**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON,D.C. 20549**

 

**FORM 10-Q**

 
| **ý****QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES  EXCHANGE ACT OF 1934** |
|--------------------------------------------------------------------------------------------------------|
|                                                                                                   |
| **FOR  THE QUARTER ENDED DECEMBER 31, 2003.**                                                          |
|                                                                                                   |
| **o****TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES  EXCHANGE ACT OF 1934**     |
|                                                                                                   |
| **COMMISSION  FILE NUMBER: 814-00237**                                                                 |

 

**GLADSTONE CAPITAL CORPORATION**

(Exact name of registrant as specified in its charter)

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

 

Indicate by checkmark whether the registrant (1) has filed all reports required to be filed bySection 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding12 months and (2) has been subject to such filing requirements for the past 90days. Yes ý No o.

 

Indicate by checkmark whether the registrant is an accelerated filer (as defined in Rule 12 b-2of the Exchange Act).

Yes ý No o.

 

Indicate thenumber of shares outstanding of each of the issuer’s classes of common stock,as of the latest practicable date.  Thenumber of shares of the issuer’s Common Stock, $0.001 par value, outstanding asof February 11, 2004 was 10,081,844.

 

 

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**GLADSTONECAPITAL CORPORATION**

 

**TABLEOF CONTENTS**

 
| PART I.    | FINANCIAL INFORMATION                                                                                                     |   |
|------------|---------------------------------------------------------------------------------------------------------------------------|--------|
|       |                                                                                                                      |   |
| Item 1.    | Financial  Statements (Unaudited)                                                                                         |   |
|       |                                                                                                                      |   |
|       | Consolidated Balance Sheets  as of December 31, 2003 and September 30, 2003                                               |   |
|       | Schedules  of Investments as of December 31, 2003 and September 30, 2003                                                  |   |
|       | Consolidated  Statements of Operations for the three months ended December 31, 2003 and  December 31, 2002                |   |
|       | Consolidated  Statements of Stockholders’ Equity for the three months ended December 31,  2003 and December 31, 2002 |   |
|       | Consolidated  Statements of Cash Flows for the three months ended December 31, 2003 and  December 31, 2002                |   |
|       | Financial  Highlights for the three months ended December 31, 2003 and December 31, 2002                                  |   |
|       | Notes to  Consolidated Financial Statements                                                                               |   |
|       |                                                                                                                      |   |
| Item  2.   | Management’s  Discussion and Analysis of Financial Condition and Results of Operations                               |   |
|       |                                                                                                                      |   |
|       | Overview                                                                                                                  |   |
|       | Results  of Operations                                                                                                    |   |
|       | Liquidity and Capital  Resources                                                                                          |   |
|       |                                                                                                                      |   |
| Item  3.   | Quantitative  and Qualitative Disclosure About Market Risk                                                                |   |
|       |                                                                                                                      |   |
| Item 4.    | Controls and  Procedures                                                                                                  |   |
|       |                                                                                                                      |   |
| PART  II.  | OTHER  INFORMATION                                                                                                        |   |
|       |                                                                                                                      |   |
| Item 1.    | Legal Proceedings                                                                                                         |   |
|       |                                                                                                                      |   |
| Item  2.   | Changes  in Securities 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 and  Reports on Form 8-K                                                                                         |   |
|       |                                                                                                                      |   |
| SIGNATURES |                                                                                                                      |

 

2

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**PARTI—FINANCIAL INFORMATION**

 

**Gladstone Capital Corporation**

 

**Consolidated Financial Statements**

 

**(Unaudited)**

 

**December 31, 2003**

 

**CONTENTS**

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

 

3

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**GLADSTONE CAPITAL CORPORATION**

 

**CONSOLIDATEDBALANCE SHEETS**

 
|                                                                                                                                     |   | **(Unaudited)**        |        | **(Audited)**           |   |
|------------------------------------------------------------------------------------------------------------------------------------------|--------|------------------------|-------------|-------------------------|--------|
|                                                                                                                                     |   | **December 31,  2003** |        | **September 30,  2003** |   |
| **ASSETS**                                                                                                                               |   |                   |        |                    |   |
| Investments at  fair value (Cost 12/31/2003: $120,663,277; 9/30/2003: $109,529,893)                                                      |   | $                      | 118,883,375 |                    | $      | 109,307,553 |   |
| Cash and cash  equivalents                                                                                                               |   | 7,252,566              |        | 21,143,972              |   |
| Cash and cash  equivalents pledged to creditors                                                                                          |   | 95,001,094             |        | 80,022,249              |   |
| Interest  receivable – investments in debt securities                                                                               |   | 1,043,095              |        | 1,041,943               |   |
| Interest  receivable – cash and cash equivalents                                                                                    |   | 1,302                  |        | 955                     |   |
| Interest  receivable – officers                                                                                                     |   | 19,543                 |        | 108,657                 |   |
| Due from  custodian                                                                                                                      |   | 37,500                 |        | 1,207,000               |   |
| Prepaid assets                                                                                                                           |   | 1,473,355              |        | 1,479,815               |   |
| Other assets                                                                                                                             |   | 499,471                |        | 254,519                 |   |
|                                                                                                                                     |   |                   |        |                    |   |
| **TOTAL ASSETS**                                                                                                                         |   | $                      | 224,211,301 |                    | $      | 214,566,663 |   |
|                                                                                                                                     |   |                   |        |                    |   |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                                                            |   |                   |        |                    |   |
|                                                                                                                                     |   |                   |        |                    |   |
| **LIABILITIES**                                                                                                                          |   |                   |        |                    |   |
| Accounts payable                                                                                                                         |   | $                      | 91,052      |                    | $      | 23,247 |   |
| Dividends  payable                                                                                                                       |   | —                 |        | 3,327,009               |   |
| Accrued expenses  and deferred liabilities                                                                                               |   | 2,059,550              |        | 1,965,025               |   |
| Repurchase  agreement                                                                                                                    |   | 93,101,000             |        | 78,449,000              |   |
|                                                                                                                                     |   |                   |        |                    |   |
| **Total Liabilities**                                                                                                                    |   | $                      | 95,251,602  |                    | $      | 83,764,281 |   |
|                                                                                                                                     |   |                   |        |                    |   |
| **STOCKHOLDERS’  EQUITY**                                                                                                           |   |                   |        |                    |   |
| Common stock,  $0.001 par value, 50,000,000 shares authorized and 10,081,844 and 10,071,844  shares issued and outstanding, respectively |   | $                      | 10,082      |                    | $      | 10,082 |   |
| Capital in excess  of par value                                                                                                          |   | 140,416,674            |        | 140,416,674             |   |
| Notes receivable  – officers                                                                                                        |   | (8,882,688             | )           | (8,985,940              | )      |
| Net unrealized  depreciation on investments                                                                                              |   | (1,779,902             | )           | (222,340                | )      |
| Undistributed/(overdistributed)  net investment income                                                                                   |   | (804,467               | )           | (416,094                | )      |
|                                                                                                                                     |   |                   |        |                    |   |
| **Total Stockholders’ Equity**                                                                                                      |   | $                      | 128,959,699 |                    | $      | 130,802,382 |   |
|                                                                                                                                     |   |                   |        |                    |   |
| **TOTAL  LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                                                     |   | $                      | 224,211,301 |                    | $      | 214,566,663 |   |

 

SEE ACCOMPANYING NOTES.

 

4

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**GLADSTONECAPITAL CORPORATION**

