we were incompliance with our covenants under the performance guaranty.

** **

 

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**Contractual Obligations**

 

As of December 31, 2007,we were a party to signed and non-binding term sheets for five loanoriginations for an aggregate of $45.4 million. To date, one investment funded for an aggregate amount of $13.9 million.

 
| ** **                   | ** ** | ** ** | ** ** | **Payment Due by Period** | ** ** |
|------------------------------|------------|------------|------------|---------------------------|------------|
| **Contractual  Obligations** | ** ** | **Total**  | ** ** | **Less than 1 Year**      | ** ** | **1-3 Years** | ** ** | **3-5 Years** | ** ** | **More than  5 Years** | ** ** |
|                         |       |       |       |                      |       |   |   |   |   |   |   |
| Investments                  |       | $          | 45,400,000 |                      | 45,400,000 |   | — |   | — |   | — |   |
| Total                        |       | $          | 45,400,000 |                      | $          | 45,400,000 |   | $ | — |   | $ | — |   | $ | — |   |
|                              |            |            |            |                           |            |  |  |  |  |  |  |  |  |  |  |  |

 

 

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

 

We are subject tofinancial market risks, including changes in interest rates.  We estimatethat ultimately approximately 20% of the loans in our portfolio will be made atfixed rates and approximately 80% will be made at variable rates.  Currently, our portfolio has approximately57% of the total loan portfolio cost basis at variable rates with a floor,approximately 2% of the total loan portfolio cost basis at a variable rate witha floor and ceiling, approximately 37% of the total loan portfolio cost basisat variable rates without a floor or ceiling and approximately 4% of the totalloan portfolio cost basis is at a fixed rate. All of our variable based loans have rates associated with either thecurrent Prime Rate or LIBOR.

 

We have a $220 millionrevolving credit facility, based on variable rates, with Deutsche Bank AG whichmatures May 2008.

 

In February 2004, we entered into an interest rate capagreement in order to fulfill an obligation under our line of credit to enterinto certain hedging transactions in connection with our borrowings under theline of credit.  We purchased this interest rate cap agreement with anotional amount of $35 million (which is amortized quarterly) for a one-time,up-front payment of $304,000.  The interest rate cap agreement entitles usto receive payments, if any, equal to the amount by which interest payments on thecurrent notional amount at one monthLIBOR exceed the payments on the current notional amount at 5%. The cap expires in February 2009.  This interest rate cap agreementeffectively caps our interest payments on our line of credit borrowing, up tothe notional amount of the interest rate cap, at five percent.  Thismitigates our exposure to increases in interest rates on our borrowings on ourlines of credit, which are at variable rates. At December 31, 2007, the cap agreement had a fair market value of$1,761 and a current notional amount of $5.7 million.  The one month LIBOR rate in effect on ourinvestment portfolio at December 31, 2007 was approximately 5.2%.

 

To illustrate the potential impact of changes ininterest rates on our net increase in net assets resulting from operations, wehave performed the following analysis, which assumes that our balance sheetremains constant and no further actions beyond the interest rate cap agreementare taken to alter our existing interest rate sensitivity.  Under this analysis, a hypothetical increasein the one month LIBOR or the Prime Rate by 1% would increase our net increasein net assets resulting from operations by approximately $2.5 million, or19.5%, over the next twelve months, compared to the net increase in net assetsresulting from operations for the twelve months ended December 31, 2007.  A hypothetical decrease in the one monthLIBOR or the Prime Rate by 1% would decrease net increase in net assetsresulting from operations by approximately $1.2 million, or 9.4%, over the nexttwelve months, compared to the net increase in net assets resulting fromoperations for the twelve months ended December 31, 2007.  Although management believes that thisanalysis is indicative of our existing interest rate sensitivity, it does notadjust for potential changes in credit quality, size and composition of ourloan portfolio on the balance sheet and other business developments that couldaffect net increase in net assets resulting from operations.  Accordingly, no assurances can be given thatactual results would not differ materially from the results under thishypothetical analysis.

 

In the event that wesecuritize a portion of our loan portfolio, we believe that we will likely berequired to enter into further hedging arrangements in the future with respectto securitized loans. While hedging activities may mitigate our exposure toadverse fluctuations in interest rates, certain hedging transactions that wemay enter into in the future, such as interest rate swap agreements, may alsolimit our ability to participate in the benefits of lower interest rates withrespect to our portfolio of investments.

