**UNITED STATES**

**SECURITIES ANDEXCHANGE COMMISSION**

**WASHINGTON, D.C.20549**

 

**FORM10-Q**

**x****           ****QUARTERLY REPORT PURSUANT TOSECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**

**FORTHE QUARTER ENDED JUNE 30, 2006**

**o****             ****TRANSITION REPORT PURSUANT TOSECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**

**COMMISSION FILENUMBER: 814-00237**

**GLADSTONE CAPITALCORPORATION**

(Exact name of registrant as specified inits charter)

 

| **MARYLAND**                                                   |   | **54-2040781**                       |
|----------------------------------------------------------------|--------|--------------------------------------|
| (State or other jurisdiction of incorporation or organization) |   | (I.R.S. Employer Identification No.) |

 

**1521 WESTBRANCH DRIVE,SUITE 200**

**MCLEAN, VIRGINIA 22102**

(Address of principal executive office)

 

**(703) 287-5800**

(Registrant’s telephone number, includingarea code)

 

Indicate by check mark whether theregistrant (1) has filed all reports required to be filed by Section 13 or15(d) of the Securities Exchange Act of 1934 during the preceding 12 months and(2) has been subject to such filing requirements for the past 90days.  Yes x   No o.

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

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

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

Indicate the number of shares outstandingof each of the issuer’s classes of common stock, as of the latest practicabledate.  The number of shares of the issuer’sCommon Stock, $0.001 par value, outstanding as of July 28, 2006 was 11,422,345.

 

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**GLADSTONE CAPITALCORPORATION**

**TABLE OF CONTENTS**

 
| PART I. |   | FINANCIAL INFORMATION                                                                                       |
|--------------|--------|-------------------------------------------------------------------------------------------------------------|
|         |   |                                                                                                        |
| Item 1.      |   | Financial Statements (Unaudited)                                                                            |
|         |   |                                                                                                        |
|         |   | Consolidated Statements of Assets and Liabilities as  of June 30, 2006 and September 30, 2005               |
|         |   | Consolidated Schedules of Investments as of June 30,  2006 and September 30, 2005                           |
|         |   | Consolidated Statements of Operations for the three  months ended June 30, 2006 and June 30, 2005           |
|         |   | Consolidated Statements of Operations for the nine  months ended June 30, 2006 and June 30, 2005            |
|         |   | Consolidated Statements of Changes in Net Assets for  the nine months ended June 30, 2006 and June 30, 2005 |
|         |   | Consolidated Statements of Cash Flows for the nine  months ended June 30, 2006 and June 30, 2005            |
|         |   | Financial Highlights for the three and nine months  ended June 30, 2006 and June 30, 2005                   |
|         |   | Notes to Consolidated Financial Statements                                                                  |
|         |   |                                                                                                        |
| Item 2.      |   | Management’s Discussion and Analysis of Financial  Condition and Results of Operations                 |
|         |   |                                                                                                        |
|         |   | Overview                                                                                                    |
|         |   | Results  of Operations                                                                                      |
|         |   | Liquidity and Capital Resources                                                                             |
|         |   |                                                                                                        |
| Item 3.      |   | Quantitative and Qualitative Disclosure About Market  Risk                                                  |
|         |   |                                                                                                        |
| Item 4.      |   | Controls and Procedures                                                                                     |
|         |   |                                                                                                        |
| PART  II.    |   | OTHER  INFORMATION                                                                                          |
|         |   |                                                                                                        |
| Item  1.     |   | Legal  Proceedings                                                                                          |
|         |   |                                                                                                        |
| Item  1A.    |   | Risk  Factors                                                                                               |
|         |   |                                                                                                        |
| Item 2.      |   | Unregistered Sales of Equity Securities and Use of  Proceeds                                                |
|         |   |                                                                                                        |
| Item 3.      |   | Defaults Upon Senior Securities                                                                             |
|         |   |                                                                                                        |
| Item 4.      |   | Submission of Matters to a Vote of Security Holders                                                         |
|         |   |                                                                                                        |
| Item  5.     |   | Other  Information                                                                                          |
|         |   |                                                                                                        |
| Item 6.      |   | Exhibits                                                                                                    |
|         |   |                                                                                                        |
| SIGNATURES   |   |                                                                                                        |

 

 

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**GLADSTONE CAPITALCORPORATIONCONSOLIDATED STATEMENTS OF ASSETS AND LIABILITIES(Unaudited)**

 
| ** **                                                                                                                               | ** ** | **June 30,  2006** | ** **  | **September 30,  2005** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------|-------------|------------------------------|------------|
|                                                                                                                                     |       |                    |        |                         |       |
| ASSETS                                                                                                                                   |       |                    |        |                         |       |
| Investments at  fair value (Cost 6/30/2006: $201,465,621; 9/30/2005: $205,375,554)                                                       |       | $                       | 202,706,650 |                         | $          | 200,846,763 |   |
| Cash and cash  equivalents                                                                                                               |       | 456,314                 |        | 503,776                      |       |
| Interest  receivable — investments in debt securities                                                                               |       | 1,132,213               |        | 1,406,212                    |       |
| Interest  receivable — officers                                                                                                     |       | 24,836                  |        | 27,067                       |       |
| Due from  custodian                                                                                                                      |       | 2,493,924               |        | 2,624,074                    |       |
| Due from Adviser                                                                                                                         |       | 207,960                 |        | —                       |       |
| Deferred  financing fees                                                                                                                 |       | 148,762                 |        | 70,000                       |       |
| Prepaid assets                                                                                                                           |       | 71,946                  |        | 177,848                      |       |
| Other assets                                                                                                                             |       | 230,450                 |        | 137,354                      |       |
| TOTAL ASSETS                                                                                                                             |       | $                       | 207,473,055 |                         | $          | 205,793,094 |   |
|                                                                                                                                     |       |                    |        |                         |       |
| LIABILITIES                                                                                                                              |       |                    |        |                         |       |
| Accounts payable                                                                                                                         |       | $                       | 45,342      |                         | $          | 21,893 |   |
| Interest payable                                                                                                                         |       | 188,392                 |        | 183,707                      |       |
| Fees due to  Adviser                                                                                                                     |       | 181,398                 |        | 391,322                      |       |
| Borrowings under  lines of credit                                                                                                        |       | 47,846,000              |        | 53,034,064                   |       |
| Accrued expenses  and deferred liabilities                                                                                               |       | 225,367                 |        | 350,665                      |       |
| Funds held in  escrow                                                                                                                    |       | 200,800                 |        | 200,760                      |       |
| TOTAL  LIABILITIES                                                                                                                       |       | 48,687,299              |        | 54,182,411                   |       |
| NET ASSETS                                                                                                                               |       | $                       | 158,785,756 |                         | $          | 151,610,683 |   |
|                                                                                                                                     |       |                    |        |                         |       |
| ANALYSIS OF NET ASSETS                                                                                                                   |       |                    |        |                         |       |
| Common stock,  $0.001 par value, 50,000,000 shares authorized and 11,384,363 and 11,303,510  shares issued and outstanding, respectively |       | $                       | 11,385      |                         | $          | 11,304 |   |
| Capital in excess  of par value                                                                                                          |       | 166,240,635             |        | 164,610,873                  |       |
| Notes receivable  — employees                                                                                                       |       | (8,815,818              | )           | (8,745,781                   | )          |
| Net unrealized  appreciation (depreciation) on investments                                                                               |       | 1,241,029               |        | (4,528,791                   | )          |
| Unrealized  depreciation on derivative                                                                                                   |       | (188,495                | )           | (253,747                     | )          |
| Realized (loss)  gain on sale of investments                                                                                             |       | (861,695                | )           | 42,250                       |       |
| Distributions  less than net investment income                                                                                           |       | 1,158,715               |        | 474,575                      |       |
| TOTAL NET ASSETS                                                                                                                         |       | $                       | 158,785,756 |                         | $          | 151,610,683 |   |
| NET ASSETS PER  SHARE                                                                                                                    |       | $                       | 13.95       |                         | $          | 13.41 |   |
|                                                                                                                                     |       |                    |        |                         |       |