**SCHEDULE OFINVESTMENTS**

**ASOF DECEMBER 31, 2003(UNAUDITED)**

 
| **Company (1)**                                                               |   | **Industry**                                                 |   | **Investment**                          |   | **Cost**   |        | **Fair Value** |   |
|-------------------------------------------------------------------------------|--------|--------------------------------------------------------------|--------|-----------------------------------------|--------|------------|-------------|----------------|--------|
|                                                                          |   |                                                         |   |                                    |   |       |        |           |   |
| America’s Water Heater Rentals, LLC                                      |   | Water heater rentals and servicing                           |   | Senior Term Debt  (2)(4)                |   | $          | 12,000,000  |           | $      | 12,000,000 |   |
|                                                                          |   |                                                         |   |                                    |   |       |        |           |   |
| ARI Holdings,  Inc.                                                           |   | Manufacturing-auto  parts                                    |   | Senior Term Debt  (2)(3)(4)             |   | 3,547,683  |        | 3,543,248      |   |
|                                                                          |   |                                                         |   | Senior Term Debt (2)(4)                 |   | 1,425,000  |        | 1,423,219      |   |
|                                                                          |   |                                                         |   |                                    |   |       |        |           |   |
| Burt’s Bees,  Inc.                                                       |   | Personal and household products                              |   | Senior Term Debt                        |   | 1,000,000  |        | 1,005,000      |   |
|                                                                          |   |                                                         |   |                                    |   |       |        |           |   |
| Coyne International Enterprises                                               |   | Industrial  services                                         |   | Senior Term Debt  (2)(3)(4)             |   | 15,499,837 |        | 15,325,464     |   |
|                                                                          |   |                                                         |   |                                    |   |       |        |           |   |
| Finn Corporation                                                              |   | Manufacturing-landscape equipment                            |   | Senior  Subordinated Term Debt(4)       |   | 10,500,000 |        | 9,121,875      |   |
|                                                                          |   |                                                         |   | Common Stock  Warrants for 2% ownership |   | 37,000     |        | 435,649        |   |
|                                                                          |   |                                                         |   |                                    |   |       |        |           |   |
| Fugate & Associates, Inc.                                                 |   | Imaging supplies                                             |   | Senior Term Debt (4)                    |   | 3,325,000  |        | 3,325,000      |   |
|                                                                          |   |                                                         |   | Senior Term Debt (4)                    |   | 1,666,666  |        | 1,666,666      |   |
|                                                                          |   |                                                         |   |                                    |   |       |        |           |   |
| GQM Acquisition Corp. d/b/a Gamill, Inc.                                      |   | Designer and assembler of quilting machines and  accessories |   | Senior Term Debt                        |   | 7,500,000  |        | 7,500,000      |   |
|                                                                          |   |                                                         |   |                                    |   |
| Senior Term Debt                                                              |   | 7,000,000                                                    |   | 7,000,000                               |
|                                                                          |   |                                                         |   |                                    |   |       |        |           |   |
| Home Care  Supply, Inc.                                                       |   | Medical  equipment rental                                    |   | Senior Term Debt  (2)(4)(5)             |   | 18,000,000 |        | 18,494,100     |   |
|                                                                          |   |                                                         |   |                                    |   |       |        |           |   |
| Inca Metal Products Corp. Kingway Acquisition, Inc.  Clymer Acquisition, Inc. |   | Material handling and storage products                       |   | Senior Term Debt  (2)(4)                |   | 2,500,000  |        | 2,246,875      |   |
|                                                                          |   |                                                         |   |                                    |   |       |        |           |   |
| Marcal Paper  Mills, Inc.                                                     |   | Manufacturing-paper products                                 |   | Senior Term Debt (2)(4)                 |   | 6,975,000  |        | 6,155,438      |   |
|                                                                          |   |                                                         |   | First Mortgage Debt (3)                 |   | 9,187,091  |        | 9,187,091      |   |
|                                                                          |   |                                                         |   |                                    |   |       |        |           |   |
| Mistras  Holdings, Inc.                                                       |   | Nondestructive testing instruments, systems and  services    |   |                                    |   |       |        |           |   |
| Senior Term Debt(2)(4)                                                        |   | 10,000,000                                                   |   | 9,987,500                               |
| Senior Term Debt (2)(4)                                                       |   | 5,000,000                                                    |   | 4,993,750                               |
|                                                                          |   |                                                         |   |                                    |   |       |        |           |   |
| Wingstop Restaurants  International, Inc.                                     |   | Restaurant – fast food                                  |   | Senior Term Debt (4)                    |   | 3,500,000  |        | 3,482,500      |   |
| Senior Debt (4)                                                               |   | 2,000,000                                                    |   | 1,990,000                               |
| Totals                                                                        |   |                                                         |   |                                    |   | $          | 120,663,277 |           | $      | 118,883,375 |   |

 

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

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

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

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

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

SEE ACCOMPANYING NOTES.

 

5

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**GLADSTONE CAPITAL CORPORATION**

**SCHEDULE OF INVESTMENTS**

**AS OF SEPTEMBER 30, 2003**

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

 

----

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

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

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

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

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

 

SEE ACCOMPANYING NOTES.

 

6

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**GLADSTONECAPITAL CORPORATION**

 

**CONSOLIDATED STATEMENT OFOPERATIONS**

 

**(UNAUDITED)**

 
|                                                                                       |   | **Three Months  Ended December 31,  2003** |      | **Three Months  Ended December 31,  2002** |   |
|--------------------------------------------------------------------------------------------|--------|--------------------------------------------|-----------|--------------------------------------------|--------|
| **INVESTMENT INCOME**                                                                      |   |                                       |      |                                       |   |
| Interest income – investments                                                         |   | $                                          | 3,539,696 |                                       | $      | 2,927,663 |   |
| Interest income – cash and cash equivalents                                           |   | 48,621                                     |      | 198,166                                    |   |
| Interest income – notes receivable from officers                                      |   | 108,632                                    |      | 109,603                                    |   |
| Managerial assistance fees                                                                 |   | 255,000                                    |      | —                                     |   |
| Other income                                                                               |   | 16,000                                     |      | —                                     |   |
| Total Investment Income                                                                    |   | $                                          | 3,967,949 |                                       | $      | 3,235,432 |   |
|                                                                                       |   |                                       |      |                                       |   |
| **EXPENSES**                                                                               |   |                                       |      |                                       |   |
| Salaries and benefits                                                                      |   | $                                          | 390,707   |                                       | $      | 433,240 |   |
| Rent                                                                                       |   | 37,760                                     |      | 54,620                                     |   |
| Professional fees                                                                          |   | 177,658                                    |      | 114,690                                    |   |
| Directors fees                                                                             |   | 24,333                                     |      | 13,500                                     |   |
| Insurance                                                                                  |   | 74,011                                     |      | 71,154                                     |   |
| Stockholder related costs                                                                  |   | 52,660                                     |      | 11,565                                     |   |
| Financing fees                                                                             |   | 144,996                                    |      | —                                     |   |
| General and administrative                                                                 |   | 127,188                                    |      | 124,509                                    |   |
| Total  Expenses                                                                       |   | $                                          | 1,029,313 |                                       | $      | 823,278 |   |
|                                                                                       |   |                                       |      |                                       |   |
| **NET INVESTMENT INCOME**                                                                  |   | $                                          | 2,938,636 |                                       | $      | 2,412,154 |   |
|                                                                                       |   |                                       |      |                                       |   |
| Net unrealized depreciation on investments                                                 |   | (1,557,562                                 | )         | —                                     |   |
|                                                                                       |   |                                       |      |                                       |   |
| **NET  INCREASE (DECREASE) IN STOCKHOLDERS’ EQUITY RESULTING FROM OPERATIONS**        |   | $                                          | 1,381,074 |                                       | $      | 2,412,154 |   |
|                                                                                       |   |                                       |      |                                       |   |
| **NET  INCREASE IN STOCKHOLDERS’ EQUITY RESULTING FROM OPERATIONS PER COMMON SHARE:** |   |                                       |      |                                       |   |
| Basic                                                                                      |   | $                                          | 0.14      |                                       | $      | 0.24 |   |
| Diluted                                                                                    |   | $                                          | 0.13      |                                       | $      | 0.24 |   |
|                                                                                       |   |                                       |      |                                       |   |
| **WEIGHTED  AVERAGE SHARES OF COMMON STOCK OUTSTANDING:**                                  |   |                                       |      |                                       |   |
| Basic                                                                                      |   | 10,081,844                                 |      | 10,071,844                                 |   |
| Diluted                                                                                    |   | 10,333,529                                 |      | 10,124,197                                 |   |

 

SEE ACCOMPANYING NOTES.

 

7

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**GLADSTONECAPITAL CORPORATION**

 

**CONSOLIDATED STATEMENTSOF STOCKHOLDERS’ EQUITY**

 

**(UNAUDITED)**

 
|                                                                |   | **Common Stock** |   | **Capital in  Excess of  Par Value** |   | **Notes  Receivable  From Sale of  Common  Stock** |   | **Under/(Over)   Distributed Net  Investment  Income** |   | **Unrealized  Appreciation/   (Depreciation)  of Investments** |       | **Total   Stockholders’  Equity** |   |
|---------------------------------------------------------------------|--------|------------------|--------|--------------------------------------|--------|----------------------------------------------------|--------|--------------------------------------------------------|--------|----------------------------------------------------------------|------------|----------------------------------------|--------|
| **Shares**                                                          |   | **Amount**       |
|                                                                |   |             |   |                                 |   |                                               |   |                                                   |   |                                                           |       |                                   |   |   |   |
| Balance at September 30, 2002                                       |   | 10,071,844       |   | $                                    | 10,072 |                                               | $      | 140,266,684                                            |   | $                                                              | (8,983,796 | )                                      | $      | (629,687 | ) | $ | — |   | $ | 130,663,273 |   |
|                                                                |   |             |   |                                 |   |                                               |   |                                                   |   |                                                           |       |                                   |   |   |   |
| Net Increase in Stockholders’ Equity Resulting from Operations |   |             |   |                                 |   |                                               |   |                                                   |   | 2,412,154                                                      |       |                                   |   | 2,412,154 |   |
|                                                                |   |             |   |                                 |   |                                               |   |                                                   |   |                                                           |       |                                   |   |   |   |
| Distributions Declared ($0.23 per common share)                     |   |             |   |                                 |   |                                               |   |                                                   |   | (2,316,523                                                     | )          | —                                 |   | (2,316,523 | ) |
|                                                                |   |             |   |                                 |   |                                               |   |                                                   |   |                                                           |       |                                   |   |   |   |
| Balance at December 31, 2002                                        |   | 10,071,844       |   | $                                    | 10,072 |                                               | $      | 140,266,684                                            |   | $                                                              | (8,983,796 | )                                      | $      | (534,056 | ) | $ | — |   | $ | 130,758,904 |   |
|                                                                |   |             |   |                                 |   |                                               |   |                                                   |   |                                                           |       |                                   |   |   |   |
| Balance at September 30, 2003                                       |   | 10,081,844       |   | $                                    | 10,082 |                                               | $      | 140,416,674                                            |   | $                                                              | (8,985,940 | )                                      | $      | (416,094 | ) | $ | (222,340 | ) | $ | 130,802,382 |   |
|                                                                |   |             |   |                                 |   |                                               |   |                                                   |   |                                                           |       |                                   |   |   |   |
| Repayment of Principal on Notes Receivable                          |   |             |   |                                 |   |                                               |   | 103,252                                                |   |                                                           |       |                                   |   | 103,252 |   |
|                                                                |   |             |   |                                 |   |                                               |   |                                                   |   |                                                           |       |                                   |   |   |   |
| Net Increase in Stockholders’ Equity Resulting from Operations |   |             |   |                                 |   |                                               |   |                                                   |   | 2,938,636                                                      |       | (1,557,562                             | )      | 1,381,074 |   |
|                                                                |   |             |   |                                 |   |                                               |   |                                                   |   |                                                           |       |                                   |   |   |   |
| Distributions Declared ($0.33 per common share)                     |   |             |   |                                 |   |                                               |   |                                                   |   | (3,327,009                                                     | )          |                                   |   | (3,327,009 | ) |
|                                                                |   |             |   |                                 |   |                                               |   |                                                   |   |                                                           |       |                                   |   |   |   |
| Balance at December 31, 2003                                        |   | 10,081,844       |   | $                                    | 10,082 |                                               | $      | 140,416,674                                            |   | $                                                              | (8,882,688 | )                                      | $      | (804,467 | ) | $ | (1,779,902 | ) | $ | 128,959,699 |   |

