**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON,D.C. 20549**

 

**FORM 10-Q**

 

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

 

**FORTHE QUARTER ENDED JUNE 30, 2005**

 

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

 

**COMMISSIONFILE NUMBER: 814-00237**

 

**GLADSTONE CAPITAL CORPORATION**

(Exact name of registrant as specified in its charter)

 
| **MARYLAND**                                                   | ** ** | **54-2040781**                       |
|----------------------------------------------------------------|------------|--------------------------------------|
| (State or other jurisdiction of incorporation or organization) |       | (I.R.S. Employer Identification No.) |
|                                                           |       |                                 |
| **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 theregistrant (1) has filed all reports required to be filed by Section 13or 15(d) of the Securities Exchange Act of 1934 during the preceding 12months and (2) has been subject to such filing requirements for the past90 days.

Yes ý No o.

 

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

Yes ý No o.

 

Indicate the number of shares outstandingof each of the issuer’s classes of common stock, as of the latest practicabledate.  The number of shares of the issuer’sCommon Stock, $0.001 par value, outstanding as of August 3, 2005 was 11,303,510.

 

 

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**GLADSTONECAPITAL CORPORATION**

**TABLEOF CONTENTS**

 
| PART I.  | FINANCIAL INFORMATION                                                                                                     |
|---------------|---------------------------------------------------------------------------------------------------------------------------|
|          |                                                                                                                      |
| Item 1.       | Financial Statements (Unaudited)                                                                                          |
|          |                                                                                                                      |
|          | Consolidated Balance Sheets as of June 30,  2005 and September 30, 2004                                         |
|          | Schedules  of Investments as of June 30, 2005 and September 30, 2004                                            |
|          | Consolidated Statements of  Operations for the three months ended June 30, 2005 and June 30,  2004              |
|          | Consolidated  Statements of Operations for the nine months ended June 30, 2005 and June 30,  2004               |
|          | Consolidated Statement of  Stockholders’ Equity for the nine months ended June 30, 2005 and June 30,  2004 |
|          | Consolidated Statements of  Cash Flows for the nine months ended June 30, 2005 and June 30, 2004                |
|          | Financial  Highlights for the three and nine months ended June 30, 2005 and June 30,  2004                      |
|          | Notes to Consolidated  Financial Statements                                                                               |
|          |                                                                                                                      |
| Item  2.      | Management’s  Discussion and Analysis of Financial Condition and Results of Operations                               |
|          |                                                                                                                      |
|          | Overview                                                                                                                  |
|          | Results of Operations                                                                                                     |
|          | Liquidity and  Capital Resources                                                                                          |
|          |                                                                                                                      |
| Item  3.      | Quantitative  and Qualitative Disclosure About Market Risk                                                                |
|          |                                                                                                                      |
| Item  4.      | Controls  and Procedures                                                                                                  |
|          |                                                                                                                      |
| PART II. | OTHER INFORMATION                                                                                                         |
|          |                                                                                                                      |
| Item  1.      | Legal  Proceedings                                                                                                        |
|          |                                                                                                                      |
| Item  2.      | Unregistered  Sales of Equity Securities and Use of Proceeds                                                              |
|          |                                                                                                                      |
| Item  3.      | Defaults  Upon Senior Securities                                                                                          |
|          |                                                                                                                      |
| Item  4.      | Submission  of Matters to a Vote of Security Holders                                                                      |
|          |                                                                                                                      |
| Item  5.      | Other  Information                                                                                                        |
|          |                                                                                                                      |
| Item  6.      | Exhibits                                                                                                                  |
|          |                                                                                                                      |
| SIGNATURES    |

 

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**GLADSTONECAPITAL CORPORATION**

 

**CONSOLIDATED BALANCE SHEETS**

**(Unaudited)**

 
| ** **                                                                                                                               | ** ** | **June 30,  2005** | ** **  | **September 30,  2004** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------|-------------|------------------------------|------------|
|                                                                                                                                     |       |                    |        |                         |       |
| ASSETS                                                                                                                                   |       |                    |        |                         |       |
| Investments at fair  value (Cost 6/30/2005: $197,749,877; 9/30/2004: $149,189,306)                                                       |       | $                       | 194,708,459 |                         | $          | 146,446,240 |   |
| Cash and cash  equivalents                                                                                                               |       | 766,922                 |        | 15,969,890                   |       |
| Cash and cash equivalents  pledged to creditors                                                                                          |       | —                  |        | 49,984,950                   |       |
| Interest receivable –  investments in debt securities                                                                               |       | 1,199,684               |        | 837,336                      |       |
| Interest receivable –  employees                                                                                                    |       | 90,915                  |        | 112,960                      |       |
| Due from custodian                                                                                                                       |       | 12,230,425              |        | 1,203,079                    |       |
| Due from affiliate                                                                                                                       |       | —                  |        | 109,639                      |       |
| Deferred financing  costs                                                                                                                |       | 171,250                 |        | 350,737                      |       |
| Prepaid assets                                                                                                                           |       | 71,622                  |        | 191,676                      |       |
| Other assets                                                                                                                             |       | 81,186                  |        | 127,220                      |       |
|                                                                                                                                     |       |                    |        |                         |       |
| TOTAL ASSETS                                                                                                                             |       | $                       | 209,320,463 |                         | $          | 215,333,727 |   |
|                                                                                                                                     |       |                    |        |                         |       |
| LIABILITIES AND  STOCKHOLDERS’ EQUITY                                                                                               |       |                    |        |                         |       |
|                                                                                                                                     |       |                    |        |                         |       |
| LIABILITIES                                                                                                                              |       |                    |        |                         |       |
| Accounts payable                                                                                                                         |       | $                       | 206,399     |                         | $          | 105,921 |   |
| Fees due to affiliate                                                                                                                    |       | 319,411                 |        | 113,511                      |       |
| Borrowings under lines  of credit                                                                                                        |       | 54,590,000              |        | 40,743,547                   |       |
| Accrued expenses and  deferred liabilities                                                                                               |       | 198,819                 |        | 798,096                      |       |
| Funds held in escrow                                                                                                                     |       | 200,000                 |        | —                       |       |
| Repurchase agreement                                                                                                                     |       | —                  |        | 21,345,997                   |       |
|                                                                                                                                     |       |                    |        |                         |       |
| Total Liabilities                                                                                                                        |       | $                       | 55,514,629  |                         | $          | 63,107,072 |   |
|                                                                                                                                     |       |                    |        |                         |       |
| STOCKHOLDERS’ EQUITY                                                                                                                |       |                    |        |                         |       |
| Common stock, $0.001  par value, 50,000,000 shares authorized and 11,303,510 and 11,278,510 shares  issued and outstanding, respectively |       | $                       | 11,304      |                         | $          | 11,279 |   |
| Capital in excess of  par value                                                                                                          |       | 164,610,873             |        | 164,294,781                  |       |
| Notes receivable for  sale of stock to employees                                                                                         |       | (8,792,349              | )           | (9,432,678                   | )          |
| Net unrealized  depreciation on investments                                                                                              |       | (3,041,418              | )           | (2,743,066                   | )          |
| Unrealized depreciation  on derivative                                                                                                   |       | (272,266                | )           | (214,259                     | )          |
| Realized gain on sale  of investments                                                                                                    |       | 42,250                  |        | 12,500                       |       |
| Distributions less than  net investment income                                                                                           |       | 1,247,440               |        | 298,098                      |       |
|                                                                                                                                     |       |                    |        |                         |       |
| Total Stockholders’  Equity                                                                                                         |       | $                       | 153,805,834 |                         | $          | 152,226,655 |   |
|                                                                                                                                     |       |                    |        |                         |       |
| TOTAL LIABILITIES AND  STOCKHOLDERS’ EQUITY                                                                                         |       | $                       | 209,320,463 |                         | $          | 215,333,727 |   |

 

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

 

2

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**GLADSTONECAPITAL CORPORATION**

**SCHEDULE OFINVESTMENTS**

**ASOF JUNE 30, 2005**

**(UNAUDITED)**

 
| **Company (1)**                         | ** ** | **Industry**                                              | ** ** | **Investment (2)**                                                  | ** ** | **Cost**   | ** ** | **Fair Value** | ** ** |
|-----------------------------------------|------------|-----------------------------------------------------------|------------|---------------------------------------------------------------------|------------|------------|------------|----------------|------------|
|                                    |       |                                                      |       |                                                                |       |       |       |           |       |
| Advanced Homecare Management, Inc. |       | Home health nursing services                              |       | Senior Subordinated Term Debt (6)  (12.6%, Due 12/2010)             |       | $          | 7,500,000  |           | $          | 7,500,000 |   |
|                                    |       |                                                      |       |                                                                |       |       |       |           |       |
| Allied Extruders, Inc.             |       | Polyethylene film manufacturer                            |       | Senior Term Debt (3)  (12.3%, Due 7/2009)                           |       | 3,950,000  |       | 3,969,750      |       |
|                                    |       |                                                      |       |                                                                |       |       |       |           |       |
| ARI Holdings, Inc.                 |       | Manufacturing-auto parts                                  |       | Senior Term Debt                                                    |       | 3,926,969  |       | 3,720,000      |       |
|                                    |       |                                                      |       | (8.2%, Due 2/2008)                                                  |       |       |       |           |       |
|                                    |       |                                                      |       |                                                                |       |       |       |           |       |
| Badanco Acquisition Corp.               |       | Manufacturing-luggage                                     |       | Senior Term Debt (6)                                                |       | 6,982,519  |       | 6,991,247      |       |
|                                    |       |                                                      |       | (8.6%, Due 2/2010)                                                  |       |       |       |           |       |
|                                    |       |                                                      |       | Senior Term Debt (3)(6)                                             |       | 8,650,000  |       | 8,660,813      |       |
|                                    |       |                                                      |       | (11.8%, Due 2/2010)                                                 |       |       |       |           |       |
|                                    |       |                                                      |       |                                                                |       |       |       |           |       |
| Benetech, Inc.                     |       | Dust management systems for the coal and electric utility |       | Senior Term Debt (6)  (8.5%, Due 5/2009)                            |       | 2,925,000  |       | 2,946,938      |       |
|                                    |       | industries                                                |       | Senior Term Debt (3) (6)                                       |       | 3,250,000  |       | 3,290,625      |       |
|                                    |       |                                                      |       | (11.5%, Due 5/2009)                                                 |       |       |       |           |       |
|                                    |       |                                                      |       |                                                                |       |       |       |           |       |
| Consolidated Bedding, Inc.         |       | Manufacturing-mattresses                                  |       | Senior Subordinated Term Debt (6)                                   |       | 2,964,609  |       | 2,937,558      |       |
|                                    |       |                                                      |       | (12.0%, Due 3/2009)                                                 |       |       |       |           |       |
|                                    |       |                                                      |       |                                                                |       |       |       |           |       |
| Coyne International Enterprises         |       | Industrial services                                       |       | Senior Term Debt (3) (5) (6)  (13.0%, PIK 2%, Due 7/2007) |       | 7,530,010  |       | 7,520,597      |       |
|                                    |       |                                                      |       |                                                                |       |       |       |           |       |
| Defiance Stamping                       |       | Manufacturing-trucking parts                              |       | Senior Term Debt (3)                                                |       | 6,325,000  |       | 6,325,000      |       |
| Company                                 |       |                                                      |       | (11.1%, Due 4/2010)                                                 |       |       |       |           |       |
|                                    |       |                                                      |       |                                                                |       |       |       |           |       |
| Finn Corporation                        |       | Manufacturing-landscape                                   |       | Senior Subordinated Term Debt (6)                                   |       | 10,500,000 |       | 7,350,000      |       |
|                                    |       | equipment                                                 |       | (13.0%, Due 2/2006)                                                 |       |       |       |           |       |
|                                    |       |                                                      |       | Common Stock Warrants                                               |       | 37,000     |       | 630,360        |       |
|                                    |       |                                                      |       |                                                                |       |       |       |           |       |
| Gammill, Inc.                      |       | Designer and assembler of                                 |       | Senior Term Debt (6)                                                |       | 3,771,427  |       | 3,776,141      |       |
|                                    |       | quilting machines and                                     |       | (9.5%, Due 12/2008)                                                 |       |       |       |           |       |
|                                    |       | accessories                                               |       | Senior Term Debt (3) (6)                                       |       | 4,690,625  |       | 4,673,035      |       |
|                                    |       |                                                      |       | (12.0%, Due 12/2008)                                                |       |       |       |           |       |
|                                    |       |                                                      |       |                                                                |       |       |       |           |       |
| Global Materials                        |       | Manufacturing-steel wool                                  |       | Senior Term Debt (3) (6)                                       |       | 5,500,000  |       | 5,506,875      |       |
| Technologies, Inc.                 |       | products and metal fibers                                 |       | (13.0%, Due 11/2009)                                                |       |       |       |           |       |
|                                    |       |                                                      |       |                                                                |       |       |       |           |       |
| Infor Global Solutions Ltd.             |       | Enterprise application solutions                          |       | Senior Subordinated Term Debt (7)  (10.6%, Due 4/2012)              |       | 6,814,500  |       | 6,965,000      |       |
|                                    |       |                                                      |       |                                                                |       |       |       |           |       |
| John Henry Holdings,                    |       | Manufacturing-packaging                                   |       | Senior Subordinated Term Debt(6)                                    |       | 5,474,630  |       | 5,472,500      |       |
| Inc.                                    |       | products                                                  |       | (10.3%, Due 6/2011)                                                 |       |       |       |           |       |
|                                    |       |                                                      |       |                                                                |       |       |       |           |       |
| Marcal Paper Mills, Inc.           |       | Manufacturing-paper products                              |       | Senior Subordinated Term Debt (6)                                   |       | 6,450,000  |       | 6,111,375      |       |
|                                    |       |                                                      |       | (13.0%, Due 12/2006)                                                |       |       |       |           |       |
|                                    |       |                                                      |       | First Mortgage Loan (5)                                             |       | 9,324,325  |       | 9,129,447      |       |
|                                    |       |                                                      |       | (16%, PIK 1%, Due 12/2006)                                          |       |       |       |           |       |
|                                         |            |                                                           |            |                                                                     |            |            |            |                |            |  |  |

 

3

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| **Company (1)**                          | ** ** | **Industry**                 | ** ** | **Investment (2)**                      | ** ** | **Cost**  | ** **      | **Fair Value** | ** ** |
|------------------------------------------|------------|------------------------------|------------|-----------------------------------------|------------|-----------|-----------------|----------------|------------|
|                                     |       |                         |       |                                    |       |      |            |           |       |
| MedAssets, Inc.                     |       | Pharmaceuticals and          |       | Senior Term Debt (6)                    |       | 1,390,618 |            | 1,384,507      |       |
|                                     |       | healthcare GPO               |       | (9.8%, Due 3/2007)                      |       |      |            |           |       |
|                                     |       |                         |       | Senior Subordinated Term Debt (6)       |       | 6,502,578 |            | 6,500,000      |       |
|                                     |       |                         |       | (15.0%, Due 3/2008)                     |       |      |            |           |       |
|                                     |       |                         |       |                                    |       |      |            |           |       |
| Mistras Holdings Corp.                   |       | Nondestructive testing       |       | Senior Term Debt (3) (6)           |       | 9,666,666 |            | 9,497,499      |       |
|                                     |       | instruments, systems and     |       | (10.5%, Due 8/2008)                     |       |      |            |           |       |
|                                     |       | services                     |       | Senior Term Debt (3) (6)           |       | 4,833,334 |            | 4,742,709      |       |
|                                     |       |                         |       | (12.5%, Due 8/2008)                     |       |      |            |           |       |
|                                     |       |                         |       | Senior Term Debt (3) (6)           |       | 1,000,000 |            | 986,750        |       |
|                                     |       |                         |       | (13.5%, Due 8/2008)                     |       |      |            |           |       |
|                                     |       |                         |       |                                    |       |      |            |           |       |
| Northern Contours                        |       | Manufacturing-veneer and     |       | Senior Subordinated Term Debt (8)       |       | 7,000,000 |            | 7,000,000      |       |
| Northern Contours of Kentucky, Inc. |       | laminate components          |       | (10.1%, Due 5/2010)                     |       |      |            |           |       |
| Norcon Holding LLC                       |       |                         |       |                                    |       |      |            |           |       |
| Norcon Lewis LLC                         |       |                         |       |                                    |       |      |            |           |       |
|                                     |       |                         |       |                                    |       |      |            |           |       |
| Penn Engineering &              |       | Manufacturing-fractional     |       | Senior Subordinated Term Debt (8)       |       | 5,009,881 |            | 5,000,000      |       |
| Manufacturing Corp.                      |       | horsepower engines           |       | (9.5%, Due 5/2012)                      |       |      |            |           |       |
| PN Merger Sub Inc.                       |       |                         |       |                                    |       |      |            |           |       |
| PEM Holding Co.                          |       |                         |       |                                    |       |      |            |           |       |
|                                     |       |                         |       |                                    |       |      |            |           |       |
| Polar Corporation                        |       | Manufacturing-trailer parts  |       | Senior Subordinated Term Debt (6)       |       | 8,615,503 |            | 8,585,000      |       |
|                                     |       |                         |       | (9.5%, Due 6/2010)                      |       |      |            |           |       |
|                                     |       |                         |       |                                    |       |      |            |           |       |
| Regency Gas Services                     |       | Midstream gas gathering and  |       | Senior Subordinated Term Debt (7)       |       | 5,030,613 |            | 5,000,000      |       |
| LLC                                      |       | processing                   |       | (8.8%, Due 12/2010)                     |       |      |            |           |       |
|                                     |       |                         |       |                                    |       |      |            |           |       |
| Santana Plastics                         |       | Manufacturing-polyethylene   |       | Senior Term Debt (3)(6)                 |       | 6,000,000 |            | 6,022,500      |       |
|                                     |       | bathroom partitions          |       | (11.2%, Due 11/2009)                    |       |      |            |           |       |
|                                     |       |                         |       | Senior Term Debt (4)(6)                 |       | 1,950,000 |            | 1,957,313      |       |
|                                     |       |                         |       | (13.0%, Due 11/2009)                    |       |      |            |           |       |
|                                     |       |                         |       |                                    |       |      |            |           |       |
| SCPH Holdings, Inc.                 |       | Manufacturing-underwater and |       | Credit Facility (9)                     |       | —    |            | —         |       |
| Sea Con Phoenix, Inc.               |       | harsh environment components |       | (8.0%, Due 3/2006)                      |       |      |            |           |       |
| Phoenix Optix, Inc.                 |       |                         |       | Senior Term Debt (3)(6)                 |       | 3,325,000 |            | 3,329,156      |       |
|                                     |       |                         |       | (8.5%, Due 2/2010)                      |       |      |            |           |       |
|                                     |       |                         |       | Senior Term Debt (6)                    |       | 3,000,000 |            | 3,003,750      |       |
|                                     |       |                         |       | (12.0%, Due 2/2010)                     |       |      |            |           |       |
|                                     |       |                         |       |                                    |       |      |            |           |       |
| Survey Sampling                          |       | Service-telecommunications   |       | Senior Subordinated Term Debt (6)       |       | 4,514,642 |            | 4,545,000      |       |
|                                     |       |                         |       | (10.7%, Due 5/2012)                     |       |      |            |           |       |
|                                     |       |                         |       |                                    |       |      |            |           |       |
| Tech Lighting LLC                        |       | Manufacturing-low voltage    |       | Senior Subordinated Term Debt (6)       |       | 9,013,066 |            | 8,977,500      |       |
|                                     |       | lighting systems             |       | (10.4%, Due 10/2010)                    |       |      |            |           |       |
|                                     |       |                         |       |                                    |       |      |            |           |       |
| Woven Electronics                        |       | Custom electrical cable      |       | Senior Term Debt (4) (6) (10) |       | 8,344,999 |            | 8,750,566      |       |
| Corporation                              |       | assemblies                   |       | (11.5%, Due 3/2009)                     |       |      |            |           |       |
|                                     |       |                         |       |                                    |       |      |            |           |       |
| Xspedius Communications                  |       | Service-telecommunications   |       | Senior Subordinated Term Debt (6)       |       | 5,986,363 |            | 5,948,948      |       |
| LLC                                      |       |                         |       | (10.0%, Due 3/2010)                     |       |      |            |           |       |
|                                     |       |                         |       |                                    |       |      |            |           |       |
| **Total:**                               | ** ** | ** **                   | ** ** | ** **                              | ** ** | **$**     | **197,749,877** | ** **     | **$**      | **194,708,459** | ** ** |
|                                          |            |                              |            |                                         |            |           |                 |                |            |  |  |

 

4

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(1) We do not “Control,” andare not an “Affiliate” of, any of our portfolio companies, each as defined inthe Investment Company Act of 1940, as amended (the “1940 Act”). In general,under the 1940 Act, we would “Control” a portfolio company if we owned 25% ormore of its voting securities and would be an “Affiliate” of a portfoliocompany if we owned 5% or more of its voting securities.