 

*THE ACCOMPANYING NOTES ARE AN INTEGRAL PARTOF THESE CONSOLIDATED FINANCIAL STATEMENTS.*

2

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**GLADSTONE CAPITALCORPORATIONCONSOLIDATED SCHEDULE OF INVESTMENTSAS OF JUNE 30, 2006(UNAUDITED)**

** **
| **Company (1)**                 | ** ** | **Industry**                                 | ** ** | **Investment (2)**                                    | ** ** | **Cost**  | ** ** | **Fair Value** | ** ** |
|--------------------------------------|------------|----------------------------------------------|------------|------------------------------------------------------------|------------|-----------|------------|---------------------|------------|
| Advanced  Homecare Management, Inc.  |       | Home health nursing services                 |       | Senior Subordinated Term Debt (5)(6)  (16.3%, Due 12/2010) |       | $         | 7,500,000  |                | $          | 7,500,000 |   |
|                                 |       |                                         |       |                                                       |       |      |       |                |       |
| Allied  Extruders, LLC               |       | Polyethylene film manufacturer               |       | Senior Real Estate Term Debt                               |       | 1,000,000 |       | 1,000,000           |       |
| P&O  Packaging Acquisition LLC   |       |                                         |       | (9.6%, Due 3/2011)                                         |       |      |       |                |       |
|                                 |       |                                         |       | Senior Term Debt (3) (5)                                   |       | 8,000,000 |       | 8,030,000           |       |
|                                 |       |                                         |       | (11.3%, Due 3/2011)                                        |       |      |       |                |       |
|                                 |       |                                         |       |                                                       |       |      |       |                |       |
| Badanco  Acquisition Corp.           |       | Manufacturing-luggage                        |       | Senior Term Debt (5)                                       |       | 5,512,519 |       | 5,519,409           |       |
|                                 |       |                                         |       | (10.6%, Due 2/2010)                                        |       |      |       |                |       |
|                                 |       |                                         |       | Senior Term Debt (3) (5)                                   |       | 8,617,563 |       | 8,649,878           |       |
|                                 |       |                                         |       | (13.6%, Due 2/2010)                                        |       |      |       |                |       |
|                                 |       |                                         |       |                                                       |       |      |       |                |       |
| Benetech,  Inc.                      |       | Dust management systems                      |       | Senior Term Debt (5)                                       |       | 2,275,000 |       | 2,303,438           |       |
|                                 |       | for the coal and electric utility industries |       | (10.1%, Due 5/2009)                                        |       |      |       |                |       |
|                                 |       |                                         |       | Senior Term Debt (3) (5)                                   |       | 3,087,500 |       | 3,141,531           |       |
|                                 |       |                                         |       | (13.1%, Due 5/2009)                                        |       |      |       |                |       |
|                                 |       |                                         |       |                                                       |       |      |       |                |       |
| Bresnan  Communications, LLC         |       | Service-telecommunications                   |       | Senior Term Debt (6)                                       |       | 1,000,000 |       | 1,000,000           |       |
|                                 |       |                                         |       | (9.6%, Due 3/2014)                                         |       |      |       |                |       |
|                                 |       |                                         |       |                                                       |       |      |       |                |       |
| Consolidated  Bedding, Inc.          |       | Manufacturing-mattresses                     |       | Senior Subordinated Term Debt (5)                          |       | 2,466,864 |       | 2,344,186           |       |
|                                 |       |                                         |       | (13.9%, Due 3/2009)                                        |       |      |       |                |       |
|                                 |       |                                         |       |                                                       |       |      |       |                |       |
| Country  Road Communications LLC     |       | Service-telecommunications                   |       | Senior Subordinated Term Debt (5) (6)                      |       | 5,960,181 |       | 6,060,000           |       |
| Country  Road Management, Inc.       |       |                                         |       | (12.6%, Due 7/2013)                                        |       |      |       |                |       |
|                                 |       |                                         |       |                                                       |       |      |       |                |       |
| Defiance  Stamping Company           |       | Manufacturing-trucking parts                 |       | Senior Term Debt (3) (5)                                   |       | 6,325,000 |       | 6,325,000           |       |
|                                 |       |                                         |       | (13.1%, Due 4/2010)                                        |       |      |       |                |       |
|                                 |       |                                         |       |                                                       |       |      |       |                |       |
| Doe  & Ingalls Management LLC    |       | Distributor-specialty chemicals              |       | Senior Term Debt (5)                                       |       | 4,900,000 |       | 4,918,375           |       |
| Doe  & Ingalls of North Carolina |       |                                         |       | (9.6%, Due 11/2010)                                        |       |      |       |                |       |
| Operating  LLC                       |       |                                         |       | Senior Term Debt (3) (5)                                   |       | 4,500,000 |       | 4,511,250           |       |
| Doe  & Ingalls of Florida        |       |                                         |       | (13.1%, Due 11/2010)                                       |       |      |       |                |       |
| Operating  LLC                       |       |                                         |       |                                                       |       |      |       |                |       |
| Doe  & Ingalls of Virginia       |       |                                         |       |                                                       |       |      |       |                |       |
| Operating  LLC                       |       |                                         |       |                                                       |       |      |       |                |       |
|                                 |       |                                         |       |                                                       |       |      |       |                |       |
| Express  Courier International, Inc. |       | Service-ground delivery and logistics        |       | Line of Credit (7) (8)                                     |       | —    |       | —              |       |
|                                 |       |                                         |       | (9.4%, Due 6/2009)                                         |       |      |       |                |       |
|                                 |       |                                         |       | Senior Term Debt (7)                                       |       | 4,700,000 |       | 4,700,000           |       |
|                                 |       |                                         |       | (9.4%, Due 6/2011)                                         |       |      |       |                |       |
|                                 |       |                                         |       | Senior Term Debt (3) (7)                                   |       | 3,950,000 |       | 3,950,000           |       |
|                                 |       |                                         |       | (11.6%, Due 6/2011)                                        |       |      |       |                |       |
|                                 |       |                                         |       |                                                       |       |      |       |                |       |
| Finn  Corporation                    |       | Manufacturing-landscape equipment            |       | Common Stock Warrants                                      |       | 37,000    |       | 1,047,778           |       |
|                                 |       |                                         |       |                                                       |       |      |       |                |       |
|                                      |            |                                              |            |                                                            |            |           |            |                     |            |  |  |