 

SEE ACCOMPANYING NOTES.

 

8

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**GLADSTONECAPITAL CORPORATION**

 

**CONSOLIDATED STATEMENT OFCASH FLOWS**

 

**(UNAUDITED)**

 
|                                                                                                                                                              |   | **Three Months  Ended  December 31, 2003** |        | **Three Months  Ended  December 31, 2002** |   |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|--------------------------------------------|-------------|--------------------------------------------|--------|
| **CASH  FLOWS FROM OPERATING ACTIVITIES**                                                                                                                         |   |                                       |        |                                       |   |
| Net increase (decrease) in stockholders’ equity resulting from  operations                                                                                   |   | $                                          | 1,381,074   |                                       | $      | 2,412,154 |   |
| Adjustments to reconcile net increase (decrease) in  stockholders’ equity resulting from operations to net cash provided by (used  in) operating activities: |   |                                       |        |                                       |   |
| Depreciation                                                                                                                                                      |   | 7,091                                      |        | 6,765                                      |   |
| Change in net unrealized depreciation                                                                                                                             |   | 1,557,562                                  |        |                                       |   |
| Decrease (increase) in interest receivable                                                                                                                        |   | 87,615                                     |        | (79,148                                    | )      |
| Decrease in funds due from custodian                                                                                                                              |   | 1,169,500                                  |        |                                       |   |
| Increase in other assets                                                                                                                                          |   | (250,476                                   | )           | (64,022                                    | )      |
| (Increase) decrease in prepaid assets                                                                                                                             |   | (52,204                                    | )           | 2,132                                      |   |
| Increase in accounts payable                                                                                                                                      |   | 67,805                                     |        | —                                     |   |
| Increase in accrued expenses and deferred liabilities                                                                                                             |   | 94,525                                     |        | 184,737                                    |   |
| Increase in investment balance due to payment in kind interest                                                                                                    |   | (137,551                                   | )           | (208,080                                   | )      |
| Net Cash Provided by Operating Activities                                                                                                                         |   | $                                          | 3,924,941   |                                       | $      | 2,254,538 |   |
|                                                                                                                                                              |   |                                       |        |                                       |   |
| **CASH  FLOWS FROM INVESTING ACTIVITIES**                                                                                                                         |   |                                       |        |                                       |   |
| Purchase of furniture and equipment, net                                                                                                                          |   | $                                          | (1,567      | )                                          | $      | (38,823 | ) |
| Purchase of investments                                                                                                                                           |   | (15,500,000                                | )           | (4,000,000                                 | )      |
| Principal repayments on investments                                                                                                                               |   | 4,504,167                                  |        | 100,000                                    |   |
| Proceeds from repurchase agreements                                                                                                                               |   | 93,101,000                                 |        | 39,205,697                                 |   |
| Repayment of repurchase agreements                                                                                                                                |   | (78,449,000                                | )           | (39,198,719                                | )      |
| Receipt of principal on notes receivable – officers                                                                                                          |   | 103,252                                    |        | —                                     |   |
| Net Cash Provided by (Used in) Investing Activities                                                                                                               |   | $                                          | 3,757,852   |                                       | $      | (3,931,845 | ) |
|                                                                                                                                                              |   |                                       |        |                                       |   |
| **CASH  FLOWS FROM FINANCING ACTIVITIES**                                                                                                                         |   |                                       |        |                                       |   |
|                                                                                                                                                              |   |                                       |        |                                       |   |
| Prepaid financing fees                                                                                                                                            |   | $                                          | 58,664      |                                       | $      | — |   |
| Distributions paid                                                                                                                                                |   | (6,654,018                                 | )           | (2,115,087                                 | )      |
| Net Cash (Used in) Financing Activities                                                                                                                           |   | $                                          | (6,595,354  | )                                          | $      | (2,115,087 | ) |
|                                                                                                                                                              |   |                                       |        |                                       |   |
| **NET  INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS**                                                                                                         |   | $                                          | 1,087,439   |                                       | $      | (3,792,394 | ) |
|                                                                                                                                                              |   |                                       |        |                                       |   |
| **CASH  AND CASH EQUIVALENTS, BEGINNING OF PERIOD**                                                                                                               |   | $                                          | 101,166,221 |                                       | $      | 91,929,328 |   |
|                                                                                                                                                              |   |                                       |        |                                       |   |
| **CASH  AND CASH EQUIVALENTS, END OF PERIOD (Note 8)**                                                                                                            |   | $                                          | 102,253,660 |                                       | $      | 88,136,934 |   |

 

SEE ACCOMPANYING NOTES.

 

9

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**GLADSTONECAPITAL CORPORATION**

 

**FINANCIAL HIGHLIGHTS**

 

**(UNAUDITED)**

 
|                                                                      |   | **Three Months  Ended December 31, 2003** |        | **Three Months  Ended December 31, 2002** |   |
|---------------------------------------------------------------------------|--------|-------------------------------------------|-------------|-------------------------------------------|--------|
| Per Share  Data(1)                                                        |   |                                      |        |                                      |   |
| Net asset value  at beginning of period                                   |   | $                                         | 12.97       |                                      | $      | 12.97 |   |
| Net investment income                                                     |   | 0.29                                      |        | 0.24                                      |   |
| Net unrealized loss on investments                                        |   | (0.15                                     | )           | —                                    |   |
| Distributions from net investment income                                  |   | (0.33                                     | )           | (0.23                                     | )      |
| Repayment of principal on notes receivable                                |   | 0.01                                      |        | —                                    |   |
| Net asset value at end of period                                          |   | $                                         | 12.79       |                                      | $      | 12.98 |   |
|                                                                      |   |                                      |        |                                      |   |
| Per share market value at beginning of period                             |   | $                                         | 19.45       |                                      | $      | 16.88 |   |
| Per share market value at end of period                                   |   | 22.35                                     |        | 16.47                                     |   |
| Total Return(2)(3)                                                        |   | 16.71                                     | %           | -1.07                                     | %      |
| Shares outstanding at end of period                                       |   | 10,081,844                                |        | 10,071,844                                |   |
|                                                                      |   |                                      |        |                                      |   |
| Ratios/Supplemental  Data                                                 |   |                                      |        |                                      |   |
| Net assets at end of period                                               |   | $                                         | 128,959,699 |                                      | $      | 130,758,904 |   |
| Average net  assets                                                       |   | 129,002,039                               |        | 131,563,142                               |   |
| Ratio of  expenses to average net assets – annualized                |   | 3.19                                      | %           | 0.63                                      | %      |
| Ratio of net  investment income to average net assets -   annualized |   | 9.11                                      | %           | 1.83                                      | %      |

 

----

(1)   Basic per share data.

(2)   Amounts were notannualized for the results of the three-month periods ended December 31, 2003and December 31, 2002.

(3)   Total return equals theincrease of the ending market value over the beginning market value plusdividends divided by the beginning market value.

 

SEE ACCOMPANYING NOTES**.**

 

10

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**GLADSTONECAPITAL CORPORATION**

 

**NOTES TO CONSOLIDATEDFINANCIAL STATEMENTS**

 

**DECEMBER 31,2003**

 

**(UNAUDITED)**

 

NOTE 1. UNAUDITED INTERIM FINANCIAL STATEMENTS

 

Interim financial statements of Gladstone CapitalCorporation (the “Company”) are prepared in accordance with generally acceptedaccounting principles (“GAAP”) for interim financial information and pursuantto the requirements for reporting on Form 10-Q and Article 10 ofRegulation S-X.  Accordingly, certaindisclosures accompanying annual financial statements prepared in accordancewith GAAP are omitted.  In the opinionof management, all adjustments, consisting solely of normal recurring accruals,necessary for the fair statement of financial statements for the interimperiods have been included.  The currentperiod’s results of operations are not necessarily indicative of results thatultimately may be achieved for the year. The interim financial statements and notes thereto should be read inconjunction with the financial statements and notes thereto included in theCompany’s Form 10-K for the fiscal year ended September 30, 2003, as filedwith the Securities and Exchange Commission.