(2) Percentage representsinterest rates in effect at June 30, 2005 and due date represents the contractualmaturity date.

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

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

(5) Has some paid in kind(PIK) interest.  Refer to Note 7 “Paymentin Kind Interest” hereto and Note 2 “Summary of Significant Accounting Policies”of the Company’s Form 10-K for the fiscal year ended September 30,2004.

(6) Fair value was based onvaluation prepared and provided by Standard & Poor’s Loan EvaluationServices.

(7) Marketable securities arevalued based on the bid price, as of June 30, 2005, from the respectiveoriginating syndication agent’s trading desk.

(8) Investment was valued atcost due to recent acquisition.

(9) Availability under thecredit facility totals $500,000.  Therewere no borrowings outstanding at June 30, 2005.

(10) Includes a success feewith a $322,117 fair value and no cost basis.

 

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

 

5

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**GLADSTONECAPITAL CORPORATION**

**SCHEDULE OFINVESTMENTS**

**ASOF SEPTEMBER 30, 2004**

 
| **Company (1)**                  | ** ** | **Industry**                                               | ** ** | **Investment (2)**                                                   | ** ** | **Cost**   | ** **      | **Fair Value** | ** ** |
|----------------------------------|------------|------------------------------------------------------------|------------|----------------------------------------------------------------------|------------|------------|-----------------|----------------|------------|
|                             |       |                                                       |       |                                                                 |       |       |            |           |       |
| A and G, Inc.               |       | Activewear  products                                       |       | Senior Term Debt  (3) (6)                                       |       | $          | 12,250,000      |           | $          | 12,250,000 |   |
| (d/b/a Alstyle)                  |       |                                                       |       | (11.0%, Due  6/2008)                                                 |       |       |            |           |       |
|                             |       |                                                       |       |                                                                 |       |       |            |           |       |
| Allied Extruders, Inc.      |       | Polyethylene  film manufacturer                            |       | Senior Term Debt  (3)                                                |       | 4,000,000  |            | 4,000,000      |       |
|                             |       |                                                       |       | (12.3%, Due  7/2009)                                                 |       |       |            |           |       |
|                             |       |                                                       |       |                                                                 |       |       |            |           |       |
| America’s Water  Heater     |       | Household  appliances rental                               |       | Senior Term Debt  (4) (6) (8)                              |       | 12,000,000 |            | 12,840,000     |       |
| Rentals                          |       | (12.5%, Due  2/2009)                                       |       |                                                                 |       |       |            |           |       |
|                             |       |                                                       |       |                                                                 |       |       |            |           |       |
| ARI Holdings, Inc.          |       | Manufacturing-auto  parts                                  |       | Senior Term Debt  (6)                                                |       | 1,190,141  |            | 1,188,653      |       |
|                             |       |                                                       |       | (9.75%, Due  6/2008)                                                 |       |       |            |           |       |
|                             |       |                                                       |       | Senior  Subordinated Term Debt (5) (6)                          |       | 3,657,164  |            | 3,634,306      |       |
|                             |       |                                                       |       | (11%, PIK 4%,  Due 12/2008)                                          |       |       |            |           |       |
|                             |       |                                                       |       |                                                                 |       |       |            |           |       |
| Bear Creek  Corporation          |       | Premium  horticultural and food products                   |       | Senior  Subordinated Term Debt (7)  (9.1%, Due 6/2010)               |       | 6,000,000  |            | 6,090,000      |       |
|                             |       |                                                       |       |                                                                 |       |       |            |           |       |
| Benetech, Inc.              |       | Dust management  systems for the coal and electric utility |       | Senior Term Debt  (6)  (8.5%, Due 5/2009)                            |       | 3,168,750  |            | 3,160,828      |       |
|                             |       | industries                                                 |       | Senior Term Debt  (3) (6)                                       |       | 3,250,000  |            | 3,241,875      |       |
|                             |       |                                                       |       | (11.5%, Due  5/2009)                                                 |       |       |            |           |       |
|                             |       |                                                       |       |                                                                 |       |       |            |           |       |
| Burt’s Bees, Inc.      |       | Personal &  household products                    |       | Senior Term Debt  (7)                                                |       | 975,000    |            | 987,188        |       |
|                             |       |                                                       |       | (5.4%, Due  11/2009)                                                 |       |       |            |           |       |
|                             |       |                                                       |       |                                                                 |       |       |            |           |       |
| Coyne  International Enterprises |       | Industrial  services                                       |       | Senior Term Debt  (3) (5) (6)  (13.0%, PIK 2%, Due 7/2007) |       | 15,700,625 |            | 15,308,110     |       |
|                             |       |                                                       |       |                                                                 |       |       |            |           |       |
| Finn Corporation                 |       | Manufacturing-landscape  equipment                         |       | Senior  Subordinated Term Debt (6)  (13.0%, Due 2/2006)              |       | 10,500,000 |            | 7,612,500      |       |
|                             |       |                                                       |       | Common Stock  Warrants                                               |       | 37,000     |            | 474,984        |       |
|                             |       |                                                       |       |                                                                 |       |       |            |           |       |
| Gammill, Inc.               |       | Designer and  assembler of quilting machines and           |       | Senior Term Debt  (6)  (9.5%, Due 12/2008)                           |       | 4,708,013  |            | 4,731,553      |       |
|                             |       | accessories                                                |       | Senior Term Debt  (3) (6)                                       |       | 4,750,000  |            | 4,767,813      |       |
|                             |       |                                                       |       | (12.0%, Due  12/2008)                                                |       |       |            |           |       |
|                             |       |                                                       |       |                                                                 |       |       |            |           |       |
| Inca Metal  Products Corporation |       | Material  handling and storage products                    |       | Senior Term Debt  (3) (6)  (4.6%, Due 9/2006)                   |       | 2,387,548  |            | 2,136,855      |       |
| Kingway  Acquisition, Inc.  |       |                                                       |       |                                                                 |       |       |            |           |       |
| Clymer  Acquisition, Inc.   |       |                                                       |       |                                                                 |       |       |            |           |       |
|                             |       |                                                       |       |                                                                 |       |       |            |           |       |
| Maidenform, Inc.            |       | Intimate apparel                                           |       | Senior  Subordinated Term Debt (7)                                   |       | 10,003,571 |            | 10,175,000     |       |
|                             |       |                                                       |       | (9.4%, Due  5/2011)                                                  |       |       |            |           |       |
|                             |       |                                                       |       |                                                                 |       |       |            |           |       |
| Marcal Paper  Mills, Inc.   |       | Manufacturing-paper  products                              |       | Senior  Subordinated Term Debt (6)                                   |       | 6,800,000  |            | 6,188,000      |       |
|                             |       |                                                       |       | (13.0%, Due  12/2006)                                                |       |       |            |           |       |
|                             |       |                                                       |       | First Mortgage  Loan (5)                                             |       | 9,254,715  |            | 9,254,715      |       |
|                             |       |                                                       |       | (16%, Due  12/2006)                                                  |       |       |            |           |       |
|                             |       |                                                       |       |                                                                 |       |       |            |           |       |
| MedAssets, Inc.             |       | Pharmaceuticals  and healthcare GPO                        |       | Senior Term Debt  (7)  (5.9%, Due 3/2007)                            |       | 1,815,497  |            | 1,806,887      |       |
|                             |       |                                                       |       | Senior  Subordinated Term Debt (7)                                   |       | 6,503,282  |            | 6,500,000      |       |
|                             |       |                                                       |       | (11.2%, Due  3/2008)                                                 |       |       |            |           |       |
|                             |       |                                                       |       |                                                                 |       |       |            |           |       |
| Mistras Holdings  Corp.          |       | Nondestructive  testing                                    |       | Senior Term Debt  (3) (6)                                       |       | 9,833,333  |            | 9,759,583      |       |
|                             |       | instruments,  systems and                                  |       | (10.5%, Due  8/2008)                                                 |       |       |            |           |       |
|                             |       | services                                                   |       | Senior Term Debt  (3) (6)                                       |       | 4,916,667  |            | 4,867,500      |       |
|                             |       |                                                       |       | (12.5%, Due  8/2008)                                                 |       |       |            |           |       |
|                             |       |                                                       |       | Senior Term Debt  (3) (6)                                       |       | 1,000,000  |            | 1,000,000      |       |
|                             |       |                                                       |       | (13.5%, Due  8/2008)                                                 |       |       |            |           |       |
|                             |       |                                                       |       |                                                                 |       |       |            |           |       |
| Woven  Electronics Corporation   |       | Custom  electrical cable assemblies                        |       | Senior Term Debt  (3) (6)  (6.5%, Due 3/2009)                   |       | 2,488,000  |            | 2,484,890      |       |
|                             |       |                                                       |       | Senior Term Debt  (4) (6)                                       |       | 12,000,000 |            | 11,985,000     |       |
|                             |       |                                                       |       | (11.5%, Due  3/2009)                                                 |       |       |            |           |       |
|                             |       |                                                       |       |                                                                 |       |       |            |           |       |
| **Total:**                       | ** ** | ** **                                                 | ** ** | ** **                                                           | ** ** | **$**      | **149,189,306** | ** **     | **$**      | **146,446,240** | ** ** |

 

6

----

 

----

(1) We do not “Control,” andare not an “Affiliate” of, any of our portfolio companies, each as defined inthe Investment Company Act of 1940, as amended (the “1940 Act”). In general,under the 1940 Act, we would “Control” a portfolio company if we owned 25% ormore of its voting securities and would be an “Affiliate” of a portfoliocompany if we owned 5% or more of its voting securities.

(2) Percentage representsinterest rates in effect at September 30, 2004 and due date represents thecontractual maturity date.

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

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

(5) Has some paid in kind(PIK) interest.  Refer to Note 7 “Paymentin Kind Interest” hereto and Note 2 “Summary of Significant Accounting Policies”of the Company’s Form 10-K for the fiscal year ended September 30,2004.

(6) Fair value was based onvaluation prepared and provided by Standard & Poor’s Loan EvaluationServices.

(7) Marketable securities arevalued based on the bid price, as of September 30, 2004, from therespective originating syndication agent’s trading desk.

(8) Includes a success feewith a fair value of $660,000 and no cost basis.

 

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

 

7

----

 

**GLADSTONECAPITAL CORPORATION**

**CONSOLIDATED STATEMENT OF OPERATIONS**

**(UNAUDITED)**

 
| ** **                                                                              | ** ** | **Three Months Ended**  | ** ** |
|-----------------------------------------------------------------------------------------|------------|-------------------------|------------|
| ** **                                                                              | ** ** | **June 30,  2005** | ** ** | **June 30,  2004** | ** ** |
| INVESTMENT INCOME                                                                       |       |                    |       |   |   |
| Interest income –  investments                                                     |       | $                       | 5,766,233  |   | $ | 5,700,139 |   |
| Interest income – cash  and cash equivalents                                       |       | 7,631                   |       | 15,268 |   |
| Interest income – notes  receivable from employees                                 |       | 108,065                 |       | 112,528 |   |
| Fee income (Refer to  Note 12)                                                          |       | —                  |       | 399,375 |   |
| Other income                                                                            |       | 245,297                 |       | 482,500 |   |
| Total investment income                                                                 |       | 6,127,226               |       | 6,709,810 |   |
|                                                                                    |       |                    |       |   |   |
| EXPENSES                                                                                |       |                    |       |   |   |
| Loan servicing (Refer  to Note 10)                                                      |       | 687,971                 |       | — |   |
| Management fee (Refer  to Notes 10 and 13)                                              |       | 358,631                 |       | — |   |
| Professional fees                                                                       |       | 133,505                 |       | 36,746 |   |
| Amortization of  deferred financing costs                                               |       | 100,663                 |       | 99,365 |   |
| Interest                                                                                |       | 563,336                 |       | 211,085 |   |
| Stockholder related  costs                                                              |       | 16,475                  |       | 10,643 |   |
| Directors fees                                                                          |       | 26,624                  |       | 28,000 |   |
| Insurance                                                                               |       | 43,891                  |       | 63,369 |   |
| Salaries and benefits                                                                   |       | —                  |       | 1,253,073 |   |
| Rent                                                                                    |       | —                  |       | 34,873 |   |
| General and  administrative                                                             |       | 64,304                  |       | 247,092 |   |
| Expenses before credit  from Gladstone Management                                       |       | 1,995,400               |       | 1,984,246 |   |
| Credit to management  fee for fees collected by Gladstone Management (Refer to Note 13) |       | (240,600                | )          | — |   |
| Total expenses net of  credit to management fee                                         |       | 1,754,800               |       | 1,984,246 |   |
|                                                                                    |       |                    |       |   |   |
| NET INVESTMENT INCOME  BEFORE INCOME TAXES                                              |       | 4,372,426               |       | 4,725,564 |   |
| Income tax expense                                                                      |       | —                  |       | — |   |
| NET INVESTMENT INCOME                                                                   |       | 4,372,426               |       | 4,725,564 |   |
|                                                                                    |       |                    |       |   |   |
| UNREALIZED GAIN (LOSS)  ON INVESTMENTS:                                                 |       |                    |       |   |   |
| Unrealized depreciation  on derivative                                                  |       | (49,044                 | )          | (129,576 | ) |
| Net unrealized  (depreciation)/appreciation on investments                              |       | (389,229                | )          | 1,013,905 |   |
| Net unrealized (loss)  gain on investments                                              |       | (438,273                | )          | 884,329 |   |
|                                                                                    |       |                    |       |   |   |
| NET INCREASE IN  STOCKHOLDERS’ EQUITY RESULTING FROM OPERATIONS                    |       | $                       | 3,934,153  |   | $ | 5,609,893 |   |
|                                                                                    |       |                    |       |   |   |
| NET INCREASE IN  STOCKHOLDERS’ EQUITY RESULTING FROM OPERATIONS PER COMMON SHARE:  |       |                    |       |   |   |
| Basic                                                                                   |       | $                       | 0.35       |   | $ | 0.56 |   |
| Diluted                                                                                 |       | $                       | 0.34       |   | $ | 0.54 |   |
|                                                                                    |       |                    |       |   |   |
| WEIGHTED AVERAGE SHARES  OF COMMON STOCK OUTSTANDING:                                   |       |                    |       |   |   |
| Basic                                                                                   |       | 11,299,010              |       | 10,105,270 |   |
| Diluted                                                                                 |       | 11,578,637              |       | 10,301,390 |   |

 

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

 

8

----

 

**GLADSTONECAPITAL CORPORATION**

**CONSOLIDATED STATEMENT OF OPERATIONS**

**(UNAUDITED)**

 
| ** **                                                                              | ** ** | **Nine Months Ended**   | ** ** |
|-----------------------------------------------------------------------------------------|------------|-------------------------|------------|
| ** **                                                                              | ** ** | **June 30,  2005** | ** ** | **June 30,  2004** | ** ** |
| INVESTMENT INCOME                                                                       |       |                    |       |   |   |
| Interest income –  investments                                                     |       | $                       | 16,671,756 |   | $ | 13,118,652 |   |
| Interest income – cash  and cash equivalents                                       |       | 29,101                  |       | 81,223 |   |
| Interest income – notes  receivable from employees                                 |       | 336,382                 |       | 330,698 |   |
| Fee income (Refer to  Note 12)                                                          |       | —                  |       | 1,010,606 |   |
| Other income                                                                            |       | 1,054,917               |       | 504,500 |   |
| Total investment income                                                                 |       | 18,092,156              |       | 15,045,679 |   |
|                                                                                    |       |                    |       |   |   |
| EXPENSES                                                                                |       |                    |       |   |   |
| Loan servicing (Refer  to Note 10)                                                      |       | 1,804,465               |       | — |   |
| Management fee (Refer  to Notes 10 and 13)                                              |       | 1,075,940               |       | — |   |
| Professional fees                                                                       |       | 528,610                 |       | 460,592 |   |
| Amortization of  deferred financing costs                                               |       | 284,487                 |       | 252,797 |   |
| Interest                                                                                |       | 1,174,587               |       | 391,237 |   |
| Stockholder related  costs                                                              |       | 192,785                 |       | 130,623 |   |
| Directors fees                                                                          |       | 77,624                  |       | 85,210 |   |
| Insurance                                                                               |       | 134,053                 |       | 200,654 |   |
| Salaries and benefits                                                                   |       | —                  |       | 2,063,549 |   |
| Rent                                                                                    |       | —                  |       | 106,597 |   |
| General and  administrative                                                             |       | 176,939                 |       | 563,595 |   |
| Expenses before credit  from Gladstone Management                                       |       | 5,449,490               |       | 4,254,854 |   |
| Credit to management  fee for fees collected by Gladstone Management (Refer to Note 13) |       | (977,100                | )          | — |   |
| Total expenses net of  credit to management fee                                         |       | 4,472,390               |       | 4,254,854 |   |
|                                                                                    |       |                    |       |   |   |
| NET INVESTMENT INCOME  BEFORE INCOME TAXES                                              |       | 13,619,766              |       | 10,790,825 |   |
| Income tax expense                                                                      |       | 138,678                 |       | — |   |
| NET INVESTMENT INCOME                                                                   |       | 13,481,088              |       | 10,790,825 |   |
|                                                                                    |       |                    |       |   |   |
| REALIZED AND UNREALIZED  GAIN (LOSS) ON                                                 |       |                    |       |   |   |
| INVESTMENTS:                                                                            |       |                    |       |   |   |
| Realized gain on sale  of investment                                                    |       | 29,750                  |       | 12,500 |   |
| Unrealized depreciation  on derivative                                                  |       | (58,007                 | )          | (134,643 | ) |
| Net unrealized  depreciation on investments                                             |       | (298,352                | )          | (849,132 | ) |
| Net realized and  unrealized gain (loss) on investments                                 |       | (326,609                | )          | (971,275 | ) |
|                                                                                    |       |                    |       |   |   |
| NET INCREASE IN  STOCKHOLDERS’ EQUITY RESULTING FROM OPERATIONS                    |       | $                       | 13,154,479 |   | $ | 9,819,550 |   |
|                                                                                    |       |                    |       |   |   |
| NET INCREASE IN  STOCKHOLDERS’ EQUITY RESULTING FROM OPERATIONS PER COMMON SHARE:  |       |                    |       |   |   |
| Basic                                                                                   |       | $                       | 1.17       |   | $ | 0.97 |   |
| Diluted                                                                                 |       | $                       | 1.13       |   | $ | 0.95 |   |
|                                                                                    |       |                    |       |   |   |
| WEIGHTED AVERAGE SHARES  OF COMMON STOCK OUTSTANDING:                                   |       |                    |       |   |   |
| Basic                                                                                   |       | 11,288,784              |       | 10,091,576 |   |
| Diluted                                                                                 |       | 11,602,986              |       | 10,336,733 |   |