 

3

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**GLADSTONE CAPITALCORPORATIONCONSOLIDATED SCHEDULE OF INVESTMENTS (Continued)AS OF JUNE 30, 2006**

 
| **Company (1)**                     | ** ** | **Industry**                                              | ** ** | **Investment (2)**                        | ** ** | **Cost**  | ** ** | **Fair Value** | ** ** |
|------------------------------------------|------------|-----------------------------------------------------------|------------|------------------------------------------------|------------|-----------|------------|---------------------|------------|
|                                     |       |                                                      |       |                                           |       |      |       |                |       |
| Gammill,  Inc.                           |       | Designer and assembler of quilting                        |       | Senior Term Debt (5)                           |       | 1,643,479 |       | 1,643,479           |       |
|                                     |       | machines and accessories                                  |       | (9.5%, Due 12/2008)                            |       |      |       |                |       |
|                                     |       |                                                      |       | Senior Term Debt (3) (5) (17)                  |       | 4,571,875 |       | 4,807,418           |       |
|                                     |       |                                                      |       | (12.0%, Due 12/2008)                           |       |      |       |                |       |
|                                     |       |                                                      |       |                                           |       |      |       |                |       |
| Global  Materials                        |       | Manufacturing-steel wool                                  |       | Senior Term Debt (3) (5)                       |       | 5,350,000 |       | 5,316,563           |       |
| Technologies,  Inc.                      |       | products and metal fibers                                 |       | (14.1%, Due 11/2009)                           |       |      |       |                |       |
|                                     |       |                                                      |       |                                           |       |      |       |                |       |
| It’s  Just Lunch International, LLC |       | Service-dating service                                    |       | Line of Credit (7) (13)  (9.1%, Due 6/2009)    |       | 200,000   |       | 200,000             |       |
|                                     |       |                                                      |       | Senior Term Debt (7) (14)  (9.4%, Due 6/2011)  |       | 3,000,000 |       | 3,000,000           |       |
|                                     |       |                                                      |       | Senior Term Debt (3) (15)  (11.6%, Due 6/2011) |       | —    |       | —              |       |
|                                     |       |                                                      |       |                                           |       |      |       |                |       |
| John  Henry Holdings, Inc.               |       | Manufacturing-packaging products                          |       | Senior Subordinated Term Debt (5) (6)          |       | 8,000,000 |       | 8,000,000           |       |
| Multi  Packaging Solutions, Inc.         |       |                                                      |       | (12.02%, Due 6/2011)                           |       |      |       |                |       |
|                                     |       |                                                      |       |                                           |       |      |       |                |       |
| LocalTel,  Inc.                          |       | Service-Yellow Pages publishing                           |       | Line of Credit (16)  (9.6%, Due 6/2009)        |       | —    |       | —              |       |
|                                     |       |                                                      |       | Senior Term Debt (7)|  (9.6%, Due 6/2011)      |       | 2,750,000 |       | 2,750,000           |       |
|                                     |       |                                                      |       | Senior Term Debt (3) (7)  (12.1%, Due 6/2011)  |       | 2,750,000 |       | 2,750,000           |       |
|                                     |       |                                                      |       |                                           |       |      |       |                |       |
| Mistras  Holdings Corp.                  |       | Nondestructive testing instruments,  systems and services |       | Senior Term Debt (3) (5)  (11.1%, Due 8/2008)  |       | 9,666,666 |       | 9,461,249           |       |
|                                     |       |                                                      |       | Senior Term Debt (4) (5)                       |       | 5,333,334 |       | 5,206,667           |       |
|                                     |       |                                                      |       | (12.5%, Due 8/2008)                            |       |      |       |                |       |
|                                     |       |                                                      |       |                                           |       |      |       |                |       |
| Network  Solutions LLC                   |       | Service-internet domain  registry and host           |       | Senior Term Debt (6)  (10.5%, Due 1/2012)      |       | 4,475,518 |       | 4,511,081           |       |
|                                     |       |                                                      |       |                                           |       |      |       |                |       |
| Northern  Contours                       |       | Manufacturing-veneer and                                  |       | Senior Subordinated Term Debt (5)              |       | 7,000,000 |       | 7,008,750           |       |
| Northern  Contours of Kentucky, Inc.     |       | laminate components                                       |       | (12.1%, Due 5/2010)                            |       |      |       |                |       |
| Norcon  Holding LLC                      |       |                                                      |       |                                           |       |      |       |                |       |
| Norcon  Lewis LLC                        |       |                                                      |       |                                           |       |      |       |                |       |
|                                     |       |                                                      |       |                                           |       |      |       |                |       |
| Puerto  Rico Cable                       |       | Service-telecommunications                                |       | Senior Subordinated Term Debt (5) (6)          |       | 7,816,958 |       | 7,833,206           |       |
| Acquisition  Company, Inc.               |       |                                                      |       | (11.8%, Due 1/2012)                            |       |      |       |                |       |
|                                     |       |                                                      |       |                                           |       |      |       |                |       |
| QCE, LLC (d/b/a Quiznos Corp.)           |       | Service-restaurant franchisor                             |       | Senior Term Debt (6)  (7.8%, Due 5/2013)       |       | 3,018,897 |       | 2,992,580           |       |
|                                     |       |                                                      |       | Senior Term Debt (3) (6)  (11.2%, Due 11/2013) |       | 3,047,171 |       | 3,037,500           |       |
|                                     |       |                                                      |       |                                           |       |      |       |                |       |
| RCS  Management Holding Co.              |       | Service-healthcare supplies                               |       | Senior Term Debt (3) (5)  (9.6%, Due 1/2011)   |       | 3,000,000 |       | 3,003,750           |       |
|                                     |       |                                                      |       | Senior  Term Debt (4) (5)  (12.1%, Due 1/2011) |       | 3,000,000 |       | 3,003,750           |       |