 

NOTE 2. ORGANIZATION

 

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.

 

Gladstone Capital Advisers, Inc., a wholly-ownedsubsidiary of the Company, conducts the daily administrative operations of theCompany.  The financial statements ofthis subsidiary are consolidated with those of the Company.

 

Gladstone Business Loan LLC, a wholly-owned subsidiaryof the Company, was established on February 3, 2003 for the purpose ofowning the Company’s portfolio of loan investments.  The financial statements of the subsidiary are consolidated withthose of the company.

 

11

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NOTE 3. STOCK OPTIONS

 

The following tables set forth the pro-forma effect offair value option accounting for the three months ended December 31, 2003and December 31, 2002 in accordance with Statement of Financial AccountingStandards (SFAS) Statement No. 148 “Accounting for Stock-Based Compensation –Transition and Disclosure”.

 
|                                                                                                              |   | **Three  Months  Ended December 31,  2003** |      | **Three  Months  Ended December 31,  2002** |   |
|-------------------------------------------------------------------------------------------------------------------|--------|--------------------------------------------------|-----------|--------------------------------------------------|--------|
|                                                                                                              |   |                                             |      |                                             |   |
| Increase in stockholders’ equity from operations, as reported                                                |   | $                                                | 1,381,074 |                                             | $      | 2,412,154 |   |
|                                                                                                              |   |                                             |      |                                             |   |
| Deduct:  total stock-based  employee compensation expense determined under fair value method for all  awards |   | (403,619                                         | )         | (388,775                                         | )      |
|                                                                                                              |   |                                             |      |                                             |   |
| Pro-forma increase in stockholders’ equity from  operations                                                  |   | $                                                | 977,455   |                                             | $      | 2,023,379 |   |
|                                                                                                              |   |                                             |      |                                             |   |
| Increase in stockholders’ equity from operations per share                                                   |   |                                             |      |                                             |   |
| Basic, as reported                                                                                                |   | $                                                | 0.14      |                                             | $      | 0.24 |   |
| Basic, pro-forma                                                                                                  |   | $                                                | 0.10      |                                             | $      | 0.20 |   |
|                                                                                                              |   |                                             |      |                                             |   |
| Diluted, as reported                                                                                              |   | $                                                | 0.13      |                                             | $      | 0.24 |   |
| Diluted, pro-forma                                                                                                |   | $                                                | 0.09      |                                             | $      | 0.20 |   |

 

NOTE 4. INCREASE IN STOCKHOLDERS’ EQUITY FROMOPERATIONS PER SHARE

 

The following table sets forth the computation ofbasic and diluted net increase in stockholders’ equity resulting fromoperations per share for the three months ended December 31, 2003 andDecember 31, 2002:

 
|                                                                                                           |   | **Three  Months  Ended December 31,  2003** |      | **Three  Months  Ended December 31,  2002** |   |
|----------------------------------------------------------------------------------------------------------------|--------|--------------------------------------------------|-----------|--------------------------------------------------|--------|
|                                                                                                           |   |                                             |      |                                             |   |
| Numerator for basic and diluted net increase in stockholders’ equity  resulting from operations per share |   | $                                                | 1,381,074 |                                             | $      | 2,412,154 |   |
|                                                                                                           |   |                                             |      |                                             |   |
| Denominator for basic weighted average shares                                                                  |   | 10,081,844                                       |      | 10,071,844                                       |   |
|                                                                                                           |   |                                             |      |                                             |   |
| Dilutive potential shares                                                                                      |   | 251,685                                          |      | 52,353                                           |   |
|                                                                                                           |   |                                             |      |                                             |   |
| Denominator for diluted weighted average shares                                                                |   | 10,333,529                                       |      | 10,124,197                                       |   |
|                                                                                                           |   |                                             |      |                                             |   |
| Employee stock options                                                                                         |   | 991,664                                          |      | 811,664                                          |   |
|                                                                                                           |   |                                             |      |                                             |   |
| Basic net increase in stockholders’ equity resulting from operations  per common share                    |   | 0.14                                             |      | 0.24                                             |   |
| Diluted net increase in stockholders’ equity resulting from operations  per common share                  |   | 0.13                                             |      | 0.24                                             |   |
|                                                                                                                |        |                                                  |           |                                                  |        |  |  |

 

12

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NOTE 5. DIVIDENDS

 

The Company is required to pay out as a dividend 90%of its ordinary income and short-term capital gains for each taxable year inorder to maintain its status as a RIC under Subtitle A, Chapter 1 of SubchapterM of the Code.  It is the policy of theCompany to pay out as a dividend up to 100% of those amounts.  The amount to be paid out as a dividend isdetermined by the Board of Directors each quarter and is based on the annualearnings estimated by the management of the Company.  Based on that estimate, a dividend is 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 illustrates the 2004 fiscal year monthly dividendsper share and the 2003 quarterly dividend per share for the three months endedDecember 31:

 
| **Record Date**     |   | **Payment  Date**  |   | **Dividend  per  Share** |   | **Monthly  or  Quarterly** |
|---------------------|--------|--------------------|--------|--------------------------|--------|----------------------------|
|                |   |               |   |                     |   |                       |
| Dec. 18, 2003       |   | Dec. 31, 2003      |   | $                        | 0.11   |                       | Monthly |
| Nov. 17, 2003       |   | Nov. 28, 2003      |   | $                        | 0.11   |                       | Monthly |
| Oct. 20, 2003       |   | Oct. 31, 2003      |   | $                        | 0.11   |                       | Monthly |
|                |   |               |   |                     |   |                       |
| Sept. 30, 2003      |   | Oct. 6, 2003       |   | $                        | 0.33   |                       | Quarterly |
| June 30, 2003  |   | July 7, 2003  |   | $                        | 0.29   |                       | Quarterly |
| March 31, 2003 |   | April 7, 2003 |   | $                        | 0.25   |                       | Quarterly |
| Dec. 31, 2002       |   | Jan 7, 2003        |   | $                        | 0.23   |                       | Quarterly |

 

NOTE 6. INVESTMENT VALUATION

 

The Company carries its investments at fair value, asdetermined by its Board of Directors. Securities that are publicly traded are valued at the closing price onthe valuation date.  Debt and equitysecurities that are not publicly traded are valued at fair value as determinedin good faith by the Board of Directors. Beginning in March 2003, theCompany engaged Standard & Poor’s Loan Evaluation Service (S&P) toperform independent valuations of its investments.  The Board of Directors uses the recommended valuations asprepared by S&P as a component of the foundation for the final fair valuedetermination.  In making suchdetermination, the Board of Directors values non-convertible debt securities atcost plus amortized original issue discount plus PIK interest, if any, unlessadverse factors lead to a determination of a lesser valuation.  In valuing convertible debt, equity, successfees or other equity like securities, the Board of Directors determines thefair value based on the collateral, the issuer’s ability to make payments, theearnings 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 we closea loan and when the loan can be evaluated by S&P, new loans are not valuedimmediately by S&P; rather, the Board makes its own determination about thevalue of the loan in accordance with our valuation policy.  Because S&P does not provide values formortgage loans or equity securities, the directors also determine fair value ofthese.

 

NOTE 7. LOAN AND MANAGERIAL ASSISTANCE FEES

 

The 1940 Act requires that a business developmentcompany make available managerial assistance to its portfolio companies.  The Company provides managerial assistanceto its portfolio companies through its wholly-owned subsidiary, GladstoneAdvisers, Inc.  The Company receives feeincome for managerial assistance it renders to portfolio companies in connectionwith its investments.  Such fees are normallypaid at the closing of the Company’s investments and are generallynon-recurring.  These managerialassistance services vary by investment, but generally consist of reviewingexisting credit facilities, arranging bank financing, arranging equity financing,structuring financing from multiple lenders, structuring financing from equityinvestors, restructuring existing loans, raising equity and debt capital, andproviding general financial advice.  Forthe three months ended December 31, 2003 and December 31, 2002, thesefees totaled $255,000 and $0 respectively.

 

From time to time, the Company will be invited toparticipate as a co-lender in a transaction. Where the Company does not provide significant managerial assistanceservices in connection with its investment, loan fees paid to the Company insuch situations will be deferred and amortized over the life of the loan.

 

13

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NOTE 8. PAYMENT IN KIND INTEREST

 

The Company has loans in its portfolio, which containa payment in kind (“PIK”) provision. The PIK interest is added to the principalbalance of the loan and recorded as income. To maintain the Company’s status as a RIC (as discussed in Note 5,above), this non-cash source of income must be paid out to stockholders in theform of dividends, even though the Company has not yet collected the cash. Forthe three months ended December 31, 2003 and December 31, 2002, theCompany recorded PIK income of $138,543 and $211,321 respectively.  At December 31, 2003 andSeptember 30, 2003 the Company had accrued on its balance sheet, a totalin PIK income of $711,156 and $608,572 respectively.  The Company does not have any original issue discount income.