 

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

 

9

----

 

**GLADSTONECAPITAL CORPORATION**

**CONSOLIDATED STATEMENT OF STOCKHOLDERS’ EQUITY**

 

**(UNAUDITED)**

 
| ** **                                                           | ** ** | **Common Stock** | ** ** | **Capital in  Excess of** | ** ** | **Notes  Receivable  From Sale of** | ** ** | **Distributions  Less Than/(in  Excess of) Net  Investment** | ** ** | **Realized  Gain on  Sale of** | ** ** | **Unrealized  Appreciation/  (Depreciation)** | ** ** | **Unrealized  Appreciation/  (Depreciation)** | ** ** | **Total  Stockholders’** | ** ** |
|----------------------------------------------------------------------|------------|------------------|------------|---------------------------|------------|-------------------------------------|------------|--------------------------------------------------------------|------------|--------------------------------|------------|-----------------------------------------------|------------|-----------------------------------------------|------------|-------------------------------|------------|
| ** **                                                           | ** ** | **Shares**       | ** ** | **Amount**                | ** ** | **Par Value**                       | ** ** | **Common Stock**                                             | ** ** | **Income**                     | ** ** | **Investment**                                | ** ** | **of Investments**                            | ** ** | **of Derivatives**            | ** ** | **Equity** | ** ** |
|                                                                 |       |             |       |                      |       |                                |       |                                                         |       |                           |       |                                          |       |                                          |       |                          |       |   |   |
| Balance at September 30,  2003                                  |       | 10,081,844       |       | $                         | 10,082     |                                | $          | 140,416,674                                                  |       | $                              | (8,985,940 | )                                             | $          | (416,094                                      | )          | $                             | —     |   | $ | (222,340 | ) | $ | — |   | $ | 130,802,382 |   |
|                                                                 |       |             |       |                      |       |                                |       |                                                         |       |                           |       |                                          |       |                                          |       |                          |       |   |   |
| Issuance of Common Stock  under Stock option Plan                    |       | 31,600           |       | 32                        |       | 479,837                             |       | (350,010                                                     | )          | —                         |       | —                                        |       | —                                        |       | —                        |       | 129,859 |   |
|                                                                 |       |             |       |                      |       |                                |       |                                                         |       |                           |       |                                          |       |                                          |       |                          |       |   |   |
| Repayment of Principal  on Notes Receivable                          |       | —           |       | —                    |       | —                              |       | 103,252                                                      |       | —                         |       | —                                        |       | —                                        |       | —                        |       | 103,252 |   |
|                                                                 |       |             |       |                      |       |                                |       |                                                         |       |                           |       |                                          |       |                                          |       |                          |       |   |   |
| Shelf Offering Costs                                                 |       | —           |       | —                    |       | (43,598                             | )          | —                                                       |       | —                         |       | —                                        |       | —                                        |       | —                        |       | (43,598 | ) |
|                                                                 |       |             |       |                      |       |                                |       |                                                         |       |                           |       |                                          |       |                                          |       |                          |       |   |   |
| Net Increase in  Stockholders’ Equity Resulting from Operations |       | —           |       | —                    |       | —                              |       | —                                                       |       | 10,790,825                     |       | 12,500                                        |       | (849,132                                      | )          | (134,643                      | )          | 9,819,550 |   |
|                                                                 |       |             |       |                      |       |                                |       |                                                         |       |                           |       |                                          |       |                                          |       |                          |       |   |   |
| Distributions Declared  ($1.005 per common share)                    |       | —           |       | —                    |       | —                              |       | —                                                       |       | (10,142,870                    | )          | —                                        |       | —                                        |       | —                        |       | (10,142,870 | ) |
|                                                                 |       |             |       |                      |       |                                |       |                                                         |       |                           |       |                                          |       |                                          |       |                          |       |   |   |
| Balance at June 30,  2004                                       |       | 10,113,444       |       | $                         | 10,114     |                                | $          | 140,852,913                                                  |       | $                              | (9,232,698 | )                                             | $          | 231,861                                       |       | $                             | 12,500     |   | $ | (1,071,472 | ) | $ | (134,643 | ) | $ | 130,668,575 |   |
|                                                                 |       |             |       |                      |       |                                |       |                                                         |       |                           |       |                                          |       |                                          |       |                          |       |   |   |
| Balance at September 30,  2004                                  |       | 11,278,510       |       | $                         | 11,279     |                                | $          | 164,294,781                                                  |       | $                              | (9,432,678 | )                                             | $          | 298,098                                       |       | $                             | 12,500     |   | $ | (2,743,066 | ) | $ | (214,259 | ) | $ | 152,226,655 |   |
|                                                                 |       |             |       |                      |       |                                |       |                                                         |       |                           |       |                                          |       |                                          |       |                          |       |   |   |
| Issuance of Common Stock  under Stock Option Plan                    |       | 25,000           |       | 25                        |       | 427,325                             |       | (157,100                                                     | )          | —                         |       | —                                        |       | —                                        |       | —                        |       | 270,250 |   |
|                                                                 |       |             |       |                      |       |                                |       |                                                         |       |                           |       |                                          |       |                                          |       |                          |       |   |   |
| Repayment of Principal  on Notes Receivable                          |       | —           |       | —                    |       | —                              |       | 797,429                                                      |       | —                         |       | —                                        |       | —                                        |       | —                        |       | 797,429 |   |
|                                                                 |       |             |       |                      |       |                                |       |                                                         |       |                           |       |                                          |       |                                          |       |                          |       |   |   |
| Shelf Offering Costs                                                 |       | —           |       | —                    |       | (111,233                            | )          | —                                                       |       | —                         |       | —                                        |       | —                                        |       | —                        |       | (111,233 | ) |
|                                                                 |       |             |       |                      |       |                                |       |                                                         |       |                           |       |                                          |       |                                          |       |                          |       |   |   |
| Net Increase in  Stockholders’ Equity Resulting from Operations |       | —           |       | —                    |       | —                              |       | —                                                       |       | 13,481,088                     |       | 29,750                                        |       | (298,352                                      | )          | (58,007                       | )          | 13,154,479 |   |
|                                                                 |       |             |       |                      |       |                                |       |                                                         |       |                           |       |                                          |       |                                          |       |                          |       |   |   |
| Distributions Declared  ($1.11 per common share)                     |       | —           |       | —                    |       | —                              |       | —                                                       |       | (12,531,746                    | )          | —                                        |       | —                                        |       | —                        |       | (12,531,746 | ) |
|                                                                 |       |             |       |                      |       |                                |       |                                                         |       |                           |       |                                          |       |                                          |       |                          |       |   |   |
| Balance at June 30,  2005                                       |       | 11,303,510       |       | $                         | 11,304     |                                | $          | 164,610,873                                                  |       | $                              | (8,792,349 | )                                             | $          | 1,247,440                                     |       | $                             | 42,250     |   | $ | (3,041,418 | ) | $ | (272,266 | ) | $ | 153,805,834 |   |

 

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

 

10

----

 

**GLADSTONECAPITAL CORPORATION**

**CONSOLIDATED STATEMENT OF CASH FLOWS**

**(UNAUDITED)**

 
| ** **                                                                                                                                   | ** ** | **Nine Months Ended**   | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------|------------|
| ** **                                                                                                                                   | ** ** | **June 30,  2005** | ** ** | **June 30,  2004** | ** ** |
| **CASH  FLOWS FROM OPERATING ACTIVITIES**                                                                                                    |       |                    |       |   |   |
| Net increase in  stockholders’ equity resulting from operations                                                                         |       | $                       | 13,154,479 |   | $ | 9,819,550 |   |
| Adjustments to  reconcile net increase in stockholders’ equity resulting from operations to  net cash provided by operating activities: |       |                    |       |   |   |
| Depreciation                                                                                                                                 |       | —                  |       | 24,356 |   |
| Net amortization of  premiums and discounts                                                                                                  |       | (6,949                  | )          | 835 |   |
| Amortization of  deferred financing costs                                                                                                    |       | 284,487                 |       | 252,797 |   |
| Unrealized depreciation  on derivative                                                                                                       |       | 58,007                  |       | 134,643 |   |
| Change in net  unrealized depreciation                                                                                                       |       | 298,352                 |       | 849,132 |   |
| (Increase) decrease in  interest receivable                                                                                                  |       | (340,303                | )          | 338,894 |   |
| (Increase) decrease in  funds due from custodian                                                                                             |       | (11,027,346             | )          | 579,328 |   |
| Decrease (increase) in  prepaid assets                                                                                                       |       | 120,054                 |       | (295,627 | ) |
| Decrease (increase) in  due from affiliate                                                                                                   |       | 109,639                 |       | (61,079 | ) |
| Increase in other  assets                                                                                                                    |       | (11,973                 | )          | (274,306 | ) |
| Increase in accounts  payable                                                                                                                |       | 100,478                 |       | 122,885 |   |
| (Decrease) increase in  accrued expenses and deferred liabilities                                                                            |       | (599,277                | )          | 324,804 |   |
| Increase in fees due to  affiliate                                                                                                           |       | 205,900                 |       | — |   |
| Increase in funds held  in escrow                                                                                                            |       | 200,000                 |       | — |   |
| Increase in investment  balance due to payment in kind interest                                                                              |       | (348,509                | )          | (412,659 | ) |
| Net cash provided by  operating activities                                                                                                   |       | 2,197,039               |       | 11,403,553 |   |
|                                                                                                                                         |       |                    |       |   |   |
| **CASH  FLOWS FROM INVESTING ACTIVITIES:**                                                                                                   |       |                    |       |   |   |
| Purchase of investments                                                                                                                      |       | (126,195,458            | )          | (82,267,500 | ) |
| Principal repayments on  investments                                                                                                         |       | 77,990,345              |       | 33,890,716 |   |
| Proceeds from  repurchase agreements                                                                                                         |       | —                  |       | 240,114,596 |   |
| Repayment of repurchase  agreements                                                                                                          |       | (21,345,997             | )          | (264,655,000 | ) |
| Receipt of principal on  notes receivable - employees                                                                                        |       | 797,429                 |       | 103,252 |   |
| Disposal of furniture &  equipment, net                                                                                             |       | —                  |       | 9,498 |   |
| Net cash used in  investing activities                                                                                                       |       | (68,753,681             | )          | (72,804,438 | ) |
|                                                                                                                                         |       |                    |       |   |   |
| **CASH  FLOWS FROM FINANCING ACTIVITIES:**                                                                                                   |       |                    |       |   |   |
| Borrowings from the  lines of credit                                                                                                         |       | 136,800,000             |       | 61,750,000 |   |
| Repayments on the lines  of credit                                                                                                           |       | (122,953,547            | )          | (28,229,334 | ) |
| Distributions paid                                                                                                                           |       | (12,531,746             | )          | (13,469,879 | ) |
| Shelf offering costs                                                                                                                         |       | (111,233                | )          | (43,598 | ) |
| Deferred financing  costs                                                                                                                    |       | (105,000                | )          | — |   |
| Exercise of stock  options                                                                                                                   |       | 270,250                 |       | 129,851 |   |
| Net cash provided by  financing activities                                                                                                   |       | 1,368,724               |       | 20,137,040 |   |
|                                                                                                                                         |       |                    |       |   |   |
| **NET  DECREASE IN CASH AND CASH EQUIVALENTS (1)**                                                                                           |       | (65,187,918             | )          | (41,263,845 | ) |
| **CASH  AND CASH EQUIVALENTS, BEGINNING OF PERIOD**                                                                                          |       | 65,954,840              |       | 101,166,221 |   |
| **CASH  AND CASH EQUIVALENTS, END OF PERIOD**                                                                                                |       | $                       | 766,922    |   | $ | 59,902,376 |   |
|                                                                                                                                         |       |                    |       |   |   |
| **CASH  PAID DURING PERIOD FOR INTEREST**                                                                                                    |       | $                       | 1,073,417  |   | $ | 129,910 |   |
| **CASH  PAID DURING PERIOD FOR INCOME TAXES**                                                                                                |       | $                       | 138,678    |   | $ | — |   |
| **NON-CASH  FINANCING ACTIVITIES**                                                                                                           |       |                    |       |   |   |
| Notes receivable issued  in exchange for common stock associated with the exercise of employee stock  options                                |       | $                       | 157,100    |   | $ | 350,010 |   |

 

----

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

 

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

 

11

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**GLADSTONECAPITAL CORPORATION**

**FINANCIALHIGHLIGHTS**

**(UNAUDITED)**

 
| ** **                                                       | ** ** | **Three Months Ended**  | ** **        |
|------------------------------------------------------------------|------------|-------------------------|-------------------|
| ** **                                                       | ** ** | **June 30,  2005** | ** **        | **June 30,  2004** | ** ** |
|                                                             |       |                    |              |   |   |
| Per Share Data (1)                                               |       |                    |              |   |   |
| Net asset value at  beginning of period                          |       | $                       | 13.64             |   | $ | 12.71 |   |
| *Income  from investment operations:*                            |       |                    |              |   |   |
| Net investment income  (2)                                       |       | 0.39                    |              | 0.47 |   |
| Realized gain on sale  of investment (2)                         |       | —                  |              | — |   |
| Net unrealized  gain/(loss) on investments (2)                   |       | (0.03                   | )                 | 0.10 |   |
| Net unrealized (loss)  on derivatives (2)                        |       | —                  |              | (0.01 | ) |
| Total from investment  operations                                |       | 0.36                    |              | 0.56 |   |
| Less distributions:                                              |       |                    |              |   |   |
| Distributions from net  investment income                        |       | (0.39                   | )                 | (0.34 | ) |
| Total distributions                                              |       | (0.39                   | )                 | (0.34 | ) |
| Issuance of common stock  under stock option plan                |       | —                  |              | 0.01 |   |
| Repayment of principal  on notes receivable                      |       | —                  |              | 0.01 |   |
| Dilutive effect of  share issuance                               |       | —                  |              | (0.03 | ) |
| Net asset value at end  of period                                |       | $                       |  13.61       |   | $ |  12.92 |   |
|                                                             |       |                    |              |   |   |
| Per share market value  at beginning of period                   |       | $                       |  21.22       |   | $ |  22.41 |   |
| Per share market value  at end of period                         |       | 23.40                   |              | 20.15 |   |
| Total Return (3)(4)                                              |       | 12.19                   | %                 | -5.73 | % |
| Shares outstanding at  end of period                             |       | 11,303,510              |              | 10,113,444 |   |
|                                                             |       |                    |              |   |   |
| Ratios/Supplemental  Data                                        |       |                    |              |   |   |
| Net assets at end of  period                                     |       | $                       | 153,805,834       |   | $ | 130,668,575 |   |
| Average net assets                                               |       | $                       |  152,484,868 |   | $ |  128,285,309 |   |
| Ratio of expenses to  average net assets-annualized (5)          |       | 5.23                    | %                 | 6.59 | % |
| Ratio of net expenses  to average net assets-annualized (6)      |       | 4.60                    | %                 | 6.59 | % |
| Ratio of net investment  income to average net assets-annualized |       | 11.47                   | %                 | 14.33 | % |

 

----

(1)          Basic per share data.

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

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

(4)          Amounts were not annualized.

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

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

 

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

 

12

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| ** **                                                       | ** ** | **Nine Months Ended**   | ** **  |
|------------------------------------------------------------------|------------|-------------------------|-------------|
| ** **                                                       | ** ** | **June 30,  2005** | ** **  | **June 30,  2004** | ** ** |
|                                                             |       |                    |        |   |   |
| Per Share Data (1)                                               |       |                    |        |   |   |
| Net asset value at  beginning of period                          |       | $                       | 13.50       |   | $ | 12.97 |   |
| *Income  from investment operations:*                            |       |                    |        |   |   |
| Net investment income  (2)                                       |       | 1.19                    |        | 1.07 |   |
| Realized gain on sale  of investment (2)                         |       | —                  |        | — |   |
| Net unrealized  gain/(loss) on investments (2)                   |       | (0.03                   | )           | (0.08 | ) |
| Net unrealized (loss)  on derivatives (2)                        |       | (0.01                   | )           | (0.01 | ) |
| Total from investment  operations                                |       | 1.15                    |        | 0.98 |   |
| Less distributions:                                              |       |                    |        |   |   |
| Distributions from net  investment income                        |       | (1.11                   | )           | (1.01 | ) |
| Total distributions                                              |       | (1.11                   | )           | (1.01 | ) |
| Offering costs                                                   |       | (0.01                   | )           | — |   |
| Issuance of common  stock under stock option plan                |       | 0.02                    |        | 0.01 |   |
| Repayment of principal  on notes receivable                      |       | 0.07                    |        | 0.01 |   |
| Dilutive effect of  share issuance                               |       | (0.01                   | )           | (0.04 | ) |
| Net asset value at end  of period                                |       | $                       | 13.61       |   | $ | 12.92 |   |
|                                                             |       |                    |        |   |   |
| Per share market value  at beginning of period                   |       | $                       | 22.71       |   | $ | 19.45 |   |
| Per share market value  at end of period                         |       | 23.40                   |        | 20.15 |   |
| Total Return (3)(4)                                              |       | 8.08                    | %           | 8.61 | % |
| Shares outstanding at  end of period                             |       | 11,303,510              |        | 10,113,444 |   |
|                                                             |       |                    |        |   |   |
| Ratios/Supplemental  Data                                        |       |                    |        |   |   |
| Net assets at end of  period                                     |       | $                       | 153,805,834 |   | $ | 130,668,575 |   |
| Average net assets                                               |       | $                       | 152,067,700 |   | $ | 128,269,663 |   |
| Ratio of expenses to  average net assets-annualized (5)          |       | 4.90                    | %           | 4.56 | % |
| Ratio of net expenses  to average net assets-annualized (6)      |       | 4.04                    | %           | 4.56 | % |
| Ratio of net investment  income to average net assets-annualized |       | 11.82                   | %           | 11.08 | % |
|                                                             |       |                    |        |   |   |

 

----

(1)          Basic per share data.

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

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

(4)          Amounts were not annualized.

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

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

 

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

 

13

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**GLADSTONECAPITAL CORPORATION**

 

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

 

**June 30,2005**

 

**(UNAUDITED)**

 

NOTE1. ORGANIZATION

 

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

 

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

 

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

 

 

NOTE2. UNAUDITED INTERIM FINANCIAL STATEMENTS

 

Interimfinancial statements of the Company are prepared in accordance with accountingprinciples generally accepted in the United States of America (“GAAP”) forinterim financial information and pursuant to the requirements for reporting onForm 10-Q and Article 10 of Regulation S-X.  Accordingly, certain disclosures accompanyingannual financial statements prepared in accordance with GAAP are omitted.  In the opinion of management, alladjustments, consisting solely of normal recurring accruals, necessary for thefair statement of financial statements for the interim periods have beenincluded.  The current period’s resultsof operations are not necessarily indicative of results that ultimately may beachieved for the year.  The interimfinancial statements and notes thereto should be read in conjunction with thefinancial statements and notes thereto included in the Company’s Form 10-Kfor the fiscal year ended September 30, 2004, as filed with the Securitiesand Exchange Commission.

 

NOTE3. STOCK OPTIONS

 

Thefollowing tables set forth the pro-forma effect of fair value option accountingfor the three and nine months ended June 30, 2005 and June 30, 2004in accordance with Statement of Financial Accounting Standards (SFAS) StatementNo. 148 “Accounting for Stock-Based Compensation – Transition andDisclosure”.