 

4

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**GLADSTONE CAPITALCORPORATION**

**CONSOLIDATED SCHEDULEOF INVESTMENTS (Continued)**

**AS OF JUNE 30, 2006**

 
| **Company (1)**          | ** ** | **Industry**                            | ** ** | **Investment (2)**                | ** ** | **Cost**   | ** **      | **Fair Value** | ** ** |
|-------------------------------|------------|-----------------------------------------|------------|----------------------------------------|------------|------------|-----------------|---------------------|------------|
|                          |       |                                    |       |                                   |       |       |            |                |       |
| SCPH  Holdings, Inc.          |       | Manufacturing-underwater                |       | Credit Facility (5) (7) (9)            |       | 500,000    |            | 500,000             |       |
| Sea  Con Phoenix, Inc.        |       | and harsh environment                   |       | (9.6%, Due 2/2007)                     |       |       |            |                |       |
| Phoenix  Optix, Inc.          |       | components                              |       | Senior Term Debt (5)                   |       | 2,800,000  |            | 2,807,000           |       |
|                          |       |                                    |       | (10.1%, Due 2/2010)                    |       |       |            |                |       |
|                          |       |                                    |       | Senior Term Debt (3) (5)               |       | 2,925,000  |            | 2,932,313           |       |
|                          |       |                                    |       | (13.1%, Due 2/2010)                    |       |       |            |                |       |
|                          |       |                                    |       |                                   |       |       |            |                |       |
| SCS  Acquisition Corp.        |       | Service-chemically treated              |       | Senior Term Debt (3) (5) (10)          |       | 6,375,000  |            | 6,382,969           |       |
|                          |       | equipment distribution                  |       | (9.1%, Due 12/2011)                    |       |       |            |                |       |
|                          |       |                                    |       | Senior Term Debt (3) (5) (11)          |       | 6,587,500  |            | 6,595,734           |       |
|                          |       |                                    |       | (11.1%, Due 12/2011)                   |       |       |            |                |       |
|                          |       |                                    |       |                                   |       |       |            |                |       |
| Thibaut  Acquisition Co.      |       | Design and disbtribution-wall coverings |       | Credit Facility (5) (12)               |       | 225,000    |            | 224,719             |       |
|                          |       |                                    |       | (9.6%, Due 1/2011)                     |       |       |            |                |       |
|                          |       |                                    |       | Senior Term Debt (5)                   |       | 3,412,500  |            | 3,412,500           |       |
|                          |       |                                    |       | (9.6%, Due 1/2011)                     |       |       |            |                |       |
|                          |       |                                    |       | Senior Term Debt (3) (5)               |       | 3,000,000  |            | 3,000,000           |       |
|                          |       |                                    |       | (12.1%, Due 1/2011)                    |       |       |            |                |       |
|                          |       |                                    |       |                                   |       |       |            |                |       |
| Visual  Edge Technology, Inc. |       | Service-office supplies distribution    |       | Senior Subordinated Term Debt (5) (18) |       | 5,000,000  |            | 5,133,000           |       |
| Graphic  Enterprises, Inc.    |       |                                    |       | (13.1%, Due 8/2011)                    |       |       |            |                |       |
| Copeco,  Inc.                 |       |                                    |       |                                   |       |       |            |                |       |
|                          |       |                                    |       |                                   |       |       |            |                |       |
| Westlake  Hardware, Inc.      |       | Retail-hardware and variety             |       | Senior Subordinated Term Debt (5)      |       | 15,000,000 |            | 15,000,000          |       |
| WHI  Holding Corp.            |       |                                    |       | (12.4%, Due 1/2011)                    |       |       |            |                |       |
|                          |       |                                    |       |                                   |       |       |            |                |       |
| Winchester  Electronics       |       | Manufacturing-high bandwidth            |       | Senior Term Debt (3) (7)               |       | 6,000,000  |            | 6,000,000           |       |
|                          |       | connectors and cables                   |       | (12.1%, Due 6/2012)                    |       |       |            |                |       |
|                          |       |                                    |       |                                   |       |       |            |                |       |
| Xspedius  Communications LLC  |       | Service-telecommunications              |       | Senior Subordinated Term Debt (5)      |       | 5,185,096  |            | 5,191,577           |       |
|                          |       |                                    |       | (15.8%, Due 3/2010)                    |       |       |            |                |       |
|                          |       |                                    |       |                                   |       |       |            |                |       |
| **Total:**                    | ** ** | ** **                              | ** ** | ** **                             | ** ** | **$**      | **201,465,621** | ** **          | **$**      | **202,706,650** |   |
| ** **                    | ** ** | ** **                              | ** ** | ** **                             | ** ** | ** ** | ** **      | ** **          |       |
|                               |            |                                         |            |                                        |            |            |                 |                     |            |  |  |

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(1)             We do not “Control,” and are not an“Affiliate” of, any of our portfolio companies, each as defined in theInvestment Company Act of 1940, as amended (the “1940 Act”). In general, underthe 1940 Act, we would “Control” a portfolio company if we owned 25% or more ofits voting securities and would be an “Affiliate” of a portfolio company if weowned 5% or more of its voting securities.

(2)             Percentage represents interestrates in effect at June 30, 2006 and due date represents the contractualmaturity date.

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

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

(5)             Fair value was based on valuationprepared and provided by Standard & Poor’s Loan Evaluation Services.

(6)             Marketable securities, such assyndicated loans, are valued based on the indicative bid price, as of June 30,2006, from the respective originating syndication agent’s trading desk.

(7)             Investment valued at cost due torecent acquisition.

(8)             Availability under the creditfacility totals $1,500,000.  There wereno borrowings outstanding at June 30, 2006.

(9)             Availability under the creditfacility totals $500,000.  The creditfacility was fully drawn at June 30, 2006.

(10)       Availability under the debt facilitytotals $7,500,000. The outstanding balance of the debt facility was $6,375,000at June 30, 2006.

(11)       Availability under the debtfacility totals $7,500,000. The outstanding balance of the debt facility was$6,587,500 at June 30, 2006.

5

----

(12)       Availability under the creditfacility totals $1,000,000.  Borrowingsof $225,000 were outstanding at June 30, 2006.

(13)       Availability under the creditfacility totals $750,000.  Borrowings of$200,000 were outstanding at June 30, 2006.

(14)       The Company may borrow anadditional $500,000 of the Senior Term Debt facility, subject to certainconditions including Gladstone Capital’s approval.