 

NOTE 9. REPURCHASE AGREEMENT

 

A repurchase agreement involves the purchase by aninvestor, such as the Company, of a specified security and the simultaneousagreement by the seller to repurchase it at an agreed upon future date and at aprice which is greater than the purchase price by an amount that reflects anagreed-upon interest date. Such interest rate is effective for the period oftime during which the investor’s money is invested in the arrangement and isrelated to current market interest rates rather than the coupon rate on thepurchased security. The Company requires the continual maintenance by itscustodian or the correspondent in its account with the Federal Reserve/TreasuryBook Entry System of underlying securities in an amount at least equal to therepurchase price. If the seller were to default on its repurchase obligation,the Company might suffer a loss to the extent that the proceeds from the saleof the underlying securities were less than the repurchase price. A seller’sbankruptcy could delay or prevent a sale of the underlying securities.

 

On December 31, 2003, the Company entered into aRepurchase Agreement with UBS Paine Webber for $93,101,000, which agreement wassettled on January 2, 2004.  TheRepurchase Agreement was recorded at cost and was fully collateralized by aUnited States Treasury Bill with a fair value of $95,005,000 and a carryingvalue of $95,001,094 that matured on January 2, 2004.  The interest rate on the RepurchaseAgreement was 0.92%.  OnSeptember 30, 2003, the Company entered into a Repurchase Agreement withUBS for $78,449,000, which agreement was settled on October 1, 2003.  The Repurchase Agreement was recorded atcost and was fully collateralized by a United States Treasury Bill with a fairvalue of $80,050,000 and a carrying value of $80,022,249 that matured on October 16,2003.  The interest rate on theRepurchase Agreement was 0.80%.

 

NOTE 10. CONTRACTUAL OBLIGATIONS

 

The Company occupies its McLean, Virginia office spacepursuant to a license agreement scheduled to expire on October 31,2004.  The Company’s New York Cityoffice facility has a service agreement scheduled to expire August 31,2004.  The future scheduled payments areas follows:

 
|                         |   | **Payment  due by period** |    |
|------------------------------|--------|----------------------------|---------|
| **Contractual  Obligations** |   | **Total**                  |    | **Less than  1  year** |   | **1-3  years** |   | **3-5  years** |   | **More than  5  years** |   |
| Office Lease  Obligations    |   | $                          | 163,453 |   | $ | 163,453 |   | — |   | — |   | — |   |
| **Total**                    |   | $                          | 163,453 |   | $ | 163,453 |   | — |   | — |   | — |   |

 

NOTE 11. DEFERRED COMPENSATION PLAN

 

The company has adopted a deferred compensation plan(the “Plan”) effective January 1, 2002. The Plan permits an employee to defer the lesser of 75% of his or hertotal compensation or the applicable Internal Revenue Service (“IRS”)limit.  The employees are eligible toparticipate in the Plan upon completion of 1,000 hours of service within thefirst six months of employment or after one year of service.  The service requirement is waived for thoseemployees who were employed as of January 1, 2002.    The Company has funded $23,987 in contributionsto the Plan that were accrued in the fiscal year ended September 30,2003.  The Company has received a determinationletter from the IRS concurring that the deferred compensation plan satisfiesthe qualification requirements of the Code.

 

14

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**ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OFFINANCIAL CONDITION AND RESULTS OF OPERATIONS.**

 

**All statements contained herein, other thanhistorical facts, may constitute “forward-looking statements” within themeaning of Section 27A of the Securities Act of 1933, as amended, andSection 21E of the Securities Exchange Act of 1934, as amended. Thesestatements may relate to, among other things, future events or our futureperformance or financial condition. In some cases, you can identifyforward-looking statements by terminology such as “may,” “might,” “believe,”“will,” “provided,” “anticipate,” “future,” “could,” “growth,” “plan,”“intend,” “expect,” “should,” “would,” “if,” “seek,” “possible,” “potential” orthe negative of such terms or comparable terminology. These forward-lookingstatements involve known and unknown risks, uncertainties and other factorsthat may cause our actual results, levels of activity, performance orachievements to be materially different from any future results, levels ofactivity, performance or achievements expressed or implied by suchforward-looking statements. Such factors include, among others: (1) adversechanges in interest rates; (2) our failure or inability to establish ormaintain referral arrangements with leveraged buyout funds and venture capitalfunds to generate loan opportunities; (3) the loss of one or more of ourexecutive officers, in particular David Gladstone, Terry Lee Brubaker or GeorgeStelljes, III; (4) our inability to maintain a credit facility on termsreasonably acceptable to us, if at all; (5) our inability to successfullysecuritize our loan portfolio on terms reasonably acceptable to us, if at all;(6) the decision 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 Securities andExchange Commission on December 11, 2003. We caution readers not to placeundue reliance on any such forward-looking statements, which are made pursuantto the Private Securities Litigation Reform Act of 1995 and, as such, speakonly as of the date made. We undertake no obligation to publicly update orrevise any forward-looking statements, whether as a result of new information,future events or otherwise, after the date of this Form 10-Q**.

 

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

 

**OVERVIEW**

 

We wereincorporated under the General Corporation Laws of the State of Maryland onMay 30, 2001. Our investment objectives are to achieve a high level ofcurrent income by investing in debt securities, consisting primarily of seniornotes, senior subordinated notes and junior subordinated notes, of establishedprivate businesses that are backed by leveraged buyout funds, venture capitalfunds or others, with a particular emphasis on senior subordinated notes.  In addition, we may acquire existing loans,which meet this profile, from leveraged buyout funds, venture capital funds andothers. We also seek to provide our stockholders with long-term capital growththrough the appreciation in the value of warrants, or other equity instrumentsthat we may receive when we extend loans. We operate as a closed-end,non-diversified management investment company, and have elected to be treatedas a business development company under the 1940 Act.

 

We seek out smalland medium-sized businesses that meet certain criteria, including (1) thepotential for growth in cash flow, (2) adequate assets for loan collateral, (3)experienced management teams with a significant ownership interest in theborrower, (4) profitable operations based on the borrower’s cash flow, (5)reasonable capitalization of the borrower (usually by leveraged buyout funds orventure capital funds) and (6) the potential to realize appreciation and gainliquidity in our equity position, if any. We anticipate that liquidity in ourequity position will be achieved through a merger or acquisition of theborrower, a public offering by the borrower or by exercise of our right torequire the borrower to buy back its warrants. We lend to borrowers that need fundsto finance growth, restructure their balance sheets or effect a change ofcontrol.

 

Our loanstypically range from $5 million to $15 million, mature in no more than sevenyears and accrue interest at a fixed or variable rate that exceeds the primerate. A number of our loans have a provision that calls for some portion of theinterest payments to be deferred and added to the principal balance so that theinterest is paid, together with the principal, at maturity. This form ofdeferred interest is often called “paid-in-kind” or “PIK” interest, and, whenearned, we record PIK interest as interest income and add the PIK interest tothe principal balance of the loans. The amount of PIK interest accrued and onour books as of December 31, 2003 was approximately $711,000.

 

15

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

 

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

 

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

 

Our business plancalls for managerial assistance fee revenue to equal or exceed our operatingexpenses (excluding interest expense). However, during the quarters endedDecember 31, 2003, and December 31, 2002, operating expenses(excluding interest expense) exceeded managerial assistance fee revenue byapproximately $731,000 and $823,000, respectively.  We believe that, as the economic environment improves, we will beable to make sufficient new investments so that over time our managerialassistance fee revenue will equal or exceed our operating expenses (excludinginterest expense), although there can be no guarantee that we will be able todo so.

 

Prior to making aninvestment, we ordinarily enter into a non-binding term sheet with thepotential borrower. These non-binding term sheets are generally subject to anumber of conditions, including but not limited to the satisfactory completionof our due diligence investigations of the potential borrower’s business andreaching agreement on the legal documentation for the loan. Typically, uponexecution of the non-binding term sheet, the potential borrower pays us anon-refundable fee for our services rendered through the date of thenon-binding term sheet. We recognize this as management fee revenue uponexecution of the non-binding term sheet.

 

In the event thatwe expend significant effort in considering and negotiating a potentialinvestment that ultimately is not consummated, we generally will seekreimbursement from the proposed borrower for our reasonable expenses incurredin connection with the proposed transaction. Any amounts collected arerecognized as “other income” in the quarter in which such reimbursement isreceived. Also, in the event that we have incurred significant legal fees inconnection with the transaction, we will typically also seek reimbursement forthese expenses from the proposed borrower. However, there can be no guaranteethat we will be successful in collecting any such reimbursements.

 

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

 

The generaleconomic climate during the quarter ended December 31, 2003 and theprevious fiscal year ended September 30, 2003 was unfavorable.  Many businesses saw their sales and businessprospects decline during the year. Consequently, many of these companies were forced to lay off employeesand engage in other cost cutting measures. As a result of the difficult business climate, we determined it prudentto proceed cautiously in making loans during these periods.  Since our initial public offering inAugust 2001, we have made 23****differentloans to, or investments in, 14****companiesfor a total of approximately $147.4****million(including the maximum aggregate amount outstanding under an $8 million line ofcredit in favor of one of our portfolio companies, that has

 

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subsequently beenretired). In the fourth quarter of the 2002 fiscal year, one of ourinvestments, including all amounts outstanding under a $7 million senior termloan and an $8 million senior line of credit, was repaid in full.  During the quarter ended December 31,2003, one company paid in full its outstanding loan balance of $900,000 and weentered into new loans with two companies, in the aggregate amount of $15.5million.