 

14

----

 
| ** **                                                                                                   | ** ** | **Three Months Ended**  | ** ** |
|--------------------------------------------------------------------------------------------------------------|------------|-------------------------|------------|
| ** **                                                                                                   | ** ** | **June 30,  2005** | ** ** | **June 30,  2004** | ** ** |
|                                                                                                         |       |                    |       |   |   |
| Net increase in  stockholders’ equity resulting from operations as reported:                            |       | $                       | 3,934,153  |   | $ | 5,609,893 |   |
|                                                                                                         |       |                    |       |   |   |
| Deduct: Total  stock-based compensation expense determined using the fair value based method  for all awards |       | (74,042                 | )          | (436,209 | ) |
| Pro forma net increase  in stockholders’ equity resulting from operations                               |       | $                       | 3,860,111  |   | $ | 5,173,684 |   |
|                                                                                                         |       |                    |       |   |   |
| Per share:                                                                                                   |       |                    |       |   |   |
| As reported - basic                                                                                          |       | $                       | 0.35       |   | $ | 0.56 |   |
| As reported - diluted                                                                                        |       | $                       | 0.34       |   | $ | 0.54 |   |
|                                                                                                         |       |                    |       |   |   |
| Pro forma-basic                                                                                              |       | $                       | 0.34       |   | $ | 0.51 |   |
| Pro forma-diluted                                                                                            |       | $                       | 0.33       |   | $ | 0.50 |   |
|                                                                                                         |       |                    |       |   |   |
| ** **                                                                                                   | ** ** | **Nine Months Ended**   | ** ** |
| ** **                                                                                                   | ** ** | **June 30,  2005** | ** ** | **June 30,  2004** | ** ** |
|                                                                                                         |       |                    |       |   |   |
| Net increase in  stockholders’ equity resulting from operations as reported:                            |       | $                       | 13,154,479 |   | $ | 9,819,550 |   |
|                                                                                                         |       |                    |       |   |   |
| Deduct: Total  stock-based compensation expense determined using the fair value based method  for all awards |       | (222,618                | )          | (1,250,990 | ) |
| Pro forma net increase  in stockholders’ equity resulting from operations                               |       | $                       | 12,931,861 |   | $ | 8,568,560 |   |
|                                                                                                         |       |                    |       |   |   |
| Per share:                                                                                                   |       |                    |       |   |   |
| As reported - basic                                                                                          |       | $                       | 1.17       |   | $ | 0.97 |   |
| As reported - diluted                                                                                        |       | $                       | 1.13       |   | $ | 0.95 |   |
|                                                                                                         |       |                    |       |   |   |
| Pro forma-basic                                                                                              |       | $                       | 1.15       |   | $ | 0.85 |   |
| Pro forma-diluted                                                                                            |       | $                       | 1.11       |   | $ | 0.83 |   |

 

In December 2004,the Financial Accounting Standards Board (“FASB”) approved the revision of SFAS123, “Accounting for Stock-Based Compensation, and issued the revised SFASStatement No. 123(R), “Share-Based Payment.”  SFAS 123(R) effectively replaces SFAS 123,and supersedes APB Opinion No. 25, “Accounting for Stock Issued toEmployees.”  The new standard iseffective for awards that are granted, modified, or settled in cash for annualperiods beginning after June 15, 2005. The adoption of SFAS 123(R) will require the Company to begin expensingunvested or newly granted stock options as compensation cost at the start ofthe Company’s 2006 fiscal year.

 

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

 

15

----

 

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

 

Thefollowing table sets forth the computation of basic and diluted net increase instockholders’ equity per share resulting from operations for the three and ninemonths ended June 30, 2005 and June 30, 2004:

 
| ** **                                                                                           | ** ** | **Three Months Ended**  | ** ** |
|------------------------------------------------------------------------------------------------------|------------|-------------------------|------------|
| ** **                                                                                           | ** ** | **June 30,  2005** | ** ** | **June 30,  2004** | ** ** |
|                                                                                                 |       |                    |       |   |   |
| Numerator for basic and  diluted net increase in stockholders’ equity resulting from operations |       | $                       |       | 3,934,153 |   | $ |   | 5,609,893 |   |
|                                                                                                 |       |                    |       |   |   |
| Denominator for basic  weighted average shares                                                       |       | 11,299,010              |       | 10,105,270 |   |
| Dilutive effect of  stock options                                                                    |       | 279,627                 |       | 196,120 |   |
| Denominator for diluted  weighted average shares                                                     |       | 11,578,637              |       | 10,301,390 |   |
|                                                                                                 |       |                    |       |   |   |
| Basic net increase in  stockholers’ equity per share resulting from operations                  |       | $                       |       | 0.35 |   | $ |   | 0.56 |   |
|                                                                                                 |       |                    |       |   |   |
| Diluted net increase in  stockholers’ equity per share resulting from operations                |       | $                       |       | 0.34 |   | $ |   | 0.54 |   |
|                                                                                                 |       |                    |       |   |   |
| ** **                                                                                           | ** ** | **Nine Months Ended**   | ** ** |
| ** **                                                                                           | ** ** | **June 30,  2005** | ** ** | **June 30,  2004** | ** ** |
|                                                                                                 |       |                    |       |   |   |
| Numerator for basic and  diluted net increase in stockholders’ equity resulting from operations |       | $                       |       | 13,154,479 |   | $ |   | 9,819,550 |   |
|                                                                                                 |       |                    |       |   |   |
| Denominator for basic  weighted average shares                                                       |       | 11,288,784              |       | 10,091,576 |   |
| Dilutive effect of  stock options                                                                    |       | 314,202                 |       | 245,157 |   |
| Denominator for diluted  weighted average shares                                                     |       | 11,602,986              |       | 10,336,733 |   |
|                                                                                                 |       |                    |       |   |   |
| Basic net increase in  stockholers’ equity per share resulting from operations                  |       | $                       |       | 1.17 |   | $ |   | 0.97 |   |
|                                                                                                 |       |                    |       |   |   |
| Diluted net increase in  stockholers’ equity per share resulting from operations                |       | $                       |       | 1.13 |   | $ |   | 0.95 |   |

 

NOTE5. DIVIDENDS

 

TheCompany is required to pay out as a dividend 90% of its ordinary income andshort-term capital gains for each taxable year in order to maintain its statusas a RIC under Subtitle 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 quarterly dividends, to ensure that it has paidout at least 90% of its ordinary income and short-term capital gains for theyear.  The Company has a policy ofretaining long-term capital gains, if any, and not paying them out asdividends.  Effective October 31,2003, the Company began paying a monthly dividend.  The following table lists the per sharedividends paid since December 2001:

 

16

----

 
| **Fiscal Year** | ** ** | **Record Date**    | ** ** | **Payment Date**   | ** ** | **Dividend per Share** | ** ** | **Monthly or Quarterly** |
|-----------------|------------|--------------------|------------|--------------------|------------|------------------------|------------|--------------------------|
| 2005            |       | Sep. 22, 2005 |       | Sep. 30, 2005 |       | $                      | 0.135      |                     | Monthly |
|            |       | Aug. 23, 2005 |       | Aug. 31, 2005 |       | $                      | 0.135      |                     | Monthly |
|            |       | Jul. 21, 2005 |       | Jul. 29, 2005 |       | $                      | 0.135      |                     | Monthly |
|            |       | Jun. 16, 2005 |       | Jun. 30, 2005 |       | $                      | 0.13       |                     | Monthly |
|            |       | May 13, 2005  |       | May 27, 2005  |       | $                      | 0.13       |                     | Monthly |
|            |       | Apr. 15, 2005 |       | Apr. 29, 2005 |       | $                      | 0.13       |                     | Monthly |
|            |       | Mar. 18, 2005 |       | Mar. 31, 2005 |       | $                      | 0.12       |                     | Monthly |
|            |       | Feb. 11, 2005 |       | Feb. 28, 2005 |       | $                      | 0.12       |                     | Monthly |
|            |       | Jan. 14, 2005 |       | Jan. 28, 2005 |       | $                      | 0.12       |                     | Monthly |
|            |       | Dec. 17, 2004 |       | Dec. 30, 2004 |       | $                      | 0.12       |                     | Monthly |
|            |       | Nov. 17, 2004 |       | Nov. 30, 2004 |       | $                      | 0.12       |                     | Monthly |
|            |       | Oct. 18, 2004 |       | Oct. 29, 2004 |       | $                      | 0.12       |                     | Monthly |
|            |       |               |       |               |       |                   |       |                     |
| 2004            |       | Sep. 17, 2004 |       | Sep. 30, 2004 |       | $                      | 0.12       |                     | Monthly |
|            |       | Aug. 18, 2004 |       | Aug. 31, 2004 |       | $                      | 0.12       |                     | Monthly |
|            |       | Jul. 19, 2004 |       | Jul. 30, 2004 |       | $                      | 0.12       |                     | Monthly |
|            |       | Jun. 17, 2004 |       | Jun. 30, 2004 |       | $                      | 0.115      |                     | Monthly |
|            |       | May 17, 2004  |       | May 28, 2004  |       | $                      | 0.115      |                     | Monthly |
|            |       | Apr. 19, 2004 |       | Apr. 30, 2004 |       | $                      | 0.115      |                     | Monthly |
|            |       | Mar. 18, 2004 |       | Mar. 31, 2004 |       | $                      | 0.11       |                     | Monthly |
|            |       | Feb. 16, 2004 |       | Feb. 27, 2004 |       | $                      | 0.11       |                     | Monthly |
|            |       | Jan. 19, 2004 |       | Jan. 30, 2004 |       | $                      | 0.11       |                     | Monthly |
|            |       | Dec. 18, 2003 |       | Dec. 31, 2003 |       | $                      | 0.11       |                     | Monthly |
|            |       | Nov. 17, 2003 |       | Nov. 28, 2003 |       | $                      | 0.11       |                     | Monthly |
|            |       | Oct. 20, 2003 |       | Oct. 31, 2003 |       | $                      | 0.11       |                     | Monthly |
| ** **      | ** ** | ** **         | ** ** | ** **         | ** ** | ** **             | ** ** | ** **               |
| 2003            |       | Sept. 30, 2003     |       | Oct. 6, 2003  |       | $                      | 0.33       |                     | Quarterly |
|            |       | Jun. 30, 2003 |       | Jul. 7, 2003  |       | $                      | 0.29       |                     | Quarterly |
|            |       | Mar. 31, 2003 |       | Apr. 7, 2003  |       | $                      | 0.25       |                     | Quarterly |
|            |       | Dec. 31, 2002 |       | Jan. 7, 2003  |       | $                      | 0.23       |                     | Quarterly |
|            |       |               |       |               |       |                   |       |                     |
| 2002            |       | Sept. 30, 2002     |       | Oct. 7, 2002  |       | $                      | 0.21       |                     | Quarterly |
|            |       | Jun. 28, 2002 |       | Jul. 8, 2002  |       | $                      | 0.21       |                     | Quarterly |
|            |       | Mar. 28, 2002 |       | Apr. 8, 2002  |       | $                      | 0.21       |                     | Quarterly |
|            |       | Dec. 31, 2001 |       | Jan. 15, 2002 |       | $                      | 0.18       |                     | Quarterly |

 

NOTE6. INVESTMENT VALUATION

 

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

 

17

----

 

ofthese investments without the input of S&P. The Board of Directors considers a number of qualitative andquantitative factors in current market conditions when performing valuations.

 

NOTE7. PAYMENT IN KIND INTEREST

 

TheCompany seeks to avoid payment in kind (“PIK”) interest, however the Company hasa few loans in its portfolio that contain a PIK provision. A PIK provisionrequires the borrower to accrue a payment to the Company but the borrower doesnot have to pay that interest until the loan is paid in full. The PIK interestis added to the principal balance of the loan and recorded as income to theCompany even though the cash has not been received.  To maintain the Company’s status as a RIC (asdiscussed in Note 5, above), this non-cash source of income must be paid out tostockholders in the form of cash dividends, even though the Company has not yetcollected the cash. For the three and nine months ended June 30, 2005, theCompany recorded PIK interest income of $63,597 and $334,872, respectively, andfor the three and nine months ended June 30, 2004, the Company recordedPIK interest income of $136,647 and $413,052, respectively.  At June 30, 2005 and September 30,2004 the Company had accrued on its balance sheets, a total in PIK income of $1,282,916and $1,138,727 respectively.  The Companydoes not hold any investments issued at original issue discount andaccordingly, has not realized any original issue discount income for the three andnine months ended June 30, 2005 or June 30, 2004.

 

NOTE8. REPURCHASE AGREEMENT

 

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

 

The Company had no outstanding repurchase agreement as of June 30,2005.  On September 29, 2004, theCompany entered into a repurchase agreement (the “Repurchase Agreement”) withFerris Baker Watts for $44,984,950. On September 30, 2004, this amount wasreduced to $21,345,997 with the application of the net proceeds from the Company’spublic offering of common stock in September 2004.  This remaining balance was settled on October 1,2004.  The Repurchase Agreement wasrecorded at cost and was fully collateralized by a United States Treasury Billwith a fair value of $50,000,000, a carrying value of $49,984,950 that maturedon October 7, 2004 and earned interest of $2,133.  The interest rate charged on the RepurchaseAgreement was 4.25% for a cost of $7,831.

 

NOTE9. CONTRACTUAL OBLIGATIONS

 

Asof June 30, 2005, the Company was a party to a signed and non-binding termsheet for one potential investment for the Company’s portfolio.  The Company expects to fund this potentialinvestment as follows:

 
| ** **                  | ** ** | ** ** | ** ** | **Payment Due by Period** | ** ** |
|-----------------------------|------------|------------|------------|---------------------------|------------|
| **Contractual Obligations** | ** ** | **Total**  | ** ** | **Less than 1 Year**      | ** ** | **1-3 Years** | ** ** | **3-5 Years** | ** ** | **More than  5 Years** | ** ** |
|                        |       |       |       |                      |       |   |   |   |   |   |   |
| Investment                  |       | 4,000,000  |       | 4,000,000                 |       |   |   |   |   |   |   |
| Total                       |       | $          |       | 4,000,000                 |       | $ | 4,000,000 |   | $ | — |   | $ | — |   | $ | — |   |
|                             |            |            |            |                           |            |  |  |  |  |  |  |  |  |  |  |  |  |

 

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

 

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NOTE10. LINES OF CREDIT

 

InJune 2004, the Company entered into a $15.0 million line of creditagreement with Branch Banking and Trust Company (“BB&T Agreement”) whichmatured in June 2005.  The line ofcredit agreement was extended through September 30, 2005.  Interest on outstanding borrowings is basedupon the one month London Interbank Offered Rate (“LIBOR”) plus 2.5% perannum.  The unused portion of the line ofcredit is subject to a fee of 0.2% per annum. The BB&T Agreement requires the Company to meet and maintain certaincovenants and ratios with respect to leverage and liquidity. As of June 30,2005, there were no borrowings outstanding under the BB&T line of creditand $15.0 million of available borrowings. At June 30, 2005 the Company was in compliance with all covenantsunder the BB&T Agreement.

 

Through its wholly-owned subsidiary Gladstone Business Loan LLC (“BusinessLoan”), the Company has a $100 million revolving credit facility (the “DBFacility) with Deutsche Bank AG, as administrative agent, pursuant to whichBusiness Loan pledged the loans it holds to secure future advances by certaininstitutional lenders. The interest rate charged on the advances under the DB Facilityis based on LIBOR, the Prime Rate or the Federal Funds Rate, depending onmarket conditions, and adjusts periodically. In May 2005, the Companyrenewed its line of credit through May 26, 2006.  As of June 30, 2005, the outstandingprincipal balance under the DB Facility was approximately $54.6 million at an interestrate of 3.2%.  Available borrowings aresubject to various constraints imposed by Deutsche Bank AG, based on theaggregate loan balance pledged by Business Loan, which varies as loans areadded and repaid, regardless of whether such repayments are early prepayment orare made as contractually required.  At June 30,2005, the remaining borrowing capacity available under the DB Facility wasapproximately $33.3 million.

 

The DB Facility contains covenants that require Business Loan tomaintain its status as a separate entity; prohibit certain significantcorporate transactions (such as mergers, consolidations, liquidations ordissolutions); and restrict material changes to the Company’s credit andcollection policies.  The DB Facilityalso restricts some of the terms and provisions (including interest rates,terms to maturity and payments schedules) and limits the borrower and industryconcentrations of loans that are eligible to secure advances.  As of June 30, 2005, Business Loan wasin compliance with all of the facility covenants.

 

The administrative agent also requires that any interest or principalpayments on pledged loans be remitted directly by the borrower into a lockboxaccount with the Bank of New York as custodian. Deutsche Bank AG is also the trustee of the account and once a monthremits the collected funds to the Company. At June 30, 2005, the amountdue from custodian was $12,230,425 and at September 30, 2004, the amountdue from custodian was $1,203,079.

 

Effective July 12, 2004, Gladstone Management, the Company’saffiliated external adviser also services 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 Management would comply fully with all of its obligations under the DB Facility.  The performance guaranty requires the Companyto maintain a minimum net worth of $100 million and to maintain “asset coverage”with respect to “senior securities representing indebtedness” of at least 200%,in accordance with Section 18 of the 1940 Act.  As of June 30, 2005, the Company was incompliance with all covenants under the performance guaranty.  Gladstone Management services these loans foran annual fee of 1.5% of the monthly aggregate outstanding loan balance of theloans pledged under the DB Facility.  Forthe three and nine months ended June 30, 2005, the Company recorded loanservicing fees of $687,971 and $1,804,465, respectively.  At June 30, 2005, the Company owed $201,380of unpaid loan servicing fees to Gladstone Management, which are recorded infees due to affiliate.  At September 30,2004, the Company owed $113,511 in loan servicing fees to Gladstone Management,recorded in fees due to affiliate.  Therewere no loan servicing fees incurred for the three and nine months ended June 30,2004, as prior to July 12, 2004, the loans pledged under the DB Facilitywere serviced by Gladstone Capital Advisers, Inc., wholly-owned subsidiaryof the Company.

 

While Gladstone Management began receiving loan servicing fees as of July 12,2004, such loan servicing fees received by Gladstone Management are credited tothe Company’s advisory fee payable to Gladstone Management under the advisoryagreement between the Company and Gladstone Management.  Accordingly, the advisory fee payable by theCompany to Gladstone Management for the three and nine months ended June 30,2005 was reduced by $687,971 and $1,804,465, respectively, in respect of thesefees received by Gladstone Management.

 

NOTE11. INTEREST RATE CAP AGREEMENT

 

Pursuant to the Deutsche Bank AG line of credit, the Company has aninterest rate cap agreement that effectively limits the interest rate on aportion of the borrowings under the line of credit.

 

The use of a cap involves risks that are different from thoseassociated with ordinary portfolio securities transactions.  Cap agreements may be considered to beilliquid.  Although the Company will notenter into any such agreements unless it believes that the other party to the transactionis creditworthy, the Company does bear the risk of loss of the amount expectedto be received under such agreements in the event of default or bankruptcy ofthe agreement counterparty.

 

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In February 2004, the Company entered into an interest rate capagreement with a notional amount of $35.0 million at a cost of $304,000.  The interest rate cap agreement’s currentnotional amount is $29.5 million and a current fair value of approximately $31,734which is recorded in other assets on the Company’s consolidated balance sheetat June 30, 2005.  At September 30,2004, the interest rate cap agreement had a fair value of $89,741.  The Company records changes in the fair valueof the interest rate cap agreement monthly based on the current marketvaluation at month end as unrealized depreciation or appreciation on derivativeon the Company’s consolidated statement of operations. The interest rate capagreement expires in February 2009. The agreement provides that theCompany’s floating interest rate or cost of funds on a portion of the portfolio’sborrowings will be capped at 5% when the LIBOR rate is in excess of 5%.