(15)       The Company may borrow anadditional $2,250,000 of the Senior Term Debt facility, subject to certainconditions including Gladstone Capital’s approval.

(16)       Availability under the creditfacility totals $3,000,000.  There wereno borrowings outstanding at June 30, 2006.

(17)       Includes a success fee with a$252,688 fair value and no cost basis.

(18)       Includes a success fee with a$58,000 fair value and no cost basis.

*THE ACCOMPANYING NOTES ARE AN INTEGRAL PARTOF THESE CONSOLIDATED FINANCIAL STATEMENTS.*

6

----

**GLADSTONE CAPITALCORPORATIONCONSOLIDATED SCHEDULE OF INVESTMENTSAS OF SEPTEMBER 30, 2005**

 
| **Company (1)**                    | ** ** | **Industry**                                                 | ** ** | **Investment (2)**                                           | ** ** | **Cost**   | ** ** | **Fair Value** |
|------------------------------------|------------|--------------------------------------------------------------|------------|--------------------------------------------------------------|------------|------------|------------|----------------|
| ** **                         | ** ** | ** **                                                   | ** ** | ** **                                                   | ** ** | ** ** | ** ** | ** **     |
| Advanced Homecare Management, Inc. |       | Home health nursing  services                                |       | Senior Subordinated Term  Debt (6)                      |       | $7,500,000 |       | $7,500,000     |
|                               |       |                                                         |       | (12.6%, Due 12/2010)                                         |       |       |       |           |
|                               |       |                                                         |       |                                                         |       |       |       |           |
| Allied Extruders, Inc.             |       | Polyethylene film  manufacturer                              |       | Senior Term Debt (3)                                         |       | 3,950,000  |       | 3,964,813      |
|                               |       |                                                         |       | (12.3%, Due 7/2009)                                          |       |       |       |           |
|                               |       |                                                         |       |                                                         |       |       |       |           |
| ARI Holdings, Inc. (11) (12)       |       | Manufacturing-auto parts                                     |       | Senior Term Debt                                             |       | 3,933,939  |       | 2,880,000      |
|                               |       |                                                         |       | (12.8%, Due 2/2008)                                          |       |       |       |           |
|                               |       |                                                         |       |                                                         |       |       |       |           |
| Badanco Acquisition Corp.          |       | Manufacturing-luggage                                        |       | Senior Term Debt (6)                                         |       | 6,615,019  |       | 6,615,019      |
|                               |       |                                                         |       | (9.2%, Due 2/2010)                                           |       |       |       |           |
|                               |       |                                                         |       | Senior Term Debt (3) (6)                                     |       | 8,650,000  |       | 8,650,000      |
|                               |       |                                                         |       | (12.2%, Due 2/2010)                                          |       |       |       |           |
|                               |       |                                                         |       |                                                         |       |       |       |           |
| Benetech, Inc.                     |       | Dust management systems for  the coal and electric           |       | Senior Term Debt (6)  (8.7%, Due 5/2009)                     |       | 2,762,500  |       | 2,783,219      |
|                               |       | utility industries                                           |       | Senior Term Debt (3) (6)                                     |       | 3,209,375  |       | 3,249,492      |
|                               |       |                                                         |       | (11.7%, Due 5/2009)                                          |       |       |       |           |
|                               |       |                                                         |       |                                                         |       |       |       |           |
| Consolidated Bedding, Inc.         |       | Manufacturing-mattresses                                     |       | Senior Subordinated Term  Debt (6)                           |       | 2,927,382  |       | 2,898,968      |
|                               |       |                                                         |       | (13.0%, Due 3/2009)                                          |       |       |       |           |
|                               |       |                                                         |       |                                                         |       |       |       |           |
| Country Road                       |       | Service-telecommunications                                   |       | Senior Subordinated Term  Debt                               |       | 5,955,942  |       | 6,060,000      |
| Communications LLC                 |       |                                                         |       | (11.6%, Due 7/2013)                                          |       |       |       |           |
| Country Road Management, Inc.      |       |                                                         |       |                                                         |       |       |       |           |
|                               |       |                                                         |       |                                                         |       |       |       |           |
| Coyne International                |       | Industrial services                                          |       | Senior Term Debt (3) (5)  (6)                                |       | 6,375,052  |       | 6,367,083      |
| Enterprises                        |       |                                                         |       | (13.0%, PIK 2%, Due 7/2007)                                  |       |       |       |           |
|                               |       |                                                         |       |                                                         |       |       |       |           |
| Defiance Stamping                  |       | Manufacturing-trucking  parts                                |       | Senior Term Debt (3)                                         |       | 6,325,000  |       | 6,332,906      |
| Company                            |       |                                                         |       | (11.7%, Due 4/2010)                                          |       |       |       |           |
|                               |       |                                                         |       |                                                         |       |       |       |           |
| Finn Corporation                   |       | Manufacturing-landscape equipment                            |       | Senior Subordinated Term  Debt (6)  (13.0%, Due 2/2006) |       | 10,500,000 |       | 7,350,000      |
|                               |       |                                                         |       | Common Stock Warrants                                        |       | 37,000     |       | 682,114        |
|                               |       |                                                         |       |                                                         |       |       |       |           |
| Gammill, Inc.                      |       | Designer and assembler of  quilting machines and accessories |       | Senior Term Debt (6)  (9.5%, Due 12/2008)                    |       | 3,771,427  |       | 3,771,427      |
|                               |       |                                                         |       | Senior Term Debt (3) (6)                                     |       | 4,690,625  |       | 4,667,172      |
|                               |       |                                                         |       | (12.0%, Due 12/2008)                                         |       |       |       |           |
|                               |       |                                                         |       |                                                         |       |       |       |           |
| Global Materials                   |       | Manufacturing-steel wool                                     |       | Senior Term Debt (3) (6)                                     |       | 5,500,000  |       | 5,486,250      |
| Technologies, Inc.                 |       | products and metal fibers                                    |       | (13.0%, Due 11/2009)                                         |       |       |       |           |
|                               |       |                                                         |       |                                                         |       |       |       |           |
| Infor Global Solutions Ltd.        |       | Enterprise application  solutions                            |       | Senior Subordinated Term  Debt (7)                      |       | 6,821,250  |       | 7,070,000      |
|                               |       |                                                         |       | (11.0%, Due 4/2012)                                          |       |       |       |           |
|                               |       |                                                         |       |                                                         |       |       |       |           |
| John Henry Holdings, Inc.          |       | Manufacturing-packaging  products                            |       | Senior Subordinated Term  Debt(6)  (11.0%, Due 6/2011)       |       | 7,067,923  |       | 7,064,500      |
|                               |       |                                                         |       |                                                         |       |       |       |           |