 

In spite of theeconomic environment, we are earnestly working toward the consummation of moreinvestments. These prospective loans are subject to, among other things, thesatisfactory completion of our due diligence investigation of each borrower,acceptance of terms and structure and necessary consents. With respect to eachprospective loan, we will only agree to provide the loan if, among otherthings, the results of our due diligence investigations are satisfactory, theterms and conditions of the loan are acceptable and all necessary consents arereceived. Our management has initiated its due diligence investigations of thepotential borrowers, however we can not assure you that we will not discoverfacts in the course of completing our due diligence that would render aparticular investment imprudent or that any of these loans will actually bemade.

 

**Expense Allocation**

 

In July, 2003, weentered into an expense sharing arrangement with Gladstone ManagementCorporation (“Gladstone Management”), a registered investment adviser thatserves as the external adviser to Gladstone Commercial Corporation, a realestate investment trust affiliated with us. Under this expense sharing arrangement, Gladstone Management reimbursesGladstone Capital Advisers, for a portion of our total payroll and benefitsexpenses (based on the percentage of total hours worked by each employee onGladstone Commercial matters). Gladstone Management also reimburses Gladstone Capital Advisers for it’spro rata portion of all other general expenses (based on the percentage oftotal hours worked by all employees on Gladstone Commercial matters).  Gladstone Management further passes itsshare of these expenses along to Gladstone Commercial under a separate advisoryagreement.  As a result of this expensesharing arrangement, certain of our expenses declined during the quarter endedDecember 31, 2003 and we expect that they will continue to be somewhat lower infuture periods than they have historically been.  However, the actual amount by which our expenses decline infuture periods will depend upon the relative time that our personnel spend onour and Gladstone Commercial matters.

 

Moreover, we havepresented to our stockholders for their consideration at our 2004 annualmeeting of stockholders a proposal to enter into an advisory agreement withGladstone Management, whereby we would pay Gladstone Management an annualadvisory fee of 1.25% of total assets excluding cash and cash equivalentspledged to creditors, payable in quarterly increments of 0.3125%, and an annualadministrative fee of 0.75% of total assets excluding cash and cash equivalentspledged to creditors, payable in quarterly increments of 0.1875%.  We would continue to pay direct expensesincluding, but not limited to, directors fees, legal and accounting fees, andstockholder related expenses.

 

**CriticalAccounting Policies**

 

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

 

**InvestmentValuation**

 

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

 

We value our investmentportfolio each quarter. Members of our portfolio management team prepare theportfolio company valuations using the most recent portfolio company financialstatements and forecasts.  Theseindividuals also consult with the respective principal who originated theportfolio investment to obtain further updates on the portfolio company’sperformance, including information such as industry trends, new productdevelopment, and other operational issues. As of March 31, 2003, we engaged Standard & Poor’s LoanEvaluation Service (S&P) to help evaluate the value of the majority of ourloan securities.  Since June 30,2003, our S&P engagement includes evaluations on exit fees (conditionalinterest included in some loan securities). We and S&P only evaluate the value of an exit fee if the probabilityof receiving the exit fee on a given loan is above 6-8%, a threshold ofsignificance, in which case a value is assigned.  Upon completing the data collection, the valuation data ispresented to S&P.  S&P makes itsindependent assessment of the data and assesses its own data to determinemarket values for the securities.  Withregard to its work, S&P has issued the following paragraph:

 

S&P providesevaluated price opinions which are reflective of what S&P believes the bidside of the market would be for each loan after careful review and analysis ofdescriptive, market and credit information. Each price reflects S&P’s best judgment based upon carefulexamination of a variety of market factors. Because of fluctuation in the market and in other factors beyond itscontrol, S&P cannot guarantee these evaluations.  The evaluations reflect the market prices, or estimate thereof,on the date specified.  The prices arebased on comparable market prices for similar securities.  Market information has been obtained fromreputable secondary market sources. Although these sources are considered reliable, S&P cannot guaranteetheir accuracy.

 

With ourassessment and S&P value estimates as a backdrop, our Board votes to acceptor not accept the analyses and values recommended by management andS&P.  At December 31, 2003, theBoard elected to accept the valuations recommended by S&P on those loans asdenoted on the Schedule of Investments in the Consolidated FinancialStatements.  Because there is a lag betweenwhen we close a loan and when the loan can be evaluated by S&P, new loansare not valued immediately by S&P; rather, the Board makes its owndetermination about the value of the loan in accordance with our valuationpolicy.  Because S&P does not providevalues for mortgage loans or equity securities, the directors also determinefair value of these using the valuation policy:

 

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General ValuationPolicy: We carry our investments at fair value, as determined by our Board ofDirectors.  Securities that are publiclytraded, if any, are valued at the closing price on the valuation date. Debt andequity securities that are not publicly traded or for which we have variousdegrees of trading restrictions, are valued at fair value as determined in goodfaith by our Board of Directors.  Inmaking the good faith determination of the securities, we start with the costbasis of the security, which includes the amortized original issue discount,exit fee (defined interest) and PIK interest, if any.  We then apply the methods set out below in ValuationMethods.  Due to the uncertaintyinherent in the valuation process, such estimates of fair value may differsignificantly from the values that would have been obtained had a ready marketfor the securities 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 value in good faithexists since fair value depends upon circumstances of each individual case.  In general, fair value is the amount that wemight reasonably expect to receive upon the current sale of the security.

 

CreditInformation:****We monitor a widevariety of key credit statistics that provide information regarding ourportfolio companies to help us assess credit quality and portfolio performance.  We require our portfolio companies toprovide annual audited and monthly, unaudited financial statements.  Using these statements, we calculate andevaluate the credit statistics.  Forpurposes of analyzing the financial performance of our portfolio companies, wemay make certain adjustments to their cash flow statements to reflect the proforma results of a company consistent with a change of control transaction, toreflect 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.

 

Loan Grading andRisk Rating:****Our loan gradingsystem uses a scale of 0 to 10.  Thissystem is used to estimate the probability of default on our debt securitiesand the probability of loss if there is a default.  These types of systems are referred to as risk rating systems andare used by banks and rating agencies. We risk rate each of our debt securities.  The risk rating system covers both qualitative and quantitativeaspects of the business and the securities we hold.

 

We seek to haveour risk rating system mirror the risk rating systems of major risk ratingorganizations such as those provided by nationally recognized statistical ratingorganizations (“NRSRO”) as defined in Rule 2a-7 under the 1940 Act. While weseek to mirror the NRSRO systems, we cannot provide any assurance that our riskrating system provides the same risk rating as a NRSRO. The following chart isan estimate of the relationship of our risk rating system to the designationsused by two NRSROs as they risk rate debt securities of major companies.  Because we have established our system torate debt securities of companies that are unrated by any NRSRO there can be noassurance that the correlation to the NRSRO set out below is accurate. It isour understanding that most debt securities of middle market companies do notexceed the grade of BBB on a NRSRO scale; so there would be no debt securitiesin the middle market that would meet the definition of AAA, AA or A.  Therefore, our scale begins with thedesignation BBB as the best risk rating.

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

 

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

 

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AtSeptember 30, 2003, the average debt security was risk rated 7.8 for alldebt securities and the weighted average risk rating was 7.6 for all the debtsecurities.  At December 31, 2003the average debt security was risk rated 7.8 for all debt securities and theweighted average risk rating was 7.6 for all debt securities. The highest ratedloan was 9.0 and the lowest was 7.0. The above scale gives an indication of theprobability of default and the magnitude of the loss if there is a defaultusing the expanded risk rating scale.

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

 

Our policy is tostop accruing interest on an investment if we determine that interest is nolonger collectible. To date we have not placed any investments on non-accrual.At September 30, 2003 no payments were past due on any of our debtsecurities, however at December 31, 2003 one investment was late inremitting its principal payment and has since remitted the past due amount. Wedo not risk rate our equity securities.

 

ValuationMethods:  For debt securities, we firstdetermine if there is a market for the debt security.  If there is a market, then we will determine the value based onthe market prices for the security, even if that market is not robust.  At December 31, 2003, Burt’s Bees wastraded in a public market and the valuation reflects the trading price atDecember 31, 2003.  AtSeptember 30, 2003 there was no market for any of the debt securities inour portfolio.  If there is no marketfor the debt securities, then we begin with the risk rating designation of thesecurity described above.  Using therisk rating designation above, we seek to determine the value of the securityas if we intended to sell the security in a current sale.  To determine the current sale price of thesecurity, we may use some or all of the following items: financial standing ofthe issuer of the security, comparison of the business and financial plan ofthe issuer with actual results, the cost of the security, the size of thesecurity held as it relates to the liquidity of the market for such securities,contractual restrictions on the disposition of the security, pending publicoffering of the issuer of the security, pending reorganization activityaffecting the issuer such as mergers or debt restructuring, reported prices ofsimilar securities of the issuer or comparable issuers, ability of the issuerto obtain needed financing, changes in the economy affecting the issuer, recentpurchases or sale of a security of the issuer, pricing by other buyers orsellers of similar securities, financial statements of the borrower, the typeof security, cost at date of purchase, size of holding, discount from marketvalue of unrestricted securities of the same class at the time of purchase,special reports prepared by analysts, information as to any transactions oroffers with respect to the security, existence of merger proposals or tenderoffers affecting the securities, the collateral, the issuer’s ability to makepayments, the current and forecasted earnings of the issuer, sales to thirdparties of similar securities, statistical ratios compared to lendingstandards, statistical ratios compared to other similar securities and otherpertinent factors.