 

NOTE12. FEE INCOME

 

The1940 Act requires that a business development company make available managerialassistance to its portfolio companies. The 1940 Act defines managerialassistance as the service made available to a portfolio company to provide “significantguidance and counsel concerning the management, operations, or businessobjectives and policies of a portfolio company.”  Prior to the start of fiscal year 2005, theCompany provided managerial assistance and other services to its portfoliocompanies through its wholly-owned subsidiary, Gladstone Capital Advisers, Inc.and therefore recorded managerial assistance and other fee revenue inconnection with these activities. Effective October 1, 2004, the Company offers managerial assistanceand other services to its portfolio companies through its external investmentadviser, Gladstone Management.  Neitherthe Company nor its external investment adviser, Gladstone Management, chargesa fee for managerial assistance. However, in the past the Company and, since October 1, 2004,Gladstone Management, have provided other services to portfolio companies inaddition to managerial assistance.  Theseother services include a wide variety of services to the portfolio companiessuch as investment banking services, arranging bank financing, arranging equityfinancing, structuring financing from multiple lenders and investors, reviewingexisting credit facilities, restructuring existing loans, raising equity anddebt capital, turnaround management, merger and acquisition services andrecruiting new management personnel. Gladstone Management is charging for these services and is crediting thefunds received from these other services to the Company as a credit against theinvestment advisory fee due from the Company under the investment advisoryagreement.  Such fees are normally paidin part at the time of signing a non-binding letter of intent, with theremainder paid upon completion of the services, and are generallynon-recurring.  For the three and ninemonths ended June 30, 2005, the Company recorded no revenue from feessince, as described above, these fees were remitted by the borrower directly toGladstone Management.  For the three and ninemonths ended June 30, 2004, the Company recorded $399,375 and $1,010,606,respectively, of fee revenue.

 

WhileGladstone Management began receiving all fees in connection with the Company’sinvestments as of October 1, 2004, such fees received by GladstoneManagement are credited to the Company as a reduction of the advisory feepayable to Gladstone Management under the advisory agreement between theCompany and Gladstone Management.  Forthe three and nine months ended June 30, 2005, Gladstone Managementreceived $240,600 and $977,100, respectively for fees for services rendered toportfolio companies. None of these fees were for managerial assistance eventhough Gladstone Management provided managerial assistance to many of theCompany’s portfolio companies. Accordingly, the advisory fee payable by the Company to GladstoneManagement for the three and nine months ended June 30, 2005 was reducedby $240,600 and $977,100, respectively, in respect of these fees received byGladstone Management.

 

NOTE13. ADVISORY AGREEMENT WITH GLADSTONE MANAGEMENT CORPORATION

 

EffectiveOctober 1, 2004, the Company entered into an advisory agreement withGladstone Management, an unconsolidated affiliate of the Company, whereby GladstoneManagement serves as an external adviser to the Company.  As compensation for the services of GladstoneManagement, the Company pays Gladstone Management an annual advisory fee of1.25% of total assets (as reduced by cash and cash equivalents pledged tocreditors), payable in quarterly computed increments of 0.3125%, and an annualadministrative fee of 0.75% of total assets (as reduced by cash and cashequivalents pledged to creditors), payable in quarterly computed increments of0.1875%, for a total annual fee of 2.0% (0.50% quarterly) of total assets (asreduced by cash and cash equivalents pledged to creditors). The Companycontinues to pay direct expenses including, but not limited to, directors’fees, legal and accounting fees, stockholder related expenses, and directorsand officers insurance.

 

GladstoneManagement services the loans held by Business Loan, in return for which,Gladstone Management receives a 1.5% annual fee based on the monthly aggregatebalance of loans held by Business Loan. Since the Company owns these loans, all loan servicing fees paid toGladstone Management are also credited directly against the 2% management fee.  These credits reduce the amount of theinvestment advisory fee and are shown above the direct credits line item in thetable below.  For the three months ended June 30,2005, March 31, 2005 and December 31, 2004, these loan servicing feestotaled $687,971, $585,542 and $530,952, respectively, all of which were creditedagainst the 2% management fee in order to derive the management fee which ispresented as the line item management fee in the consolidated statement ofoperations.  Under the advisoryagreement, Gladstone Management also provides the managerial assistance andother services that the Company previously made available to its portfoliocompanies through its wholly-owned subsidiary Gladstone Capital Advisers, Inc. To the extent that Gladstone Managementreceives any fees directly from a portfolio company for such services, GladstoneManagement credits these fees directly against the 2% management fee and these

 

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amountsare shown in the table below as a credit to the management fee.  For the three months ended June 30,2005, March 31, 2005 and December 31, 2004, Gladstone Managementrecorded $240,600, $450,000 and $286,500, respectively, of such fees andcredited this amount against the 2% management fee received from the Companyand reflected on the consolidated statement of operations as credit tomanagement fees for fees collected by Gladstone Management.  Overall, the management fee due to GladstoneManagement cannot exceed 2% of total assets (as reduced by cash and cashequivalents pledged to creditors) during any given fiscal year.  Because the Company was internally managed atall times prior to October 1, 2004, no management fee was recorded for thethree months ended June 30, 2004, March 31, 2004 or December 31,2003.

 

Thefollowing table sets forth the quarterly computation of the management fee forthe three months ended June 30, 2005, March 31, 2005 and December 31,2004, based on the quarterly increment of 0.50% (0.3125% quarterly advisory feeand 0.1875% quarterly administrative fee):

 
| ** **                                                 | ** ** | **June 30, 2005** | ** **  | **March 31, 2005** | ** ** | **December 31, 2004** | ** ** |
|------------------------------------------------------------|------------|------------------------|-------------|-------------------------|------------|----------------------------|------------|
| **Fee:**                                                   |       |                   |        |                    |       |                       |       |
| Total assets                                               |       | $                      | 209,320,463 |                    | $          | 213,753,998                |       | $ | 194,085,591 |   |
| Less: Borrowings under  line of credit *(a)*               |       | —                 |        | (18,644,179             | )          | (22,435,000                | )          |
| Total assets subject to  fee                               |       | 209,320,463            |        | 195,109,819             |       | 171,650,591                |       |
| Quarterly fee rate                                         |       | 0.50                   | %           | 0.50                    | %          | 0.50                       | %          |
| Gross management fee  before loan servicing fee credit     |       | 1,046,602              |        | 975,549                 |       | 858,254                    |       |
| Less: loan servicing  fee from Gladstone Business Loan LLC |       | 687,971                |        | 585,542                 |       | 530,952                    |       |
| Management fee before credit:                              |       | 358,631                |        | 390,007                 |       | 327,302                    |       |
| **Direct  Credit to Management Fee:**                      |       |                   |        |                    |       |                       |       |
| Fee revenue recorded by  Gladstone Management:             |       | 240,600                |        | 450,000                 |       | 286,500                    |       |
| Net management fee for  the three months ended:            |       | $                      | 118,031     |                    | $          | (59,993                    | )          | $ | 40,802 |   |

 

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*(a) **This amount represents borrowings under one of the Company’s lines ofcredit that were held in cash and cash equivalents as of June 30, 2005, March 31,2005 and December 31, 2004, respectively of each quarterly computation,for the purpose of satisfying the Company’s asset diversification requirementsunder the Code. There were no borrowings outstanding for this purpose at June 30,2005.  Solely for the purposes ofcalculating the amount of the management fee due to Gladstone Management, theCompany treats any such amounts as “cash and cash equivalents pledged tocreditors” under the terms of the Company’s advisory agreement with GladstoneManagement.  As a result, such amountsare deducted from the Company’s total assets for purposes of computing theasset base upon which the management fee is determined.*

 

NOTE14. FEDERAL AND STATE INCOME TAXES

 

TheCompany has historically operated, and intends to continue to operate, in amanner to qualify for treatment as a RIC under Subchapter M of the Code.  As a RIC, the Company is not subject tofederal or state income tax on the portion of its taxable income and gainsdistributed to stockholders.  To qualifyas a RIC, the Company is required to distribute to its stockholders at least90% of investment company taxable income, as defined by the Code and as such noincome tax provisions have been recorded for the individual companies ofGladstone Capital Corporation and Gladstone Business Loan LLC.

 

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

 

NOTE15. SUBSEQUENT EVENTS

 

In July 2005, MedAssets, Inc.repaid its senior term debt of approximately $1.4 million and its seniorsubordinated term debt of approximately $6.5 million.

 

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

 

**All statements contained herein, other than historical facts, mayconstitute “forward-looking statements” within the meaning of Section 27Aof the Securities Act of 1933, as amended, and Section 21E of theSecurities Exchange Act of 1934, as amended. These statements may relate to,among other things, future events or our future performance or financialcondition. In some cases, you can identify forward-looking statements byterminology such as “may,” “might,” “believe,” “will,” “provided,” “anticipate,”“future,” “could,” “growth,” “plan,” “intend,” “expect,” “should,” “would,” “if,”“seek,” “possible,” “potential,” “likely” or the negative of such terms or comparableterminology. These forward-looking statements involve known and unknown risks,uncertainties and other factors that may cause our actual results, levels ofactivity, performance or achievements to be materially different from anyfuture results, levels of activity, performance or achievements expressed orimplied by such forward-looking statements. Such factors include, among others:(1) adverse changes in interest rates; (2) our failure or inabilityto establish or maintain referral arrangements with leveraged buyout funds andventure capital funds to generate loan opportunities; (3) the loss of oneor more of our executive officers, in particular David Gladstone, Terry LeeBrubaker, or George Stelljes III; (4) our inability to extend, refinanceor maintain our credit facilities on terms reasonably acceptable to us, if atall in future equity capital resources; (5) our inability to successfullysecuritize our loan portfolio on terms reasonably acceptable to us, if at all; (6) thedecision of our competitors to aggressively seek to make senior andsubordinated loans to small and medium-sized businesses on terms more favorablethan we intend to provide; and (7) those factors listed under the caption “RiskFactors” of the Annual Report on Form 10-K as filed with the Securitiesand Exchange Commission on December 14, 2004. We caution readers not toplace undue reliance on any such forward-looking statements, which are madepursuant to the Private Securities Litigation Reform Act of 1995 and, as such,speak only as of the date made. We undertake no obligation to publicly updateor revise any forward-looking statements, whether as a result of newinformation, future events or otherwise, after the date of this Form 10-Q**.

 

*The following analysis of our financial condition and results ofoperations should be read in conjunction with our financial statements and thenotes thereto contained elsewhere in this report.*

 

**OVERVIEW**

 

We were incorporated under the General CorporationLaws of the State of Maryland on May 30, 2001. Our investment objectivesare to achieve a high level of current income by investing in debt securities,consisting primarily of senior notes, second lien notes, and seniorsubordinated notes of established private businesses that are backed by leveragedbuyout funds, venture capital funds or others, with a particular emphasis on secondlien and senior subordinated notes.  Inaddition, we may acquire existing loans, which meet this profile, fromleveraged buyout funds, venture capital funds and others. We also seek toprovide our stockholders with long-term capital growth through the appreciationin the value of warrants, or other equity instruments that we may receive whenwe extend loans. We operate as a closed-end, non-diversified management investmentcompany, and have elected to be treated as a business development company underthe 1940 Act.

 

We seek out small and medium-sized businesses thatmeet certain criteria, including (1) the potential for growth in cashflow, (2) adequate assets for loan collateral, (3) experiencedmanagement teams with a significant ownership interest in the borrower, (4) profitableoperations based on the borrower’s cash flow, (5) reasonablecapitalization of the borrower (usually by buyout funds or venture capital funds)and (6) the potential to realize appreciation and gain liquidity in ourequity position, if any. We anticipate that liquidity in our equity positionwill be achieved through a merger or acquisition of the borrower, a publicoffering by the borrower or by exercise of our right to require the borrower tobuy back its warrants. We lend to borrowers that need funds to finance growth,restructure their balance sheets or effect a change of control.

 

Our loans typically range from $5 million to $15million, mature in no more than seven years and accrue interest at a fixed orvariable rate that exceeds the prime rate. A number of our loans have aprovision that calls for some portion of the interest payments to be deferredand added to the principal balance so that the interest is paid, together withthe principal, at maturity. This form of deferred interest is often called “paymentin kind” or “PIK” interest, and, when earned, we record PIK interest asinterest income and add the PIK interest to the principal balance of the loans.We seek to avoid PIK interest with all potential investments under review. Theamount of cost basis PIK interest accrued on our balance sheet as of June 30,2005 was approximately $1,283,000.

 

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Because our loans will generally be subordinated debtof private companies who typically cannot or will not expend the resources tohave their debt securities rated by a credit rating agency, we expect thatmost, if not all, of the debt securities we acquire will be unrated. We cannotaccurately predict what ratings these loans might receive if they were in factrated, and therefore we cannot determine whether or not they could beconsidered to be “investment grade” quality.

 

To the extent possible, our loans generally arecollateralized by a security interest in the borrower’s assets. Interestpayments are generally made monthly or quarterly (except to the extent of anyPIK interest) with amortization of principal generally being deferred for severalyears. The principal amount of the loans and any accrued but unpaid interestgenerally become due at maturity at five to seven years. When we receive awarrant to purchase stock in a borrower in connection with a loan, the warrantwill typically have an exercise price equal to the fair value of the portfoliocompany’s common stock at the time of the loan and entitle us to purchase amodest percentage of the borrower’s stock.

 

Original issue discounts (“OID”) arise when we extenda loan and receive an equity interest in the borrower at the same time.  To the extent that the price paid for theequity is not at market value, the Company must allocate part of the price paidfor the loan, to the value of the equity. Then the amount allocated to the equity, the OID, must be amortized overthe life of the loan.  As with PIKinterest, the amortization of OID also produces income that must be recognizedfor purposes of satisfying the regulated investment company (“RIC”)distribution requirements, whereas the cash is received, if at all, when the equityinstrument is sold.

 

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

 

Prior to making an investment, we ordinarily enterinto a non-binding term sheet with the potential borrower. These non-bindingterm sheets are generally subject to a number of conditions, including but notlimited to the satisfactory completion of our due diligence investigations ofthe potential borrower’s business and reaching agreement on the legaldocumentation for the loan. Upon execution of the non-binding term sheet, thepotential borrower generally pays Gladstone Management a non-refundable fee forits services rendered through the date of the non-binding term sheet. Prior tothe externalization of our management on October 1, 2004, we recognizedthis as fee revenue upon execution of the non-binding term sheet. Effective October 1,2004, these fees are received by Gladstone Management and are offset againstamounts due to Gladstone Management, which has the effect of reducing ourexpenses to the extent of any such fees received by Gladstone Management.

 

In the event that we expend significant effort inconsidering and negotiating a potential investment that ultimately is notconsummated, we generally will seek reimbursement from the proposed borrowerfor our reasonable expenses incurred in connection with the proposedtransaction.  Any amounts collected forexpenses incurred by Gladstone Management in connection with unconsummatedinvestments will be reimbursed to Gladstone Management. Amounts collected forthese expenses incurred by us will be reimbursed to us and will be recognizedas “other income” in the period in which such reimbursement is received.  Also, in the event that we have incurredsignificant legal fees in connection with the transaction, we will typicallyseek reimbursement for these expenses from the proposed borrower.  However, there can be no guarantee that wewill be successful in collecting any such reimbursements.

 

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The only significant continuing revenue associatedwith the investments we have already closed is interest income and,potentially, capital gains realized in connection with the liquidation of anyassociated equity interest (e.g., warrants).

 

During the nine months ended June 30, 2005, weextended, directly or through participations, approximately $126.2 million of newloans to a total of 19 companies.  Also,during the nine months ended June 30, 2005, eight borrowers repaid theirloans ahead of contractual maturity and we sold two loan investments for anaggregate return of capital of approximately $60.0 million and we receivedscheduled contractual principal repayments of approximately $18.0 million, fortotal principal repayments of approximately $78.0 million.  Since our initial public offering in August 2001,we have made 68****different loansto, or investments in, 41****companiesfor a total of approximately $345.2****million,before giving effect to principal repayments on investments and divestitures.

 

We are earnestly working toward the consummation ofmore investments. These prospective loans are subject to, among other things,the satisfactory completion of our due diligence investigation of eachborrower, acceptance of terms and structure and necessary consents. Withrespect to each prospective loan, we will only agree to provide the loan if,among other things, the results of our due diligence investigations aresatisfactory, the terms and conditions of the loan are acceptable and allnecessary consents are received. Our management has initiated its due diligenceinvestigations of the potential borrowers, however we cannot assure you that wewill not discover facts in the course of completing our due diligence thatwould render a particular investment imprudent or that any of these loans willactually be made.

 

**External Adviser**

 

Effective October 1, 2004, pursuant to ouradvisory agreement with Gladstone Management, we pay Gladstone Management anannual advisory fee of 1.25% of our total assets (as reduced by cash and cashequivalents pledged to creditors), payable in quarterly computed increments of0.3125%, and an annual administrative fee of 0.75% of our total assets (asreduced by cash and cash equivalents pledged to creditors), payable inquarterly computed increments of 0.1875%. This fee is then directly reduced bythe amount of loan servicing fees paid to Gladstone Management and any otherfees received by Gladstone Management from our borrowers and potentialborrowers.  We continue to pay directexpenses including, but not limited to, directors’ fees, legal and accountingfees, stockholder related expenses, and directors and officers insurance.

 

Effective July 12, 2004, Gladstone Managementassumed the responsibility for servicing our loan portfolio pursuant to a loanservicing agreement with Gladstone Business Loan LLC (“Business Loan”).Gladstone Management services these loans in return for a 1.5% annual fee,based on the monthly aggregate outstanding loan balance of the loans pledgedunder the facility.  For the three and ninemonths ended June 30, 2005, we incurred approximately $688,000 and $1.8million, respectively, in loan servicing fees. Prior to July 12, 2004, our loans were serviced under a similaragreement between Business Loan and Gladstone Capital Advisers Inc., ourwholly-owned subsidiary, although the fees from these intercompany transactionswere eliminated through the consolidation of our financial results with thoseof Business Loan and Gladstone Capital Advisers.

 

For the three months ended June 30, 2005, thegross management fee, before reductions for loan servicing fees and other feeswas approximately $1.0 million.  Afterbeing reduced by loan servicing fees of approximately $688,000 and other feesreceived by Gladstone Management of approximately $241,000, our net managementfee for the three months ended June 30, 2005 was approximately $118,000.  For the three months ended March 31,2005, the gross management fee, before reductions for loan servicing fees andother fees was approximately $976,000. After being reduced by loan servicing fees of approximately $586,000 andother fees received by Gladstone Management of $450,000, our net management feefor the three months ended March 31, 2005 was a credit of approximately$60,000.  For the three months ended December 31,2004, the gross management fee, before reductions for loan servicing fees and otherfees was approximately $858,000.  Afterbeing reduced by loan servicing fees of approximately $531,000 and other feesreceived by Gladstone Management of approximately $286,500, our net managementfee for the three months ended December 31, 2004 was $40,802.  Since the fees are computed quarterly it isnecessary to sum the three quarters in order to derive the year to datemanagement fee, therefore the nine months ended June 30, 2005 grossmanagement fee before reductions was approximately $2.9 million and the aggregatenet management fee after reductions was approximately $99,000 for the ninemonths ended June 30, 2005.  Therewas no fee for the three months ended June 30, 2004, March 31, 2004or December 31, 2003 because we were internally managed at all times untilOctober 1, 2004.