** **

7

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**GLADSTONE CAPITALCORPORATIONCONSOLIDATED SCHEDULE OF INVESTMENTSAS OF SEPTEMBER 30, 2005**

 
| **Company (1)**               | ** ** | **Industry**                                | ** ** | **Investment (2)**                      | ** ** | **Cost**   | ** ** | **Fair Value** |
|-------------------------------|------------|---------------------------------------------|------------|-----------------------------------------|------------|------------|------------|----------------|
| ** **                    | ** ** | ** **                                  | ** ** | ** **                              | ** ** | ** ** | ** ** | ** **     |
| Marcal Paper Mills, Inc. (12) |       | Manufacturing-paper  products               |       | Senior Subordinated Term  Debt (6) |       | $6,275,000 |       | $6,149,500     |
|                          |       |                                        |       | (13.0%, Due 12/2006)                    |       |       |       |           |
|                          |       |                                        |       | First Mortgage Loan (5)                 |       | 9,277,877  |       | 9,277,877      |
|                          |       |                                        |       | (16%, PIK 1%, Due 12/2006)              |       |       |       |           |
|                          |       |                                        |       |                                    |       |       |       |           |
| Mistras Holdings Corp.        |       | Nondestructive testing                      |       | Senior Term Debt (3) (6)                |       | 9,666,666  |       | 9,461,249      |
|                          |       | instruments, systems                        |       | (10.5%, Due 8/2008)                     |       |       |       |           |
|                          |       | and services                                |       | Senior Term Debt (3) (6)                |       | 4,833,334  |       | 4,724,584      |
|                          |       |                                        |       | (12.5%, Due 8/2008)                     |       |       |       |           |
|                          |       |                                        |       | Senior Term Debt (3) (6)                |       | 1,000,000  |       | 982,500        |
|                          |       |                                        |       | (13.5%, Due 8/2008)                     |       |       |       |           |
|                          |       |                                        |       |                                    |       |       |       |           |
| Northern Contours             |       | Manufacturing-veneer and                    |       | Senior Subordinated Term                |       | 7,000,000  |       | 7,000,000      |
| Northern Contours             |       | laminate components                         |       | Debt (8)                           |       |       |       |           |
| of Kentucky, Inc.             |       |                                        |       | (10.7%, Due 5/2010)                     |       |       |       |           |
| Norcon Holding LLC            |       |                                        |       |                                    |       |       |       |           |
| Norcon Lewis LLC              |       |                                        |       |                                    |       |       |       |           |
|                          |       |                                        |       |                                    |       |       |       |           |
| Penn Engineering &        |       | Manufacturing-fractional                    |       | Senior Subordinated Term                |       | 5,009,524  |       | 5,050,000      |
| Manufacturing Corp.           |       | horsepower engines                          |       | Debt (8)                                |       |       |       |           |
| PN Merger Sub Inc.            |       |                                        |       | (10.0%, Due 5/2012)                     |       |       |       |           |
| PEM Holding Co.               |       |                                        |       |                                    |       |       |       |           |
|                          |       |                                        |       |                                    |       |       |       |           |
| Polar Corporation             |       | Manufacturing-trailer parts                 |       | Senior Subordinated Term                |       | 8,609,566  |       | 8,627,500      |
|                          |       |                                        |       | Debt (6)                                |       |       |       |           |
|                          |       |                                        |       | (10.3%, Due 6/2010)                     |       |       |       |           |
|                          |       |                                        |       |                                    |       |       |       |           |
| Puerto Rico Cable             |       | Service-telecommunications                  |       | Senior Subordinated Term  Debt          |       | 5,050,182  |       | 5,075,000      |
| Acquisition Company, Inc.     |       |                                        |       | (10.3%, Due 1/2012)                     |       |       |       |           |
|                          |       |                                        |       |                                    |       |       |       |           |
| Regency Gas Services LLC      |       | Midstream gas gathering and                 |       | Senior Subordinated Term                |       | 5,029,188  |       | 5,037,500      |
|                          |       | processing                                  |       | Debt (7)                                |       |       |       |           |
|                          |       |                                        |       | (9.9%, Due 12/2010)                     |       |       |       |           |
|                          |       |                                        |       |                                    |       |       |       |           |
| Santana Plastics              |       | Manufacturing-polyethylene                  |       | Senior Term Debt (3) (6)                |       | 6,000,000  |       | 6,007,500      |
|                          |       | bathroom partitions                         |       | (11.7%, Due 11/2009)                    |       |       |       |           |
|                          |       |                                        |       | Senior Term Debt (4) (6)                |       | 1,950,000  |       | 1,952,438      |
|                          |       |                                        |       | (13.0%, Due 11/2009)                    |       |       |       |           |
|                          |       |                                        |       |                                    |       |       |       |           |
| SCPH Holdings, Inc.           |       | Manufacturing-underwater                    |       | Credit Facility (9)                     |       | —     |       | —         |
| Sea Con Phoenix, Inc.         |       | and harsh environment                       |       | (8.0%, Due 3/2006)                      |       |       |       |           |
| Phoenix Optix, Inc.           |       | components                                  |       | Senior Term Debt (3) (6)                |       | 3,237,500  |       | 3,241,547      |
|                          |       |                                        |       | (8.7%, Due 2/2010)                      |       |       |       |           |
|                          |       |                                        |       | Senior Term Debt (6)                    |       | 3,000,000  |       | 3,003,750      |
|                          |       |                                        |       | (12.0%, Due 2/2010)                     |       |       |       |           |
|                          |       |                                        |       |                                    |       |       |       |           |
| Survey Sampling               |       | Service-telecommunications                  |       | Senior Subordinated Term  Debt (6)      |       | 4,514,105  |       | 4,539,375      |
|                          |       |                                        |       | (11.0%, Due 5/2012)                     |       |       |       |           |
|                          |       |                                        |       |                                    |       |       |       |           |
| Tech Lighting LLC             |       | Manufacturing-low voltage  lighting systems |       | Senior Subordinated Term  Debt (6) |       | 9,012,452  |       | 9,067,500      |
|                          |       |                                        |       | (10.4%, Due 10/2010)                    |       |       |       |           |
|                          |       |                                        |       |                                    |       |       |       |           |
| Visual Edge Technology, Inc.  |       | Service-office supplies                     |       | Senior Subordinated Term  Debt          |       | 5,000,000  |       | 5,000,000      |
| Graphic Enterprises, Inc.     |       | distribution                                |       | (11.7%, Due 8/2011)                     |       |       |       |           |
| Copeco, Inc.                  |       |                                        |       |                                    |       |       |       |           |