 

For equitysecurities, we first determine if there is any market for the equitysecurity.  If there is a market, then wedetermine the value based on the market prices for the security, even if thatmarket is not robust.  AtDecember 31, 2003 and September 30, 2003 there was no market for anyof the equity securities we owned.  Ifthere is no market for the equity securities, then we use the same informationwe would use for a debt security valuation described above, except risk-rating,as well as standard valuation techniques used by major valuation firms to valuethe equity securities of private companies. These valuation techniques consist of: discounted cash flow of theexpected sales price in the future, the value of the securities based on therecent sale of comparable transactions and a review of similar companies thatare publicly traded and the market multiple of their equity securities.  At December 31, 2003 we had $37,000invested, at cost, in equity securities compared to our debt portfolio with acost basis of $120,626,277.

 

AtDecember 31, 2003, The Home Care Supply, Inc. senior loan had anappreciation of $494,100 in its value as a result of the value applied to theexit fee.  Further, the value of ourwarrants in Finn Corporation had an appreciation of $398,649 atDecember 31, 2003.  Thisappreciation plus an increase of $5,000 on the Burt’s Bee’s investment totals$897,749 and partially offsets depreciation of $2,677,651.

 

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**ManagerialAssistance Fees**

 

The 1940 Actrequires that a business development company make available managerialassistance to its portfolio companies. We provide managerial assistance to ourportfolio companies in connection with our investments through our wholly ownedsubsidiary, Gladstone Advisers, Inc. and receive fees for our managerialassistance services. These fees are normally paid at the closing of ourinvestments in our portfolio companies, are generally non-recurring and arerecognized as revenue when earned. The managerial assistance services weprovide vary by investment, but generally consist of reviewing existing creditfacilities, arranging bank financing, arranging equity financing, structuringfinancing from multiple lenders, structuring financing from equity investors,restructuring existing loans, raising equity and debt capital, and providinggeneral financial advice. From time to time, we are invited to participate as aco-lender in a transaction. In the event that we do not provide significantmanagerial assistance services in connection with our investment, loan feespaid to us in such situations are deferred and amortized over the life of theloan.

 

**RESULTSOF OPERATIONS**

 

*Comparison of the three months ended December 31,2003 to the three months ended December 31, 2002*

 

**Investment Income**

 

Investment incomefor the three months ended December 31, 2003 was approximately $4.0million as compared to $3.2 million for the three months endedDecember 31, 2002. This increase was primarily a result of increasedinterest income from an increased number of investments as compared to the sameperiod of the prior year.

 

Interest incomefrom our investments in debt securities of private companies was approximately$3.6 million, including $138,000 of PIK interest, for the three months endedDecember 31, 2003 as compared to $2.9 million , including $211,000 of PIKinterest, for the three months ended December 31, 2001. This increase****wasprimarily a result of an increase in investments of $36.8 million atDecember 31, 2003 as compared to investments at December 31, 2002.

 

The weightedaverage yield on our portfolio for the three months ended December 31,2003 was 12.29% (without giving effect to PIK interest) and 13.12% (aftergiving effect to PIK interest). The weighted average yield on our portfolio forthe three months ended December 31, 2002 was 13.36% (without giving effectto PIK interest) and 14.30% (after giving effect to PIK interest).

 

Interest incomefrom invested cash and cash equivalents for the three months endedDecember 31, 2003 was approximately $49,000, as compared to $198,000 forthe three months ended December 31, 2002. This decrease****was primarily a result of the $58.5million of new investments made between December 31, 2002 andDecember 31, 2003.

 

For the threemonths ended December 31, 2003 and December 31, 2002, we recordedapproximately $109,000 in interest income from loans to our employees inconnection with the exercise of employee stock options.

 

Managerialassistance fees were $255,000 for the three months ended December 31,2003, as compared to $0 for the three months ended December 31, 2002. Thisincrease****was the result of the new GQM Acquisition Corp.investment closing during the quarter with related fees.

 

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**Operating Expenses**

 

Operating expensesfor the three months ended December 31, 2003 were approximately $1.0million, as compared to approximately $823,000 for the three months endedDecember 31, 2002. This increase****wasprimarily a result of an increase in professional fees, directors fees,stockholder related costs and financing fees.

 

Salaries andbenefits for the three months ended December 31, 2003 were approximately$391,000, as compared to approximately $443,000 for the three months endedDecember 31, 2002. Although employee headcount increased for the quarter endedDecember 31, 2003 as compared to December 31, 2002, the salaries and benefitsexpense decreased due to the new expense sharing arrangement with GladstoneManagement, which allocates expenses based on each employee's time to GladstoneCommercial Corporation.

 

Rent expense forthe three months ended December 31, 2003 were approximately $38,000, ascompared to approximately $55,000 for the three months ended December 31,2002.  The decrease in rent is due tothe new expense sharing arrangement with Gladstone Management, which allocatesgeneral expenses based on a ratio of all employees’ time allocated to GladstoneCommercial Corporation to total time spent.

 

Professional fees,consisting primarily of legal and audit fees, for the three months endedDecember 31, 2003 were approximately $178,000, as compared toapproximately $115,000 for the three months ended December 31, 2002.  The increase is due to a rise in legal fees.

 

Directors’ feesfor the three months ended December 31, 2003 were approximately $24,000,as compared to approximately $14,000 for the three months endedDecember 31, 2002. The increase is due to an increase in the number ofdirectors during the three months ended December 31, 2003 as compared to December 31,2002.

 

Insurance expensefor the three months ended December 31, 2003 was approximately $74,000, ascompared to approximately $71,000 for the three months ended December 31,2002.

 

Stockholderrelated costs for the three months ended December 31, 2003 wereapproximately $53,000, as compared to approximately $12,000 for the threemonths ended December 31, 2002. The increase is mainly due to the printing of the 2003 annual report tostockholders.

 

Financing feesconsist of the related service fees associated with the line of credit, backupservice and the amortization of deferred financing costs.  Financing fees for the three months endedDecember 31, 2003 were approximately $145,000.  There were no financing fees incurred the three months endedDecember 31, 2002.

 

General andadministrative expenses, consisting primarily of office operations, travel, anddata communications expenses for the three months ended December 31, 2003were approximately $127,000, as compared to approximately $125,000 for thethree months ended December 31, 2002. This increase****was primarily a result of the relatedexpenses from increased operations during the three months endedDecember 31, 2003 as compared to the three months ended December 31,2002.  General and administrative expensesare also in accordance with the new expense sharing arrangement with GladstoneManagement, which allocates general expenses based on a ratio of all employees’time allocated to Gladstone Commercial Corporation to total time spent.

 

**Net Increase in Stockholders’ Equity fromOperations**

 

We had a net increase in stockholders’ equity resulting fromoperations of $1,381,074 for the three months ended December 31,2003.  Based on a weighted-average of10,081,844 (basic) and 10,333,529 (diluted) shares outstanding, our netincrease in stockholders’ equity from operations per common share for the threemonths ended December 31, 2003 was $0.14 for basic earnings and $0.13 fordiluted earnings.

 

For the three months endedDecember 31, 2002, we realized a net increase in stockholders’ equity resulting fromoperations of approximately $2.4 million. Based on a weighted-average of 10,071,844 (basic) and 10,124,197(diluted) shares outstanding, our net increase in stockholders’ equityresulting from operations per common share for the three months endedDecember 31, 2002 was $0.24 for both basic and diluted.

 

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**LIQUIDITY AND CAPITAL RESOURCES**

 

AtDecember 31, 2003, we had investments in debt securities of, or loans to, 12private companies, totaling approximately $117.6 million of total investmentassets. This number includes approximately $138,000 in accrued PIK interest,which as described in “Overview,” is added to the carrying value of ourinvestments.

 

In November 2003, we purchased a $1.0 million participationin a $55.0 million senior term loan to Burt’s Bees, Inc., a manufacturer ofpersonal and household products.

 

In December 2003 we closed two loans with GQM AcquisitionCorp. totaling $14.5 million and also containing a success fee provision.  GQM Acquisition Corp conducts business asGamill, Inc. and is the designer and assembler of quilting machines andaccessories.

 

In November 2003, Kozy Shack Enterprises repaid $900,000 tofully settle its principal obligation. In December 2003, we sold a $3.2 million principal portion of ourInca Metal Products Corp/Kingway Acquisition Inc./Clymer Acquisition Inc.investment.  The remaining portion ofthis investment currently has a cost basis of $2.5 million.