 

Prior to the externalization of our management, we wereparty to an expense sharing arrangement with Gladstone Management, which duringsuch time served as the external adviser to Gladstone Commercial Corporation (“GladstoneCommercial”), a real estate investment trust affiliated with us. Under thisexpense sharing arrangement, Gladstone Management reimbursed Gladstone CapitalAdvisers for a portion of our total payroll and benefits expenses (based on thepercentage of total hours worked by each of our employees on GladstoneCommercial matters). Gladstone Management also reimbursed Gladstone CapitalAdvisers for its pro rata portion of all other general expenses (based on thepercentage of total hours worked by all of our employees

 

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on Gladstone Commercial matters). Gladstone Management further passedits share of these expenses along to Gladstone Commercial under a separateadvisory agreement.  At September 30,2004, Gladstone Management owed us $109,639 of reimbursements recorded in feesdue from affiliate, all of which was subsequently paid.  Following our engagement of GladstoneManagement on October 1, 2004, the first day of our 2005 fiscalyear, Gladstone Management now directly employs all of our personnel andpays its payroll, benefits, and general expenses directly.  Thus, the expense sharing arrangement betweenGladstone Capital Advisers and Gladstone Management terminated upon theexternalization of our management on October 1, 2004.

 

**Critical Accounting Policies**

 

The preparation of financial statements and relateddisclosures in conformity with accounting principles generally accepted in theUnited States requires management to make estimates and assumptions that affectthe reported consolidated amounts of assets and liabilities, and disclosure ofcontingent assets and liabilities at the date of the financial statements, andrevenues and expenses during the period reported. Actual results could differmaterially from those estimates.  Ouraccounting policies are more fully described in the “Notes to ConsolidatedFinancial Statements” contained elsewhere in this report.  We have identified our investment valuationprocess as our most critical accounting policy.

 

**Investment Valuation**

 

The most significant estimate inherent in thepreparation of our consolidated financial statements is the valuation ofinvestments and the related amounts of unrealized appreciation and depreciationof investments recorded.

 

*General Valuation Policy*: Wevalue our investment portfolio each quarter. We carry our investments at fairvalue, as determined in good faith by our board of directors.  Securities that are publicly traded, if any,are valued at the closing price of the exchange or securities market on whichthey are listed on the valuation date. Securities which are not traded on apublic exchange or securities market, but for which a limited market exists andthat have been rated by a NRSRO (as defined below), such as certain participationsin syndicated loans, are valued at the indicative bid price offered by thesyndication agent on the valuation date.

 

Debt and equity securities that are not publiclytraded, for which a limited market does not exist, or for which a limitedmarket exists but that have not been rated by a NRSRO (or for which we havevarious degrees of trading restrictions) are valued at fair value as determinedin good faith by our board of directors. In making the good faith determination of the value of these securities,we start with the cost basis of the security, which includes the amortizedoriginal issue discount, and PIK interest, if any.  We then apply the methods set out below in “ValuationMethods.”  Members of our portfoliomanagement team prepare the valuations of our investments in portfoliocompanies using the most recent portfolio company financial statements andforecasts.  These individuals alsoconsult with portfolio company senior management and ownership to obtainfurther updates on the portfolio company’s performance, including informationsuch as industry trends, new product development, and other operationalissues.  Due to the uncertainty inherentin the valuation process, such estimates of fair value may differ significantlyfrom the values that would have been obtained had a ready market for thesecurities existed, and the differences could be material.  Additionally, changes in the marketenvironment and other events that may occur over the life of the investmentsmay cause the gains or losses ultimately realized on these investments to bedifferent than the valuations currently assigned.  No single standard for determining fair valuein good faith exists since fair value depends upon circumstances of eachindividual case.  In general, fair valueis the amount that we might reasonably expect to receive upon the current saleof the security.

 

We currently engage Standard & Poor’s LoanEvaluation Service (S&P) to help evaluate the value of the majority of ourloan securities (other than those which are publicly traded or for which alimited market exists, as described above), as well as for evaluations onsuccess fees (conditional interest included in some loan securities).  We and S&P only evaluate the value of asuccess fee if the probability of receiving the success fee on a given loan isabove 6-8%, a threshold of significance, in which case a value isassigned.  Upon completing our collectionof data with respect to the investments (including the information describedunder “Credit Information,” the risk ratings of the loans described under “LoanGrading and Risk Rating” and the factors described under “Valuation Methods”),this valuation data is presented to S&P. S&P makes its independent assessment of the data that we haveassembled and assesses its own data to determine market values for thesecurities.  With regard to its work,S&P has issued the following paragraph:

 

S&P provides evaluated price opinions which arereflective of what S&P believes the bid side of the market would be foreach loan after careful review and analysis of descriptive, market and creditinformation.  Each price reflects S&P’sbest judgment based upon careful examination of a variety of marketfactors.  Because of fluctuation in themarket and in other factors beyond its control, S&P cannot guarantee theseevaluations.  The evaluations reflect themarket prices, or estimates thereof, on the date specified.  The prices are based on comparable marketprices for similar securities.  Marketinformation has been obtained from reputable secondary market sources.  Although these sources are consideredreliable, S&P cannot guarantee their accuracy.

 

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With our assessment and S&P value estimates as abackdrop, our board of directors votes to accept or not accept the analyses andvalues recommended by management and S&P. At June 30, 2005 and September 30, 2004, the board ofdirectors elected to accept the valuations recommended by S&P on thoseloans as denoted on the Schedules of Investments as of June 30, 2005 and September 30,2004 in our consolidated financial statements.

 

Because there is a delay between when we close a loanand when the loan can be evaluated by S&P, some new loans are not valuedimmediately by S&P; rather, the board of directors makes its owndetermination about the value of these loans in accordance with our valuationpolicy.  Because S&P does not providevalues for mortgage loans or equity securities, our board of directors alsodetermines the fair value of these investments using our valuation policywithout the input of S&P.

 

*Credit Information:*****We monitor a wide variety of key creditstatistics that provide information regarding our portfolio companies to helpus assess credit quality and portfolio performance.  We require our portfolio companies to provideannual audited and either monthly or quarterly unaudited financialstatements.  Using these statements, wecalculate and evaluate the credit statistics. For purposes of analyzing the financial performance of our portfoliocompanies, we may make certain adjustments to their cash flow statements toreflect the pro forma results of a company consistent with a change of controltransaction, to reflect anticipated cost savings resulting from a merger or restructuring,costs related to new product development, compensation to previous owners, andother acquisition or restructuring related items.  For those investments for which S&Pprepares valuation recommendations, we provide this credit information toS&P for its use in preparing its recommendations.  For those investments for which S&P doesnot prepare valuation recommendations, management uses this credit informationin connection with its preparation of valuation recommendations.

 

*Loan Grading and Risk Rating:*Aspart of our valuation procedures we risk rate all of our loans.  Our risk rating system uses a scale of 0 to10.  This system is used to estimate theprobability of default on our debt securities and the probability of loss ifthere is a default.  These types ofsystems are referred to as risk rating systems and are used by banks and ratingagencies.  The risk rating system coversboth qualitative and quantitative aspects of the business and the securities wehold.  For those investments for which S&Pprepares valuation recommendations, we compile this information and provide itto S&P for its consideration in determining its valuationrecommendations.  For those investmentsfor which S&P does not prepare valuation recommendations, management usesthis information to develop valuation recommendations.

 

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

 
| **Company’s  System** | ** ** | **First  NRSRO** | ** ** | **Second  NRSRO** | ** ** | **Gladstone Capital’s  Description(a)**                                                         |
|----------------------------|------------|------------------|------------|-------------------|------------|------------------------------------------------------------------------------------------------------|
| **>10**                 |       | Baa2             |       | BBB               |       | Probability of Default (PD during the next ten years  is 4% and the Expected Loss (EL) is 1% or less |
| **10**                     |       | Baa3             |       | BBB-              |       | PD is 5% and the EL is 1% to 2%                                                                      |
| **9**                      |       | Ba1              |       | BB+               |       | PD is 10% and the EL is 2% to 3%                                                                     |
| **8**                      |       | Ba2              |       | BB                |       | PD is 16% and the EL is 3% to 4%                                                                     |
| **7**                      |       | Ba3              |       | BB-               |       | PD is 17.8% and the EL is 4% to 5%                                                                   |
| **6**                      |       | B1               |       | B+                |       | PD is 22.0% and the EL is 5% to 6.5%                                                                 |
| **5**                      |       | B2               |       | B                 |       | PD is 25% and the EL is 6.5% to 8%                                                                   |
| **4**                      |       | B3               |       | B-                |       | PD is 27% and the EL is 8% to 10%                                                                    |
| **3**                      |       | Caa1             |       | CCC+              |       | PD is 30% and the EL is 10.0% to 13.3%                                                               |
| **2**                      |       | Caa2             |       | CCC               |       | PD is 35% and the EL is 13.3% to 16.7%                                                               |
| **1**                      |       | Caa3             |       | CC                |       | PD is 65% and the EL is 16.7% to 20%                                                                 |
| **0**                      |       | N/a              |       | D                 |       | PD is 85% or there is a Payment Default: and the EL  is greater than 20%                             |

 

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*(a) the defaultrates set forth herein are for a ten year term debt, if the company’s debtsecurity is less than ten years then the probability of default is adjusted toa lower percentage for the shorter period which may move the security higher onour risk rating scale.*

 

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* *

The above scale gives an indication of the probabilityof default and the magnitude of the loss if there is a default. The followingtable lists the risk ratings for all of the debt securities outstanding at June 30,2005, March 31, 2005, December 31, 2004 and September 30,2004:

 
| **Rating**       | ** ** | **June 30, 2005** | ** ** | **Mar. 31, 2005** | ** ** | **Dec. 31, 2004** | ** ** | **Sept. 30, 2004** | ** ** |
|------------------|------------|------------------------|------------|------------------------|------------|------------------------|------------|--------------------|------------|
| Average          | ** ** | **7.1**                | ** ** | **7.2**                | ** ** | **7.2**                | ** ** | **7.6**            | ** ** |
| Weighted Average | ** ** | **7.2**                | ** ** | **7.2**                | ** ** | **7.2**                | ** ** | **7.6**            | ** ** |
| Highest          | ** ** | **10.0**               | ** ** | **10.0**               | ** ** | **10.0**               | ** ** | **9.0**            | ** ** |
| Lowest           | ** ** | **5.0**                | ** ** | **5.0**                | ** ** | **5.0**                | ** ** | **5.0**            | ** ** |

 

Our policy is to stop accruing interest on aninvestment if we determine that interest is no longer collectible. To date wehave not placed any investments on non-accrual. At June 30, 2005 and September 30, 2004, no payments were pastdue on any of our debt securities.  We donot risk rate our equity securities.

 

*Valuation Methods:*  For debt securities, we first determine ifthe debt security is publicly traded (i.e., if it is listed on an exchange orsecurities market).  If it is publiclytraded, then we determine the value based on the closing price for the securityon the exchange or securities market on which it is listed on the valuationdate.  If the security is not publiclytraded, but a limited market for the security exists, such as for syndicatedloans, and if the security has been rated by a NRSRO, then we value the loan atthe indicative bid price offered by the syndication agent on the valuationdate.  At June 30, 2005, none of thedebt securities in our portfolio were publicly traded and there was a limitedmarket for 11 debt securities in our portfolio. At September 30, 2004, none of the debt securities in our portfoliowere publicly traded and there was a limited market for five debt securities inour portfolio.

 

For debt securities that either are not publiclytraded, for which there is no market, or for which there is a market but havenot been rated by a NRSRO, we begin with the risk rating designation of thesecurity described above.  Using the riskrating designation above, we seek to determine the value of the security as ifwe intended to sell the security in a current sale.  To determine the current sale price of thesecurity, we consider some or all of the following factors:

•      financial standing of theissuer of the security;

•      comparison of the businessand financial plan of the issuer with actual results;

•      the cost of the security;

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

•      contractual restrictions onthe disposition of the security;

•      pending public offering ofthe issuer of the security;

•      pending reorganization activityaffecting the issuer such as mergers or debt restructuring;

•      reported prices of similarsecurities of the issuer or comparable issuers;

•      ability of the issuer toobtain needed financing;

•      changes in the economyaffecting the issuer;

•      recent purchases or sale ofa security of the issuer;

•      pricing by other buyers orsellers of similar securities;

•      financial statements of theborrower;

•      reports from portfoliocompany senior management and ownership;

•      the type of security;

•      cost at date of purchase;

•      size of holding;

•      discount from market valueof unrestricted securities of the same class at the time of purchase;

•      special reports prepared byanalysts;

•      information as to anytransactions or offers with respect to the security;

•      existence of mergerproposals or tender offers affecting the securities;

•      the collateral;

•      the issuer’s ability to makepayments;

•      the current and forecastedearnings of the issuer;

•      sales to third parties ofsimilar securities;

•      statistical ratios comparedto lending standards;

•      statistical ratios comparedto other similar securities; and

 

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•      other pertinent factors.

 

For those debt securities for which S&P preparesvaluation recommendations, we provide the foregoing information to S&P forits use in preparing its recommendations.

 

For convertible debt, equity, success fees or otherequity-like securities, we first determine if there is any market for thesecurity.  If there is a market, then wedetermine the value based on the market prices for the security, even if thatmarket is not robust.  At June 30,2005 and September 30, 2004 there was no market for any of the equitysecurities we owned.  If there is nomarket for the equity securities, then we use the same information we would usefor a debt security valuation described above, except risk-rating, as well asstandard valuation techniques used by major valuation firms to value the equitysecurities of private companies.  Thesevaluation techniques consist of: discounted cash flow of the expected saleprice in the future, valuation of the securities based on recent sales incomparable transactions, and a review of similar companies that are publiclytraded and the market multiple of their equity securities.  At June 30, 2005 and September 30,2004 we had $37,000 invested, at cost, in equity securities compared to ourdebt portfolio with a cost basis of $197,712,877 and $149,152,306,respectively.

 

At June 30, 2005, we had total unrealizeddepreciation of $4,372,364, which was mainly composed of unrealizeddepreciation in our senior subordinated term debt investment in FinnCorporation (excluding the warrants) of $3,150,000 and our senior subordinatedterm debt investment in Marcal Paper Mills, Inc. of $338,625, and ourfirst mortgage loan to Marcal Paper Mills, Inc. of $194,878, partiallyoffset by unrealized appreciation, most notably, the value of our warrants ofFinn Corporation had an unrealized appreciation of $593,360 and WovenElectronics Corporation had unrealized appreciation of $405,567.  This aforementioned unrealized appreciationplus unrealized appreciation of $181,519 on certain other investments,primarily in our originated loan investments and certain syndicateparticipation, most notably Infor Global Solutions, which had unrealized appreciationof $150,500, for overall unrealized appreciation of $1,330,946.

 

**Tax Status**

 

*Federal Income Taxes*

 

We intend to continue to qualify for treatment as aRIC under Subtitle A, Chapter 1 of Subchapter M of the Code. As a RIC, we arenot subject to federal income tax on the portion of our taxable income andgains distributed to stockholders. To qualify as a RIC, we are required todistribute to stockholders at least 90% of investment company taxable income,as defined by the Code.  We have a policyto pay out as a dividend up to 100% of that amount.

 

**Revenue Recognition**

 

*Interest Income Recognition*

 

Interest income is recorded on the accrual basis tothe extent that such amounts are expected to be collected. We will stopaccruing interest on investments when it is determined that interest is nolonger collectible. Conditional interest or a success fee is recorded whenearned upon full repayment of a loan investment.

 

*Payment in Kind Interest*

 

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

 

**Fee Income**

 

The 1940 Act requires that a business developmentcompany make available managerial assistance to its portfolio companies byproviding significant guidance and counsel concerning the management,operations, or business objective and policies of the respective portfoliocompany. Prior to October 1, 2004, we provided managerial assistance toour portfolio companies in connection with our investments through ourwholly-owned subsidiary, Gladstone Capital Advisers, Inc.  Effective October 1, 2004, we beganproviding these and other services through our external adviser, GladstoneManagement.  Currently, neither we nor GladstoneManagement receive fees in connection with managerial assistance. However, effectiveOctober 1, 2004 our adviser, Gladstone Management, receives the fees forthe other services it provides, and those fees for other services are creditedto the investment advisory fees due to Gladstone Management.  These other fees are generally paid toGladstone Management in part at the time a prospective portfolio company signsa non-binding term sheet with us, with the remainder paid at the closing of theinvestment.  These fees are generallynon-recurring, are recognized as revenue when earned and are paid directly toGladstone Management by the

 

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borrower or potential borrower, effective October 1, 2004 and forall future periods.  The servicesGladstone Management provides vary by investment, but generally include a widevariety of services to the portfolio companies such as investment banking services,arranging bank financing, arranging equity financing structuring financing frommultiple lenders and investors, reviewing existing credit facilities,restructuring existing loans, raising equity and debt capital, turnaroundmanagement, merger and acquisition services and recruiting new managementpersonnel.  Any services of this naturesubsequent to the closing would generally generate a separate fee at the timeof completion. From time to time, we are invited to participate as a co-lenderin a transaction. In the event that we do not provide significant services inconnection with our investment, loan fees paid directly to Gladstone Managementin such situations are deferred and amortized over the life of the loan.

 

**RESULTS OF OPERATIONS**

 

*Comparisonof the three months ended June 30, 2005 to the three months ended June 30,2004*

 

**Investment Income**

 

Investment income for the three months ended June 30,2005 was approximately $6.1 million as compared to approximately $6.7 millionfor the three months ended June 30, 2004. This decrease was primarily theresult of a decline in fee revenue resulting from the receipt of such fees byour external investment adviser as well as a decline in other income, which ismainly composed of prepayment penalty fees, due to a decline in prepayments ascompared to the three months ended June 30, 2004.

 

Interest income from our investments in debtsecurities of private companies was approximately $5.8 million, including approximately$64,000 of PIK interest, for the three months ended June 30, 2005 ascompared to approximately $5.7 million for the three months ended June 30,2004, which included approximately $137,000 of PIK interest. This increase****wasprimarily a result of a net increase in investments of $38.9 million over June 30,2004.  This increase consisted of $130.2million of new investments, offset by principal repayments and investment salesof approximately $91.3 million.

 

The annualized weighted average yield on our portfoliofor the three months ended June 30, 2005 was 11.4% (without giving effectto PIK interest) and 11.8% (after giving effect to PIK interest). The annualizedweighted average yield on our portfolio for the three months ended June 30,2004 was 16% (without giving effect to PIK interest) and 16.4% (after givingeffect to PIK interest). The decline is due to the early repayments ofprincipal balances on certain loans.

 

Interest income from invested cash and cashequivalents for the three months ended June 30, 2005 was approximately $8,000,as compared to approximately $15,000 for the three months ended June 30,2004. This decrease****was primarilya result of a decrease in invested cash and cash equivalents resulting from anet increase in investments of $38.9 million over June 30, 2004, whichconsisted of $130.2 million of new investments, offset by principal repayments andinvestment sales of approximately $91.3 million.

 

For the three months ended June 30, 2005 and June 30,2004, we recorded approximately $108,000 and $113,000, respectively, ininterest income from loans to our employees in connection with the exercise ofemployee stock options.

 

No fee income was recorded for the three months ended June 30,2005, as compared to $399,000 for the three months ended June 30, 2004.This decrease was the result of the externalization of our management,effective October 1, 2004, through the engagement of our affiliateGladstone Management to serve as our external investment adviser.  As noted above, Gladstone Management receivesall fees in connection with our investments and prospective investments, whichfees are offset against the advisory fee payable to Gladstone Management.  During the three months ended June 30,2005, Gladstone Management received an aggregate of $240,600 in such fees.