 

We may also experiencerisk associated with investing in securities of companies with foreignoperations. We currently do not anticipate investing in debt or equity offoreign companies, however, some potential portfolio companies may haveoperations located outside the United States. These risks include, but are notlimited to, fluctuations in foreign currency exchange rates, imposition offoreign taxes, changes in exportation regulations and political and socialinstability.

 

**ITEM 4. CONTROLS ANDPROCEDURES.**

 

As of December 31, 2007, we, including our Chief Executive Officerand Chief Financial Officer, evaluated the effectiveness of the design andoperation of our disclosure controls and procedures.  Based on that evaluation, our management,including the Chief Executive Officer and Chief Financial Officer, concludedthat our disclosure controls and procedures were effective in timely alertingmanagement, including the Chief Executive Officer and Chief Financial Officer,of material information about us required to be included in periodic Securitiesand Exchange Commission filings. However, in evaluating the disclosure controls and procedures,management recognized that any controls and procedures, no matter how welldesigned and operated can provide only reasonable assurance of achieving thedesired control objectives, and management necessarily was required to applyits judgment in evaluating the cost-benefit relationship of possible controlsand procedures.

 

There have been no changes in our internal control over financialreporting that occurred during the quarter ended December 31, 2007, that havematerially affected, or are reasonably likely to materially affect, ourinternal control over financial reporting.

 

** **

 

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**PART II–OTHERINFORMATION**

 

**ITEM 1. LEGAL PROCEEDINGS.**

 

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

 

**ITEM 1A. RISK FACTORS.**

 

Our business is subjectto certain risks and events that, if they occur, could adversely affect ourfinancial condition and results of operations and the trading price of ourcommon stock. For a discussion of these risks, please refer to the “RiskFactors” section of our Prospectus dated January 23, 2008, filed by us with theSecurities and Exchange Commission on January 23, 2008.

 

*We may not be able to extend or renewour credit facility on terms reasonably acceptable to us, if at all.*

 

We are reliant on ourcredit facility in order to be able to continue to obtain capital to financeour loans.  In the event that we are notable to renew our facility, scheduled to mature on May 23, 2008, we may not beable to finance new investments and may be forced to liquidate a portion of ourinvestments at terms that may not be favorable to us.  This could ultimately have a material adverseeffect on our business, financial condition and results of operations.

 

**ITEM 2. UNREGISTEREDSALES OF EQUITY SECURITIES AND USE OF PROCEEDS.**

 

Not applicable.

 

**ITEM 3. DEFAULTS UPONSENIOR SECURITIES.**

 

Not applicable.

 

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

 

No matters were submitted to a vote ofsecurity holders during the three months ended December 31, 2007.

 

**ITEM 5. OTHERINFORMATION.**

 

Not applicable

 

**ITEM 6. EXHIBITS**

** **

See the exhibit index.

 

**SIGNATURE**

 

Pursuant to the requirements of the Securities Exchange Act of 1934,the registrant has duly caused this report to be signed on its behalf by theundersigned thereunto duly authorized.

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

 

Date: February 5, 2008

 

 

48

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**EXHIBIT INDEX**

 
| **Exhibit** | ** ** | **Description**                                                                                                                                                                                                                           |
|-------------|------------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|        |       |                                                                                                                                                                                                                                      |
| 3.1         |       | Articles of Amendment and Restatement of the Articles of  Incorporation, incorporated by reference to Exhibit a.2 to Pre-Effective  Amendment No. 1 to the Registration Statement on Form N-2 (File No.  333-63700), filed July 27, 2001. |
|        |       |                                                                                                                                                                                                                                      |
| 3.2         |       | By-laws, incorporated by reference to Exhibit b to Pre-Effective  Amendment No. 1 to the Registration Statement on Form N-2 (File No.  333-63700), filed July 27, 2001.                                                                   |
|        |       |                                                                                                                                                                                                                                      |
| 3.3         |       | Amendment to by-laws, incorporated by reference to Exhibit 3.3  to the Company’s Quarterly Report on Form 10-Q for the quarter ended December  31, 2003 (File No. 814-00237), filed February 17, 2004.                               |
|        |       |                                                                                                                                                                                                                                      |
| 3.4         |       | Second amendment to by-laws, incorporated by reference to  Exhibit 99.1 to the Company’s Current Report on Form 8-K (File No.  814-00237), filed July 10, 2007.                                                                      |
|        |       |                                                                                                                                                                                                                                      |
| 11          |       | Computation of Per Share Earnings (included in the notes to the  unaudited consolidated 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.

 

 

49

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