 

8

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**GLADSTONE CAPITALCORPORATIONCONSOLIDATED SCHEDULE OF INVESTMENTSAS OF SEPTEMBER 30, 2005**

 
| **Company (1)**             | ** ** | **Industry**               | ** ** | **Investment (2)**                      | ** ** | **Cost**         | ** ** | **Fair Value**   |
|-----------------------------|------------|----------------------------|------------|-----------------------------------------|------------|------------------|------------|------------------|
|                        |       |                       |       |                                    |       |             |       |             |
| Woven Electronics           |       | Custom electrical cable    |       | Senior Term Debt (4) (6)  (10)          |       | $8,344,999       |       | $8,776,435       |
| Corporation                 |       | assemblies                 |       | (11.5%, Due 3/2009)                     |       |             |       |             |
|                        |       |                       |       |                                    |       |             |       |             |
| Xspedius Communications LLC |       | Service-telecommunications |       | Senior Subordinated Term  Debt (6) |       | 5,972,727        |       | 4,479,545        |
|                        |       |                       |       | (14.3%, Due 3/2010)                     |       |             |       |             |
|                        |       |                       |       |                                    |       |             |       |             |
| **Total:**                  | ** ** | ** **                 | ** ** | ** **                              | ** ** | **$205,375,554** | ** ** | **$200,846,763** |

----

(1)             We do not “Control,” and are not an“Affiliate” of, any of our portfolio companies, each as defined in theInvestment Company Act of 1940, as amended (the “1940 Act”). In general, underthe 1940 Act, we would “Control” a portfolio company if we owned 25% or more ofits voting securities and would be an “Affiliate” of a portfolio company if weowned 5% or more of its voting securities.

(2)             Percentage represents interestrates in effect at September 30, 2005 and due date represents the contractualmaturity date.

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

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

(5)             Has some paid in kind (PIK)interest.  Refer to Note 2 “Summary ofSignificant Accounting Policies” of the Company’s Form 10-K for the fiscal yearended September 30, 2005.

(6)             Fair value was based on valuationprepared and provided by Standard & Poor’s Loan Evaluation Services.

(7)             Marketable securities, such assyndicated loans, are valued based on the indicative bid price, as of September30, 2005, from the respective originating syndication agent’s trading desk.

(8)             Investment was valued at cost dueto recent acquisition.

(9)             Availability under the creditfacility totals $500,000.  There were noborrowings outstanding at September 30, 2005.

(10)       Includes a success fee with a$347,986 fair value and no cost basis.

(11)       Non-income producing at September30, 2005.

(12)       Subsequent to September 30, 2005,the entire investment in the portfolio company was sold at the fair valuereflected herein.

 

*THE ACCOMPANYING NOTES ARE AN INTEGRAL PARTOF THESE CONSOLIDATED FINANCIAL STATEMENTS.*

9

----

**GLADSTONE CAPITAL CORPORATIONCONSOLIDATED STATEMENTS OF OPERATIONS(UNAUDITED)**
| ** **                                                                              | ** ** | **Three Months Ended June 30,** | ** ** |
|-----------------------------------------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                                                              | ** ** | **2006**                                            | ** ** | **2005** | ** ** |
| INVESTMENT  INCOME                                                                      |       |                                                |       |   |   |
| Interest income — investments                                                      |       | $                                                   | 5,775,522  |   | $ | 5,766,233 |   |
| Interest income — cash and cash equivalents                                        |       | 8,178                                               |       | 7,631 |   |
| Interest income — notes receivable from employees                                  |       | 108,877                                             |       | 108,065 |   |
| Prepayment fees and other income                                                        |       | 630,239                                             |       | 245,297 |   |
| Total investment income                                                                 |       | 6,522,816                                           |       | 6,127,226 |   |
|                                                                                    |       |                                                |       |   |   |
| EXPENSES                                                                                |       |                                                |       |   |   |
| Loan servicing (Refer to Note 12)                                                       |       | 693,965                                             |       | 687,971 |   |
| Management fee (Refer to Notes 12 and 15)                                               |       | 331,040                                             |       | 358,631 |   |
| Professional fees                                                                       |       | 166,405                                             |       | 133,505 |   |
| Amortization of deferred financing fees                                                 |       | 36,036                                              |       | 100,663 |   |
| Interest expense                                                                        |       | 702,449                                             |       | 563,336 |   |
| Stockholder related costs                                                               |       | 28,371                                              |       | 16,475 |   |
| Directors fees                                                                          |       | 27,500                                              |       | 26,624 |   |
| Insurance expense                                                                       |       | 50,589                                              |       | 43,891 |   |
| Stock option compensation                                                               |       | 202,296                                             |       | — |   |
| Other expenses                                                                          |       | 35,083                                              |       | 64,304 |   |
| Expenses before credit from Gladstone Management                                        |       | 2,273,734                                           |       | 1,995,400 |   |
| Credit to management fee for fees collected by  Gladstone Management (Refer to Note 15) |       | (539,000                                            | )          | (240,600 | ) |
| Total expenses net of credit to management fee                                          |       | 1,734,734                                           |       | 1,754,800 |   |
|                                                                                    |       |                                                |       |   |   |
| NET INVESTMENT  INCOME BEFORE INCOME TAXES                                              |       | 4,788,082                                           |       | 4,372,426 |   |
| Income tax expense                                                                      |       | —                                              |       | — |   |
| NET INVESTMENT  INCOME                                                                  |       | 4,788,082                                           |       | 4,372,426 |   |
|                                                                                    |       |                                                |       |   |   |
| REALIZED AND  UNREALIZED GAIN (LOSS) ON                                                 |       |                                                |       |   |   |
| INVESTMENTS:                                                                            |       |                                                |       |   |   |
| Realized loss on sale of investments                                                    |       | (100,850                                            | )          | — |   |
| Realized gain on settlement of derivative                                               |       | 1,367                                               |       | — |   |
| Unrealized appreciation (depreciation) on derivative                                    |       | 41,486                                              |       | (49,044 | ) |
| Net unrealized appreciation (depreciation) on  investments                              |       | 812,991                                             |       | (389,229 | ) |
| Net gain (loss) on investments                                                          |       | 754,994                                             |       | (438,273 | ) |
|                                                                                    |       |                                                |       |   |   |
| NET INCREASE IN  NET ASSETS RESULTING FROM OPERATIONS                                   |       | $                                                   | 5,543,076  |   | $ | 3,934,153 |   |
|                                                                                    |       |                                                |       |   |   |
| NET INCREASE IN  NET ASSETS RESULTING FROM OPERATIONS PER COMMON SHARE:                 |       |                                                |       |   |   |
| Basic                                                                                   |       | $                                                   | 0.49       |   | $ | 0.35 |   |
| Diluted                                                                                 |       | $                                                   | 0.48       |   | $ | 0.34 |   |

 
|                                                  |   |       |   |       |   |
|-------------------------------------------------------|--------|------------|--------|------------|--------|
| WEIGHTED AVERAGE  SHARES OF COMMON STOCK OUTSTANDING: |   |       |   |       |   |
| Basic                                                 |   | 11,337,291 |   | 11,299,010 |   |
| Diluted                                               |   | 11,570,425 |   | 11,578,637 |   |
|                                                  |   |       |   |       |   |