 

For the three months ended June 30, 2005, werecorded approximately $245,000 of other income as compared to $483,000 ofother income for the three months ended June 30, 2004.  The income for both periods consisted ofprepayment penalty fees received upon the full repayment of certain loaninvestments ahead of contractual maturity and prepayment fees received upon theearly unscheduled principal repayments ahead of scheduled payment dates which, inboth instances were based on a percentage of the outstanding principal amountof the loan at the date of prepayment.

 

**Operating Expenses**

 

Operating expenses for the three months ended June 30,2005 were approximately $1.8 million, as compared to approximately $2.0 millionfor the three months ended June 30, 2004.  Operating expenses for the three months ended June 30,2005 reflected a significant reduction in direct operating expenses as a resultof the externalization of our management effective October 1, 2004, offsetby the loan servicing fees and management fee incurred as a result of thisexternalization, and increases in interest expense, professional fees, andstockholder related costs.

 

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Loan servicing fees of approximately $688,000 wereincurred for the three months ended June 30, 2005.  These fees were incurred in connection with aloan servicing agreement between Gladstone Business Loan LLC (“Business Loan”)and Gladstone Management, which became effective July 12, 2004.  These fees were directly credited against theamount of the management fee due to Gladstone Management.  During the three months ended June 30,2004, our loan portfolio was serviced under a similar agreement with GladstoneCapital Advisers Inc., our wholly-owned subsidiary, and the fees Business Loanpaid to Gladstone Capital Advisers, Inc. were eliminated upon consolidationof our financial results.

 

Effective October 1, 2004, we entered intoan advisory agreement with Gladstone Management whereby Gladstone Management servesas our external adviser.  As compensationfor the services of Gladstone Management, we pay Gladstone Management an annualadvisory fee of 1.25% of total assets (as reduced by cash and cash equivalentspledged to creditors), payable in quarterly computed increments of 0.3125%, andan annual administrative fee of 0.75% of total assets (as reduced by cash andcash equivalents pledged to creditors), payable in quarterly computed incrementsof 0.1875%, for a total fee of 2% of total assets (as reduced by cash and cashequivalents pledged to creditors). We continue to pay direct expensesincluding, but not limited to, directors’ fees, legal and accounting fees,stockholder related expenses, and directors and officers insurance.  Under the advisory agreement, GladstoneManagement provides the managerial assistance and other services to ourportfolio companies that we previously provided through our wholly-ownedsubsidiary Gladstone Capital Advisers, and likewise Gladstone Managementdirectly receives any fees for such services. Any such fees are credited directly against the 2% management feepayable to Gladstone Management.  The 2%management fee is also directly reduced by the amount of the monthly loanservicing fees we pay to Gladstone Management. Overall, the management fee dueto Gladstone Management cannot exceed 2% of total assets (as reduced by cash andcash equivalents pledged to creditors) during any given fiscal year.  Because we were internally managed at alltimes prior to October 1, 2004, no management fee was recorded for thethree months ended June 30, 2004.

 

The following table sets forth the computationof the management fee for the three months ended June 30, 2005, based onthe quarterly increment of 0.50% (0.3125% quarterly advisory fee plus 0.1875%quarterly administrative fee):

 
| ** **                                                         | ** ** | **June 30, 2005** | ** **        |
|--------------------------------------------------------------------|------------|------------------------|-------------------|
| **Fee:**                                                           |       |                   |              |
| Total assets at June 30,  2005                                |       | $                      |  209,320,463 |   |
| Less: Borrowings under  line of credit at June 30, 2005*(a)*  |       | —                 |              |
| Total assets subject to  fee as of June 30, 2005              |       | 209,320,463            |              |
| Quarterly fee rate                                                 |       | 0.50                   | %                 |
| Gross management fee  before loan servicing fee credit             |       | 1,046,602              |              |
| Less: loan servicing  fee from Gladstone Business Loan LLC         |       | 687,971                |              |
| Management fee before  credit:                                     |       | 358,631                |              |
| **Direct  Credit to Management Fee:**                              |       |                   |              |
| Fee revenue recorded by  Gladstone Management:                     |       | 240,600                |              |
| Net management fee for  the three months ended June 30, 2005: |       | $                      |  118,031     |   |

 

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*(a) **There wereno borrowings under our lines of credit that were held in cash and cashequivalents as of June 30, 2005 for the purpose of satisfying our assetdiversification requirements under the Internal Revenue Code.  If such borrowings did exist then, for thepurposes of calculating the amount of the management fee due to GladstoneManagement, we treat any such amounts as “cash and cash equivalents pledged tocreditors” under the terms of our advisory agreement with Gladstone Management.  As a result, such amounts are deducted fromour total assets for purposes of computing the asset base upon which themanagement fee is determined.*

 

Professional fees, consisting primarily of legal andaudit fees, for the three months ended June 30, 2005 were approximately $134,000,as compared to approximately $37,000 for the three months ended June 30,2004.  The increase is due primarily to anincrease in non-reimbursable legal fees as well as an increase in audit costs,associated with internal control procedures.

 

 Amortization ofdeferred financing costs, in connection with our lines of credit, wereapproximately $101,000 for the three months ended June 30, 2005 andapproximately $99,000 for the three months ended June 30, 2004.

 

 Interestexpense for the three months ended June 30, 2005 was approximately $563,000as compared to approximately $211,000 for the three months ended June 30,2004.  This increase is primarily aresult of increased borrowings under our lines of credit during the threemonths ended June 30, 2005, which borrowings were used, in part, tofinance our increased investments and to a lesser extent, an increase in theinterest rates on our borrowings.

 

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Stockholder related costs for the three months ended June 30, 2005were approximately $16,000, as compared to approximately $11,000 for the threemonths ended June 30, 2004. Stockholder related costs include such recurring items as transfer agentfees, securities fees, electronic filing fees and printing and mailing of proxyreports to stockholders.

 

Directors’ fees for the three months ended June 30,2005 were $27,000, as compared to approximately $28,000 for the three monthsended June 30, 2004.

 

Insurance expense for the three months ended June 30,2005 was approximately $44,000, as compared to approximately $63,000 for thethree months ended June 30, 2004. The decrease is primarily the result ofthe externalization of our management. Effective October 1, 2004, Gladstone Management pays generalinsurance expenses directly and such insurance coverage is included in theservices we receive in consideration for the 2% management fee we pay toGladstone Management.  Insurance expenseincurred during the three months ended June 30, 2005 represents theamortization of our directors and officers insurance premiums, which areexpenses for which we continue to be responsible for following theexternalization of our management.

 

Effective October 1, 2004, all of our employeesbecame employees of Gladstone Management and therefore no salaries or benefitexpenses were incurred by us for the three months ended June 30, 2005 ascompared to approximately $1.3 million for the three months ended June 30,2004.  We reimburse Gladstone Managementfor its employee services as part of the 2% of total assets (excluding cash andcash equivalents pledged to creditors) management fee.

 

Effective October 1, 2004, our external adviser,Gladstone Management, began to pay rent directly and therefore for the three monthsended June 30, 2005 no rent expense was incurred by us as compared toapproximately $35,000 for the three months ended June 30, 2004.  General overhead expenses such as rent arealso included as part of the management fee to Gladstone Management.

 

General and administrative expenses were approximately$64,000 for the three months ended June 30, 2005, as compared toapproximately $247,000 for the three months ended June 30, 2004. This decrease****is primarily a result of GladstoneManagement handling general overhead type expenses.  The expenses for the three months ended June 30,2005 primarily represent direct expenses such as travel related specifically toour portfolio companies, loan evaluation services for our portfolio companies,press releases and backup servicer expenses.

 

**Net Unrealized Appreciation (Depreciation) onDerivative**

 

During the three months ended June 30, 2005, werecorded net unrealized depreciation of approximately $49,000 due to a decreasein the fair market value of our interest rate cap agreement, as compared tounrealized depreciation of approximately $130,000 during the three months endedJune 30, 2004.

 

**Net Unrealized Depreciation on Investments**

 

For the three months ended June 30, 2005, werecorded net unrealized depreciation on investments of approximately $389,000as compared to net unrealized appreciation of approximately $1.0 million, forthe three months ended June 30, 2004. The unrealized depreciation is mainly attributable to the decrease inthe value of our first mortgage loan in Marcal Paper Mills, Inc. and thedecline in ARI Holdings, Inc. partially offset by unrealized appreciationon certain of our syndicated loan participations.

 

**Net Increase inStockholders’ Equity from Operations**

 

Overall, werealized a net increase in stockholders’ equity resulting from operations of approximately$3.9 million for the three months ended June 30, 2005.  Based on a weighted-average of 11,299,010(basic) and 11,578,637 (diluted) shares outstanding, our net increase instockholders’ equity from operations per weighted average common share for thethree months ended June 30, 2005 was $0.35 (basic) and $0.34 (diluted).

 

 For the three months ended June 30,2004, we realizeda net increase in stockholders’ equity resulting from operations ofapproximately $5.6 million.  Based on aweighted-average of 10,105,270 (basic) and 10,301,390 (diluted) shares outstanding,our net increase in stockholders’ equity resulting from operations per weightedaverage common share for the three months ended June 30, 2004 was $0.56 (basic)and $0.54 (diluted).

 

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*Comparisonof the nine months ended June 30, 2005 to the nine months ended June 30,2004*

 

**Investment Income**

 

Investment income for the nine months ended June 30,2005 was approximately $18.1 million as compared to approximately $15.0 millionfor the nine months ended June 30, 2004. This increase was primarily aresult of increased interest income from an increased number of investmentsduring the nine months ended June 30, 2005, as compared to the same periodof the prior year, partially offset by a decline in fee revenue resulting fromthe receipt of such fees by our external investment adviser.

 

Interest income from our investments in debtsecurities of private companies was approximately $16.7 million, includingapproximately $335,000 of PIK interest, for the nine months ended June 30,2005 as compared to approximately $13.1 million for the nine months ended June 30,2004, which included approximately $413,000 of PIK interest. This increase****wasprimarily a result of a net increase in investments of $38.9 million over June 30,2004.  This increase consisted of $130.2million of new investments, offset by principal repayments and investment salesof approximately $91.3 million.

 

The annualized weighted average yield on our portfoliofor the nine months ended June 30, 2005 was 12.5% (without giving effectto PIK interest) and 12.6% (after giving effect to PIK interest). Theannualized weighted average yield on our portfolio for the nine months ended June 30,2004 was 13.6% (without giving effect to PIK interest) and 13.9% (after givingeffect to PIK interest).

 

Interest income from invested cash and cashequivalents for the nine months ended June 30, 2005 was approximately $29,000,as compared to approximately $81,000 for the nine months ended June 30,2004. This decrease****was primarilya result of a decrease in invested cash and cash equivalents resulting from anet increase in investments of $38.9 million over June 30, 2004, whichconsisted of $130.2 million of new investments, offset by principal repaymentsand investment sales of approximately $91.3 million.

 

For the nine months ended June 30, 2005 and June 30,2004, we recorded approximately $336,000 and $331,000, respectively, ininterest income from loans to our employees in connection with the exercise ofemployee stock options.

 

No fee income was recorded for the nine months ended June 30,2005, as compared to approximately $1,010,000 for the nine months ended June 30,2004. This decrease was the result of the externalization of our management,effective October 1, 2004, through the engagement of our affiliateGladstone Management to serve as our external investment adviser.  As noted above, Gladstone Management receivesall fees in connection with our investments and prospective investments, whichfees are offset against the advisory fee payable to Gladstone Management.  During the nine months ended June 30,2005, Gladstone Management received an aggregate of $977,100 in such fees.

 

For the nine months ended June 30, 2005, werecorded approximately $1.1 million of other income as compared to $505,000 ofother income for the nine months ended June 30, 2004.  The income for both periods consisted ofprepayment penalty fees received upon the full repayment of certain loaninvestments ahead of contractual maturity and prepayment fees received upon theearly unscheduled principal repayments ahead of scheduled payment dates which,in both instances were based on a percentage of the outstanding principalamount of the loan at the date of prepayment.

 

**Operating Expenses**

 

Operating expenses for the nine months ended June 30,2005 were approximately $4.5 million, as compared to approximately $4.3 millionfor the nine months ended June 30, 2004. This increase****was mainly a result of an increase ininterest expense, stockholder related costs and professional fees.  Additionally, operating expenses for the ninemonths ended June 30, 2005 reflected a significant reduction in directoperating expenses, as a result of the externalization of our managementeffective October 1, 2004, offset by an increase in loan servicing feesand management fee incurred as a result of this externalization.

 

Loan servicing fees of approximately $1.8 million wereincurred for the nine months ended June 30, 2005.  These fees were incurred in connection with aloan servicing agreement between Gladstone Business Loan LLC (“Business Loan”)and Gladstone Management, which became effective July 12, 2004.  These fees were directly credited against theamount of the management fee due to Gladstone Management.  During the nine months ended June 30,2004, our loan portfolio was serviced under a similar agreement with GladstoneCapital Advisers Inc., our wholly-owned subsidiary, and the fees Business Loanpaid to Gladstone Capital Advisers, Inc. were eliminated uponconsolidation of our financial results.

 

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Effective October 1, 2004, we entered intoan advisory agreement with Gladstone Management whereby Gladstone Managementserves as our external adviser.  Ascompensation for the services of Gladstone Management, we pay GladstoneManagement an annual advisory fee of 1.25% of total assets (as reduced by cashand cash equivalents pledged to creditors), payable in quarterly computedincrements of 0.3125%, and an annual administrative fee of 0.75% of totalassets (as reduced by cash and cash equivalents pledged to creditors), payablein quarterly computed increments of 0.1875%, for a total fee of 2% of totalassets (as reduced by cash and cash equivalents pledged to creditors). Wecontinue to pay direct expenses including, but not limited to, directors’ fees,legal and accounting fees, stockholder related expenses, and directors andofficers insurance.  Under the advisoryagreement, Gladstone Management provides the managerial assistance and otherservices to our portfolio companies that we previously provided through ourwholly-owned subsidiary Gladstone Capital Advisers, and likewise GladstoneManagement directly receives any fees for such services.  Any such fees are credited directly againstthe 2% management fee payable to Gladstone Management.  The 2% management fee is also directlyreduced by the amount of the monthly loan servicing fees we pay to GladstoneManagement. Overall, the management fee due to Gladstone Management cannotexceed 2% of total assets (as reduced by cash and cash equivalents pledged tocreditors) during any given fiscal year. Because we were internally managed at all times prior to October 1,2004, no management fee was recorded for the three months ended June 30,2004, March 31, 2004 or December 31, 2003.

 

Thefollowing table sets forth the quarterly computations of the management fee forthe three months ended June 30, 2005, March 31, 2005 and December 31,2004, based on the quarterly increment of 0.50% (0.3125% quarterly advisory feeplus 0.1875% quarterly administrative fee):

 
| ** **                                                 | ** ** | **June 30,  2005** | ** **  | **March 31,  2005** | ** ** | **December 31,  2004** | ** ** |
|------------------------------------------------------------|------------|-------------------------|-------------|--------------------------|------------|-----------------------------|------------|
| **Fee:**                                                   |       |                    |        |                     |       |                        |       |
| Total assets                                               |       | $                       | 209,320,463 |                     | $          | 213,753,998                 |       | $ | 194,085,591 |   |
| Less: Borrowings under  line of credit *(a)*               |       | —                  |        | (18,644,179              | )          | (22,435,000                 | )          |
| Total assets subject to  fee                               |       | 209,320,463             |        | 195,109,819              |       | 171,650,591                 |       |
| Quarterly fee rate                                         |       | 0.50                    | %           | 0.50                     | %          | 0.50                        | %          |
| Gross management fee  before loan servicing fee credit     |       | 1,046,602               |        | 975,549                  |       | 858,254                     |       |
| Less: loan servicing  fee from Gladstone Business Loan LLC |       | 687,971                 |        | 585,542                  |       | 530,952                     |       |
| Management fee before  credit:                             |       | 358,631                 |        | 390,007                  |       | 327,302                     |       |
| **Direct  Credit to Management Fee:**                      |       |                    |        |                     |       |                        |       |
| Fee revenue recorded by  Gladstone Management:             |       | 240,600                 |        | 450,000                  |       | 286,500                     |       |
| Net management fee for  the three months ended:            |       | $                       | 118,031     |                     | $          | (59,993                     | )          | $ | 40,802 |   |

 

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*(a) **This amountrepresents borrowings under one of our lines of credit that were held in cashand cash equivalents as of March 31, 2005 and December 31, 2004, foreach respective quarter, for the purpose of satisfying our assetdiversification requirements under the Internal Revenue Code. There were noborrowings outstanding for this purpose at June 30, 2005.  Solely for the purposes of calculating theamount of the management fee due to Gladstone Management, we treat any suchamounts as “cash and cash equivalents pledged to creditors” under the terms ofour advisory agreement with Gladstone Management.  As a result, such amounts are deducted fromour total assets for purposes of computing the asset base upon which themanagement fee is determined.*

 

Professional fees, consisting primarily of legal andaudit fees, for the nine months ended June 30, 2005 were approximately $529,000,as compared to approximately $461,000 for the nine months ended June 30,2004.  The increase is due primarily to aincrease in non-reimbursable legal fees and audit costs incurred in connectionwith internal control procedures.

 

Amortization of deferred financing costs, inconnection with our lines of credit, were approximately $284,000 for the ninemonths ended June 30, 2005 and approximately $253,000 for the nine monthsended June 30, 2004.  The increaseis due to the amortization of deferred financing costs for both lines of creditduring the nine months ended June 30, 2005 as compared to the amortizationof deferred financing costs for only one line of credit for the nine monthsended June 30, 2004 and one month of amortization for the line of creditadded in June 2004.

 

Interest expense for the nine months ended June 30,2005 was approximately $1,175,000 as compared to approximately $391,000 for thenine months ended June 30, 2004.  Thisincrease is a result of increased borrowings under our lines of credit duringthe nine months ended June 30, 2005, which borrowings were used, in part,to finance our increased investments, and to a lesser extent, an increase inthe interest rate.

 

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Stockholder related costs for the nine months ended June 30,2005 were approximately $193,000, as compared to approximately $131,000 for thenine months ended June 30, 2004. Stockholder related costs include such recurring items as transfer agentfees, securities fees, electronic filing fees and printing and mailing ofannual reports and proxy statements to stockholders.

 

Directors’ fees for the nine months ended June 30,2005 were $78,000, as compared to approximately $85,000 for the nine monthsended June 30, 2004. This is the result of fewer board meetings heldduring the nine months ended June 30, 2005 as compared to the nine monthsended June 30, 2004.

 

 Insuranceexpense for the nine months ended June 30, 2005 was approximately $134,000,as compared to approximately $201,000 for the nine months ended June 30,2004. The decrease is primarily the result of the externalization of ourmanagement.  Effective October 1,2004, Gladstone Management pays general insurance expenses directly and suchinsurance coverage is included in the services we receive in consideration forthe 2% management fee we pay to Gladstone Management.  Insurance expense incurred during the ninemonths ended June 30, 2005 represents the amortization of our directorsand officers insurance premiums, which are expenses for which we continue to beresponsible for following the externalization of our management.

 

Effective October 1, 2004, all of our employeesbecame employees of Gladstone Management and therefore no salaries or benefitexpenses were incurred by us for the nine months ended June 30, 2005 ascompared to approximately $2.1million for the nine months ended June 30,2004.  We reimburse Gladstone Managementfor its employee services as part of the 2% of total assets (excluding cash andcash equivalents pledged to creditors) management fee.

 

Effective October 1, 2004, our external adviser,Gladstone Management, began to pay rent directly and therefore for the ninemonths ended June 30, 2005 no rent expense was incurred by us as comparedto approximately $107,000 for the nine months ended June 30, 2004.  General overhead expenses such as rent arealso included as part of the management fee to Gladstone Management.