 

The followingtable summarizes the contractual principal amortization and maturity of ourinvestment portfolio by fiscal year:

 
| **Year**   |   | **Amount** |        |
|------------|--------|------------|-------------|
| 2004       |   | $          | 3,047,870   |   |
| 2005       |   | $          | 14,139,932  |   |
| 2006       |   | $          | 17,665,455  |   |
| 2007       |   | $          | 26,197,753  |   |
| 2008       |   | $          | 17,741,667  |   |
| Thereafter |   | $          | 41,870,600  |   |
| Total      |   | $          | 120,663,277 |   |

 

Cash provided byoperating activities for the three months ended December 31, 2003,consisting primarily of the items described in “Results of Operations,” wasapproximately $3.9 million. Net cash provided by investing activities wasapproximately $3.8 million during the three months ended December 31,2003. The net cash provided by investing activities was mainly due to theproceeds of $93.1 million from the repurchase agreement and principalrepayments of $4.5 million from our portfolio companies, partially offset bynew investments of $15.5 million and repayment of repurchase agreement of $78.4million. ** **Net cash used in financing activities was approximately$6.5 million for the three months ended December 31, 2003 and consistedmainly of the payment of dividends.

 

During the threemonths ended December 31, 2003, cash and cash equivalents increased fromapproximately $101.1 million at the beginning of the period to approximately$102.2 million at the end of the period.

 

OnDecember 31, 2003, we entered into a repurchase agreement with UBS PaineWebber for approximately $93.1 million. The repurchase agreement was fullycollateralized by a United States treasury bill with a fair value ofapproximately $95.0 million that matured on January 2, 2004. The interestrate on the repurchase agreement was 0.92%. This repurchase agreement wasreflected on our balance sheet as of December 31, 2003 as an increase incash and cash equivalents pledged to creditors of $95.0 million, along with acorresponding liability for approximately the same amount. The repurchaseagreement was settled on January 2, 2004. In the future, we plan to use asimilar form of repurchase agreement as an investment option or in order tosatisfy certain asset diversification requirements and maintain our status as aRIC.

 

In order toqualify as a regulated investment company and to avoid corporate level tax onthe income we distribute to our stockholders, we are required, under SubchapterM of the Code, to distribute at least 90% of our ordinary income and short-termcapital gains to our stockholders on an annual basis. In accordance with theserequirements, we declared and paid a monthly cash dividend of $0.11 per commonshare for each month in October, November and December 2003.

 

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

 

**Revolving Credit Facility**

 

Through our wholly-owned subsidiary, Gladstone Business Loan LLC(“Business Loan”), we have obtained a $100 million revolving creditfacility.  On May 19, 2003, weexecuted a Purchase and Sale Agreement pursuant to which we agreed to sellcertain loans to Business Loan in consideration of a membership interesttherein.  Simultaneously, Business Loanexecuted a Credit Agreement with CIBC World Markets Inc., as administrativeagent, and others, pursuant to which Business Loan pledged the loans purchasedfrom us to secure future advances by certain institutional lenders.  Interest rates charged on the advances underthe facility will be based on LIBOR, the Prime Rate or the Federal Funds Rate,depending on market conditions, and will adjust periodically.

 

The facility contains covenants that, among other things, requireBusiness Loan to maintain its status as a separate entity; prohibit certainsignificant corporate transactions (such as mergers, consolidations,liquidations or dissolutions); and restrict material changes to our credit andcollection policies.  The facility alsorestricts some of the terms and provisions (including interest rates, terms tomaturity and payments schedules) and limits the borrower and industry concentrationsof loans that are eligible to secure advances. As of December 31, 2003, Business Loan was in compliance with allof the facility covenants.  We currentlyintend to securitize all of the loans held by Business Loan and will use theproceeds from the securitization to pay down any amounts then outstanding underthe revolving credit facility.  Thereare currently no advances outstanding under this facility.

 

Gladstone Advisers, Inc. (“Advisers”), our servicing subsidiary, willservice the loans pledged under the facility. As a condition to this servicing arrangement, we executed a PerformanceGuaranty pursuant to which we guaranteed that Advisers would comply fully withall of its obligations under the facility.   The Performance Guaranty requires us to maintain a minimum net worth of$100 million and to maintain “asset coverage” with respect to “seniorsecurities representing indebtedness” of at least 200%, in accordance withSection 18 of the 1940 Act.  As ofDecember 31, 2003, we were in compliance with our covenants under thePerformance Guaranty.

 

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

 

We are subject to financial market risks, including changes ininterest rates.  We expect thatultimately approximately 50% of the loans in our portfolio will be made atfixed rates, with approximately 50% made at variable rates.  Currently our portfolio has approximately62% of the total loan portfolio value at fixed rates and the remaining 38% ofthe total loan portfolio value at variable rates.

 

Pursuant to our line of credit, we have agreed to enter into hedgingtransactions, such as interest rate swaps, in connection with the borrowingsthat we make under the line of credit, which we currently expect to beginmaking in the near future.  Suchtransactions will effectively convert our fixed rate portfolio loans intovariable rate loans in an effort to mitigate our exposure to increases ininterest rates on our borrowings on the line of credit, which will be atvariable rates.  Furthermore, in theevent that we securitize a portion of our loan portfolio in the future, webelieve that we will likely be required to enter into similar arrangements withrespect to securitized loans.

 

While hedgingactivities may insulate us against adverse fluctuations in interest rates, theymay also limit our ability to participate in the benefits of lower interestrates with respect to our portfolio of investments.

 

**ITEM4. CONTROLS AND PROCEDURES.**

 

As of December 31, 2003, we, including our Chief ExecutiveOfficer and Chief Financial Officer, evaluated the effectiveness of the designand operation of our disclosure controls and procedures.  Based on that evaluation, our management,including the Chief Executive Officer and Chief Financial Officer, concludedthat our disclosure controls and procedures were effective in timely alertingmanagement, including the Chief Executive Officer and Chief Financial Officer,of material information about us required to be included in periodic Securitiesand Exchange Commission filings. However, in evaluating the disclosure controls and procedures,management recognized that any controls and procedures, no matter how welldesigned and operated can provide only reasonable assurance of achieving thedesired control objectives, and management necessarily was required to applyits judgment in evaluating the cost-benefit relationship of possible controlsand procedures.

 

There have been no changes in our internal control over financialreporting that occurred during the quarter ended December 31, 2003, thathave materially affected, or are reasonably likely to materially affect, ourinternal control over financial reporting.

 

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**PART II–OTHER INFORMATION**

 

**ITEM 1. LEGAL PROCEEDINGS.**

 

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

 

**ITEM2. CHANGES IN SECURITIES AND USE OF PROCEEDS.**

 

Not applicable.

 

**ITEM 3. DEFAULTS UPON SENIOR SECURITIES.**

 

Not applicable.

 

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

 

Not applicable.

 

**ITEM5. OTHER INFORMATION.**

 

On December 9, 2003, John Outland was appointed to the Boardof Directors by the existing members of the Board of Directors to fill a newlycreated seat.

 

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

 

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

 

See the exhibit index on page 25.

 

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

 

On December 11, 2003, the Company filed an Item 12 Form 8-Kannouncing the release of earnings for the quarter ended September 30,2003.

 

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**SIGNATURE**

 

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

 
|                          | **GLADSTONE CAPITAL CORPORATION**      |
|-------------------------------|----------------------------------------|
|                          |                                   |
|                          | By:                                    | /s/ HARRY BRILL |   |
|                          |                                   |
|                          | Harry Brill                            |
|                          | Chief Financial  Officer and Treasurer |
|                          |                                   |
| Date:  February 17, 2004 |                                   |

 

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**EXHIBITINDEX**

 
| **Exhibit** |   | **Description**                                                                                                                                                                                                                                |
|-------------|--------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|        |   |                                                                                                                                                                                                                                           |
| 3.1         |   | Articles of  Amendment and Restatement of the Articles of Incorporation, incorporated by  reference to Exhibit a.2 to Pre-Effective Amendment No. 1 to the Registration  Statement on Form N-2 (File No. 333-63700), filed July 27, 2001. |
|        |   |                                                                                                                                                                                                                                           |
| 3.2         |   | By-laws,  incorporated by reference to Exhibit b to Pre-Effective Amendment No. 1 to  the Registration Statement on Form N-2 (File No. 333-63700), filed  July 27, 2001.                                                                  |
|        |   |                                                                                                                                                                                                                                           |
| 3.3         |   | Amendment to  By-laws.                                                                                                                                                                                                                         |
|        |   |                                                                                                                                                                                                                                           |
| 11          |   | Computation of  Per Share Earnings (included in the notes to the unaudited financial  statements contained in this report).                                                                                                                    |
|        |   |                                                                                                                                                                                                                                           |
| 31.1        |   | Certification of  Chief Executive Officer pursuant to section 302 of The Sarbanes-Oxley  Act of 2002.                                                                                                                                     |
|        |   |                                                                                                                                                                                                                                           |
| 31.2        |   | Certification of  Chief Financial Officer pursuant to section 302 of The Sarbanes-Oxley  Act of 2002.                                                                                                                                     |
|        |   |                                                                                                                                                                                                                                           |
| 32.1        |   | Certification of  Chief Executive Officer pursuant to section 906 of The Sarbanes-Oxley  Act of 2002.                                                                                                                                     |
|        |   |                                                                                                                                                                                                                                           |
| 32.2        |   | Certification of  Chief Financial Officer pursuant to section 906 of The Sarbanes-Oxley  Act of 2002.                                                                                                                                     |

 

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

 

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