 

General and administrative expenses were approximately$177,000 for the nine months ended June 30, 2005, as compared toapproximately $564,000 for the nine months ended June 30, 2004. Thisdecrease****is primarily a result ofGladstone Management handling general overhead type expenses.  The expenses for the nine months ended June 30,2005 primarily represent direct expenses such as travel related specifically toour portfolio companies, loan evaluation services for our portfolio companies,press releases and backup servicer expenses.

 

**Income Tax Expense**

 

Gladstone Capital Advisers, Inc., a wholly-ownedsubsidiary of Gladstone Capital Corporation, is subject to federal and stateincome taxation on the income it has recorded such as managerial assistance andother fees.  During the nine months endedJune 30, 2005, Gladstone Capital Advisers incurred aggregate federal andstate income taxes of $138,678 resulting from taxable income it received duringthe 2004 fiscal year.  Following theexternalization of our management effective October 1, 2004 substantiallyall revenues previously received by Gladstone Capital Advisers are now receivedby Gladstone Management.  As a result, wedo not anticipate incurring significant tax expense as a result of the activitiesof Gladstone Capital Advisers in the future.

 

**Realized Gain on Sale of Investment**

 

During the nine months ended June 30, 2005, wesold our $975,000 syndicated participation in Burt’s Bees, Inc. for a gainof $9,750 and we sold our $2.0 million syndicated participation in Marietta Corp.for a gain of $20,000, as compared to the nine months ended June 30, 2004in which we bought and sold our $1.0 million investment in Metokote Corporationfor a gain of $12,500.

 

**Net Unrealized Depreciation on Derivative**

 

As a result of the decline in fair market value of ourinterest rate cap agreement, we recorded net unrealized depreciation onderivative of approximately $58,000 for the nine months ended June 30,2005, as compared to net unrealized depreciation of approximately $135,000 forthe five months the investment was held during the nine months ended June 30,2004.

 

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**Net Unrealized Appreciation (Depreciation) onInvestments**

 

For the nine months ended June 30, 2005, werecorded net unrealized depreciation on investments of approximately $298,000as compared to net unrealized depreciation of approximately $849,000, for the ninemonths ended June 30, 2004.  The declinein unrealized depreciation is mainly attributable to the increase in the value ofthe Finn warrant of approximately $593,000, and the fair value of the successfee on Woven Electronics of approximately $322,000 as well as unrealized appreciationof approximately $181,000 on certain of our syndicated loan participations, partiallyoffset by unrealized depreciation of approximately $3.2 million on our seniorsubordinated term debt investment in Finn Corporation.

 

**Net Increase inStockholders’ Equity from Operations**

 

Overall, werealized a net increase in stockholders’ equity resulting from operations ofapproximately $13.2 million for the nine months ended June 30, 2005.  Based on a weighted-average of 11,288,784(basic) and 11,602,986 (diluted) shares outstanding, our net increase instockholders’ equity from operations per weighted average common share for the ninemonths ended June 30, 2005 was $1.17 (basic) and $1.13 (diluted).

 

 For the nine months ended June 30,2004, we realizeda net increase in stockholders’ equity resulting from operations ofapproximately $9.8 million.  Based on aweighted-average of 10,091,576 (basic) and 10,336,733 (diluted) sharesoutstanding, our net increase in stockholders’ equity resulting from operationsper weighted average common share for the nine months ended June 30, 2004was $0.97 (basic) and $0.95 (diluted).

 

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**LIQUIDITYAND CAPITAL RESOURCES**

 

At June 30, 2005, we had investments in debtsecurities of, or loans to 26 private companies, totaling approximately $197.7million (cost basis) of total assets. This number includes approximately $264,000in accrued PIK interest income for the nine months ended June 30, 2005,which as described in “Overview,” is added to the carrying value of ourinvestments.

 

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

 

During November 2004,we extended a $5.5 million loan to Global Materials Technologies, Inc. a manufacturerof steel wool products and metal fibers and also extended a $7.95 million loanto Santana Plastics, Inc., a manufacturer of polyethylene bathroompartitions. We also purchased syndicated loan participations in ValorTelecommunications, a rural telecommunications company, in the amount of $8.0million and Tech Lighting LLC, a manufacturer of low voltage lighting systemsin the amount of $7.0 million. We also received full principal repayments aheadof contractual maturity of $12.25 million from A & G, Inc. and$12.0 million from America’s Water Heater Rentals, Inc., which alsoremitted $1.4 million of prepayment and success fees with its final payment.

 

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

 

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

 

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

 

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

 

In April 2005,we extended a loan of $6.3 million to Defiance Stamping Company, a manufacturerof metal fasteners, and purchased a loan participation in Infor GlobalSolutions of $7.0 million, and an additional $3.0 million of Polar Corporation.

 

In May 2005,we extended a $7.0 million loan to Northern Contours, Inc., a manufacturerof cabinets and purchased a $4.5 million participation in Survey Sampling,telecommunications, and a $5.0 million participation in Penn Engineering, amanufacturer of engines, and an additional purchase of $2.0 million of RegencyGas Services LLC.  We also received afull principal repayment from Woven Electronics LLC on the senior term note ofapproximately $2.5 million.

 

In June 2005,we received the full repayment of our $10.0 million investment in Maidenform, Inc.

 

The followingtable summarizes the new investments and principal repayments that took placeduring the three and nine months ended June 30, 2005:

 
| ** **            | ** ** | **For the three  months ended  June 30, 2005** | ** ** | **For the nine  months ended  June 30, 2005** | ** ** |
|-----------------------|------------|-----------------------------------------------------|------------|----------------------------------------------------|------------|
| New investments       |       | $                                                   | 34,732,083 |                                               | $          | 126,195,458 |   |
| Principal  repayments |       | 18,154,719                                          |       | 77,990,345                                         |       |
| Net new  investments  |       | $                                                   | 16,577,364 |                                               | $          | 48,205,113 |   |

 

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

 
| **Year**   | ** ** | **Amount** | ** **  |
|------------|------------|------------|-------------|
| 2005       |       | $          | 2,046,823   |   |
| 2006       |       | $          | 20,217,440  |   |
| 2007       |       | $          | 30,944,369  |   |
| 2008       |       | $          | 26,355,125  |   |
| 2009       |       | $          | 29,800,034  |   |
| Thereafter |       | $          | 88,386,086  |   |
| Total      |       | $          | 197,749,877 |   |

 

Net cash provided by operating activities for the ninemonths ended June 30, 2005, consisting primarily of the items described in“Results of Operations,” was approximately $2.2 million.  Net cash used in investing activities wasapproximately $68.8 million during the nine months ended June 30, 2005 andprimarily consisted of new investments in the aggregate amount of approximately$126.2 million and the repayment of the repurchase agreement of approximately$21.3 million, partially offset by principal repayments of approximately $78.0million from our portfolio companies. ** **Net cash provided by financingactivities was approximately $1.4 million for the nine months ended June 30,2005 and consisted primarily of cash provided from borrowings on our lines ofcredit, net of repayments, of approximately $13.8 million and the exercise ofstock options which provided approximately $270,000, offset by the payment ofdividends of approximately $12.5 million, additional fees paid to renew a lineof credit of $105,000 and some costs incurred subsequent to the shelf offeringin September 2004.

 

As a result of the above factors, during the ninemonths ended June 30, 2005, cash and cash equivalents decreased fromapproximately $66.0 million at the beginning of the period to approximately $767,000at the end of the period.

 

On October 1, 2004, we settled an outstandingrepurchase agreement (the “Repurchase Agreement”) with Ferris Baker WattsIncorporated for $21,345,997. The interest rate on the Repurchase Agreement was4.25% for a cost of $7,831. In the future, we may or may not use a similar formof repurchase agreement as an investment option or in order to satisfy certainasset diversification requirements and maintain our status as a RIC underSubchapter M of the Internal Revenue Code. At June 30, 2005, we did not use a repurchase agreement as aninvestment option in order to satisfy our asset diversification requirement,nor did we have any borrowings outstanding under our lines of credit at June 30,2005 in order to satisfy our asset diversification requirement.

 

In order to qualify as a RIC and to avoid corporatelevel tax on the income we distribute to our stockholders, we are required,under Subchapter M of the Code, to distribute at least 90% of our ordinaryincome and short-term capital gains to our stockholders on an annual basis. Inaccordance with these requirements, we declared and paid a monthly cashdividend of $0.12 per common share for each of October, November and December 2004and January, February, and March 2005 and a dividend of $0.13 per commonshare for each April, May, and June 2005. In July 2005, we declared a monthly dividend of $0.135 per commonshare for each July, August and September 2005.

 

We anticipate continuing to borrow funds and, fromtime to time issuing additional equity securities to obtain additional capitalto make further investments. To this end, we have an effective registrationstatement on file with the Securities and Exchange Commission (“SEC”) thatwould permit us to issue, through one or more transactions, up to an aggregateof $48.8 million in securities, which may consist of shares of our commonstock, preferred stock, and/or debt securities.

 

**Revolving Credit Facilities**

 

Through our wholly-owned subsidiary, Business Loan, wehave a $100 million revolving credit facility (the “DB Facility”) with DeutscheBank AG, as administrative agent, which matured on May 26, 2005 and wasrenewed by us for another year, maturing on May 26, 2006.  Pursuant to the DB Facility, Business Loan haspledged the loans it holds to secure future advances by certain institutionallenders.  Interest rates charged on theadvances under the DB Facility will be based on the London Interbank OfferedRate (“LIBOR”), the Prime Rate or the Federal Funds Rate, depending on marketconditions, and will adjust periodically. As of June 30, 2005, our outstanding principal balance under this DBFacility was approximately $54.6 million at an interest rate of 3.2%.  Available borrowings are subject to variousconstraints imposed by Deutsche Bank AG, based on the aggregate loan balancepledged by Business Loan, which varies as loans or added and repaid, regardlessof whether such repayments are early prepayment or are made as contractuallyrequired.  At June 30, 2005, theremaining borrowing capacity available under the DB Facility was approximately$33.3 million.  We are in the process ofnegotiating a renewal of this DB Facility, however there can be no guaranteethat we will be able to renew the DB Facility on terms that are favorable tous, if at all.  In the event that we arenot able to renew the DB Facility this could have a material adverse impact onour liquidity and ability to fund new investments.

 

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The DB Facility contains covenants that, among otherthings, require Business Loan to maintain its status as a separate entity;prohibit certain significant corporate transactions (such as mergers,consolidations, liquidations or dissolutions); and restrict material changes toour credit and collection policies.  TheDB Facility 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 June 30, 2005, Business Loan wasin compliance with all of the DB Facility covenants.  We currently intend to securitize all of theloans held by Business Loan and to use the proceeds from the securitization topay down any amounts then outstanding under the revolving credit facility.  However, there can be no assurance that wewill be able to successfully securitize any of these loans on terms acceptableto us, if at all.

 

The administrative agent also requires that anyinterest or principal payments on pledged loans be remitted directly by theborrower into a lockbox account with the Bank of New York as custodian.  Deutsche Bank AG is also the trustee of theaccount and once a month remits the collected funds to the Company. For the ninemonths ended June 30, 2005, the amount due from custodian increased byapproximately $11.0 million.

 

Gladstone Management, our affiliated external adviser,services the loans pledged under the DB Facility.  As a condition to this servicing arrangement,we executed a performance guaranty pursuant to which we guaranteed thatGladstone Management would comply fully with all of its obligations under thefacility. The performance guaranty requires us to maintain a minimum net worthof $100 million and to maintain “asset coverage” with respect to “seniorsecurities representing indebtedness” of at least 200%, in accordance with Section 18of the 1940 Act.  As of June 30, 2005,we were in compliance with our covenants under the performance guaranty.

 

We also have a $15.0 million line of credit agreementwith Branch Banking and Trust Company (“BB&T Agreement”) which matured in June 2005.  The line of credit was extended through September 30,2005.  Interest on outstanding borrowingsis based on the one month LIBOR plus 2.5% per annum.  The unused portion of the line of credit issubject to a fee of 0.2% per annum.  TheBB&T Agreement requires us to meet and maintain certain covenants andratios with respect to leverage and liquidity. As of June 30, 2005, therewere no borrowings outstanding under the BB&T line of credit with a remainingborrowing capacity available under the BB&T Agreement of $15.0 million.

 

Both lines of credit are availablefor general corporate purposes.

 

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

 

We are subject to financial market risks, includingchanges in interest rates.  We expect that ultimately approximately 20% ofthe loans in our portfolio will be made at fixed rates, with approximately 80%made at variable rates.  Currently our portfolio has approximately 17% ofthe total of the loan portfolio cost basis at fixed rates, approximately 43% ofthe total loan portfolio cost basis at variable rates with a floor.Approximately 4% of the total loan portfolio cost basis at a variable rate witha floor and ceiling, and the remaining 37% of the total loan portfolio cost basisat variable rates.

 

In addition, we have two variable rate borrowingfacilities.  We have a $100 millionrevolving credit facility with Deutsche Bank AG which matures in May 2006.  We also have a $15 million line of creditagreement with Branch Banking and Trust Company which matures in September 2005.

 

In February 2004,we entered into an interest rate cap agreement in order to fulfill anobligation under our line of credit to enter into certain hedging transactionsin connection with our borrowings under the line of credit.  We purchasedthis interest rate cap agreement with a notional amount of $35 million for aone-time, up-front payment of $304,000.  The interest rate cap agreemententitles us to receive payments, if any, equal to the amount by which interestpayments on $35 million at the pointwhich one month LIBOR exceed the payments on $35 million at 5%. The cap expires in February 2009.  This interest rate capagreement effectively caps our interest payments on our line of creditborrowing, up to the notional amount of the interest rate cap, at five percent. This mitigates our exposure to increases in interest rates on ourborrowings on our lines of credit, which are at variable rates.  At June 30, 2005, the cap agreement hada fair market value of $31,734 and a current notional amount of $29.5 million.  At June 30, 2005, the one month LIBOR rate wasapproximately 3.34%.

 

Toillustrate the potential impact of changes in interest rates on our netincrease in stockholders’ equity resulting from operations, we have performedthe following analysis, which assumes that our balance sheet remains constantand no further actions beyond the interest rate cap agreement are taken toalter our existing interest rate sensitivity. Under this analysis, a hypothetical increase in the one month LIBOR by1% would increase our net increase in stockholders’ equity resulting fromoperations by approximately $1.1 million or 8.1%, over the next twelve months,compared to the net increase in stockholders’ equity resulting from operationsfor the twelve months ended June 30, 2005. A hypothetical decrease in the one month LIBOR by 1% would decrease netincrease in stockholders’ equity resulting from operations by approximately $1.1million, or 8.1%, over the next twelve months, compared to the net increase instockholders’ equity resulting from operations for the twelve months ended June 30,2005.  Although management believes thatthis analysis is indicative of our existing interest rate sensitivity, it doesnot adjust for potential changes in credit quality, size and composition of ourloan portfolio on the balance sheet and other business developments that couldaffect net increase in stockholders’ equity resulting from operations.  Accordingly, no assurances can be given thatactual results would not differ materially from the results under thishypothetical analysis.

 

In the event that we securitize a portion of our loanportfolio, we believe that we will likely be required to enter into furtherhedging arrangements in the future with respect to securitized loans.  While hedging activities may mitigate ourexposure to adverse fluctuations in interest rates, certain hedgingtransactions that we may enter into in the future, such as interest rate swapagreements, may also limit our ability to participate in the benefits of lowerinterest rates with respect to our portfolio of investments.

 

**ITEM 4. CONTROLS ANDPROCEDURES.**

 

As of June 30,2005, we, including our Chief Executive Officer and Chief Financial Officer,evaluated the effectiveness of the design and operation of our disclosurecontrols and procedures.  Based on thatevaluation, our management, including the Chief Executive Officer and ChiefFinancial Officer, concluded that our disclosure controls and procedures wereeffective in timely alerting management, including the Chief Executive Officerand Chief Financial Officer, of material information about us required to beincluded in periodic Securities and Exchange Commission filings.  However, in evaluating the disclosurecontrols and procedures, management recognized that any controls andprocedures, no matter how well designed and operated can provide onlyreasonable assurance of achieving the desired control objectives, andmanagement necessarily was required to apply its judgment in evaluating thecost-benefit relationship of possible controls and procedures.

 

There have been nochanges in our internal control over financial reporting that occurred duringthe quarter ended June 30, 2005, that have materially affected, or arereasonably likely to materially affect, our internal control over financialreporting.

 

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**PART II–OTHERINFORMATION**

 

**ITEM 1. LEGAL PROCEEDINGS.**

 

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

 

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

 

Notapplicable.

 

**ITEM 3. DEFAULTS UPONSENIOR SECURITIES.**

 

Notapplicable.

 

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

 

Notapplicable.

 

**ITEM 5. OTHERINFORMATION.**

 

Notapplicable

 

**ITEM 6. EXHIBITS**

 

See theexhibit index.

 

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**SIGNATURE**

 

Pursuant tothe requirements of the Securities Exchange Act of 1934, the registrant hasduly caused this report to be signed on its behalf by the undersigned thereuntoduly authorized.

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

 

Date: August 3, 2005

 

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**EXHIBIT INDEX**

 
| **Exhibit** | ** ** | **Description**                                                                                                                                                                                                                                                    |
|-------------|------------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|        |       |                                                                                                                                                                                                                                                               |
| 3.1         |       | Articles of Amendment and Restatement of  the Articles of Incorporation, incorporated by reference to Exhibit a.2  to Pre-Effective Amendment No. 1 to the Registration Statement on Form N-2  (File No. 333-63700), filed July 27, 2001. |
|        |       |                                                                                                                                                                                                                                                               |
| 3.2         |       | By-laws, incorporated by reference to Exhibit b  to Pre-Effective Amendment No. 1 to the Registration Statement on Form N-2  (File No. 333-63700), filed July 27, 2001.                                                                   |
|        |       |                                                                                                                                                                                                                                                               |
| 3.3         |       | Amendment to by-laws, incorporated by  reference to Exhibit 3.3 to the Company’s Quarterly Report on Form 10-Q  for the quarter ended December 31, 2003 (File No. 814-00237), filed  February 17, 2004.                              |
|        |       |                                                                                                                                                                                                                                                               |
| 10.30       |       | Amendment No. 5, Consent and Waiver  to Credit Agreement dated as of May 27, 2005.                                                                                                                                                                       |
|        |       |                                                                                                                                                                                                                                                               |
| 11          |       | Computation of Per Share Earnings  (included in the notes to the unaudited financial statements contained in  this report).                                                                                                                                        |
|        |       |                                                                                                                                                                                                                                                               |
| 31.1        |       | Certification of Chief Executive Officer  pursuant to section 302 of The Sarbanes-Oxley Act of 2002.                                                                                                                                                          |
|        |       |                                                                                                                                                                                                                                                               |
| 31.2        |       | Certification of Chief Financial Officer  pursuant to section 302 of The Sarbanes-Oxley Act of 2002.                                                                                                                                                          |
|        |       |                                                                                                                                                                                                                                                               |
| 32.1        |       | Certification of Chief Executive Officer  pursuant to section 906 of The Sarbanes-Oxley Act of 2002.                                                                                                                                                          |
|        |       |                                                                                                                                                                                                                                                               |
| 32.2        |       | Certification of Chief Financial Officer  pursuant to section 906 of The Sarbanes-Oxley Act of 2002.                                                                                                                                                          |

 

All otherexhibits for which provision is made in the applicable regulations of theSecurities and Exchange Commission are not required under the relatedinstruction or are inapplicable and therefore have been omitted.

 

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