 

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

10

----

**GLADSTONE CAPITAL CORPORATIONCONSOLIDATED STATEMENTS OF OPERATIONS(UNAUDITED)**

** **
| ** **                                                                              | ** ** | **Nine Months Ended June 30,** | ** ** |
|-----------------------------------------------------------------------------------------|------------|----------------------------------------------------|------------|
| ** **                                                                              | ** ** | **2006**                                           | ** ** | **2005** | ** ** |
| INVESTMENT  INCOME                                                                      |       |                                               |       |   |   |
| Interest income — investments                                                      |       | $                                                  | 18,497,893 |   | $ | 16,671,756 |   |
| Interest income — cash and cash equivalents                                        |       | 21,714                                             |       | 29,101 |   |
| Interest income — notes receivable from employees                                  |       | 323,003                                            |       | 336,382 |   |
| Prepayment fees and other income                                                        |       | 711,225                                            |       | 1,054,917 |   |
| Total investment income                                                                 |       | 19,553,835                                         |       | 18,092,156 |   |
|                                                                                    |       |                                               |       |   |   |
| EXPENSES                                                                                |       |                                               |       |   |   |
| Loan servicing (Refer to Note 12)                                                       |       | 2,144,024                                          |       | 1,804,465 |   |
| Management fee (Refer to Notes 12 and 15)                                               |       | 952,120                                            |       | 1,075,940 |   |
| Professional fees                                                                       |       | 399,758                                            |       | 528,610 |   |
| Amortization of deferred financing fees                                                 |       | 94,572                                             |       | 284,487 |   |
| Interest expense                                                                        |       | 2,302,693                                          |       | 1,174,587 |   |
| Stockholder related costs                                                               |       | 273,170                                            |       | 192,785 |   |
| Directors fees                                                                          |       | 81,712                                             |       | 77,624 |   |
| Insurance expense                                                                       |       | 151,956                                            |       | 134,053 |   |
| Stock option compensation                                                               |       | 279,618                                            |       | — |   |
| Other expenses                                                                          |       | 151,663                                            |       | 176,939 |   |
| Expenses before credit from Gladstone Management                                        |       | 6,831,286                                          |       | 5,449,490 |   |
| Credit to  management fee for fees collected by Gladstone Management (Refer to Note 15) |       | (1,762,000                                         | )          | (977,100 | ) |
| Total expenses net of credit to management fee                                          |       | 5,069,286                                          |       | 4,472,390 |   |
|                                                                                    |       |                                               |       |   |   |
| NET INVESTMENT  INCOME BEFORE INCOME TAXES                                              |       | 14,484,549                                         |       | 13,619,766 |   |
| Income tax expense                                                                      |       | 50,237                                             |       | 138,678 |   |
| NET INVESTMENT  INCOME                                                                  |       | 14,434,312                                         |       | 13,481,088 |   |
|                                                                                    |       |                                               |       |   |   |
| REALIZED AND  UNREALIZED GAIN (LOSS) ON                                                 |       |                                               |       |   |   |
| INVESTMENTS:                                                                            |       |                                               |       |   |   |
| Net realized (loss) gain on sale of investments                                         |       | (903,945                                           | )          | 29,750 |   |
| Realized gain on settlement of derivative                                               |       | 1,367                                              |       | — |   |
| Unrealized appreciation (depreciation) on derivative                                    |       | 65,252                                             |       | (58,007 | ) |
| Net unrealized appreciation (depreciation) on  investments                              |       | 5,769,820                                          |       | (298,352 | ) |
| Net gain (loss) on investments                                                          |       | 4,932,494                                          |       | (326,609 | ) |
|                                                                                    |       |                                               |       |   |   |
| NET INCREASE IN  NET ASSETS RESULTING FROM OPERATIONS                                   |       | $                                                  | 19,366,806 |   | $ | 13,154,479 |   |
|                                                                                    |       |                                               |       |   |   |
| NET INCREASE IN  NET ASSETS RESULTING FROM OPERATIONS PER COMMON SHARE:                 |       |                                               |       |   |   |
| Basic                                                                                   |       | $                                                  | 1.71       |   | $ | 1.17 |   |
| Diluted                                                                                 |       | $                                                  | 1.68       |   | $ | 1.13 |   |
|                                                                                    |       |                                               |       |   |   |
| WEIGHTED AVERAGE  SHARES OF COMMON STOCK OUTSTANDING:                                   |       |                                               |       |   |   |
| Basic                                                                                   |       | 11,317,437                                         |       | 11,288,784 |   |
| Diluted                                                                                 |       | 11,549,054                                         |       | 11,602,986 |   |
|                                                                                    |       |                                               |       |   |   |

 

*THE ACCOMPANYING NOTES ARE AN INTEGRAL PARTOF THESE CONSOLIDATED FINANCIAL STATEMENTS.*

11

----

**GLADSTONE CAPITAL CORPORATIONCONSOLIDATED STATEMENTS OF CHANGES IN NET ASSETS(UNAUDITED)**

 
| ** **                                                 | ** ** | **Nine Months Ended June 30,** | ** **  |
|------------------------------------------------------------|------------|----------------------------------------------------|-------------|
| ** **                                                 | ** ** | **2006**                                           | ** **  | **2005** | ** ** |
| *Operations:*                                              | * *   | * *                                           | * *    | * * | * * |
| Net investment income                                      |       | $                                                  | 14,434,312  |   | $ | 13,481,088 |   |
| Net realized (loss) gain on sale of investments            |       | (903,945                                           | )           | 29,750 |   |
| Realized gain on settlement of derivative                  |       | 1,367                                              |        | — |   |
| Unrealized appreciation (depreciation) on derivative       |       | 65,252                                             |        | (58,007 | ) |
| Net unrealized appreciation (depreciation) on  investments |       | 5,769,820                                          |        | (298,352 | ) |
| Net increase in net assets from operations                 |       | 19,366,806                                         |        | 13,154,479 |   |
|                                                       |       |                                               |        |   |   |
| *Capital  transactions:*                                   | * *   | * *                                           | * *    | * * | * * |
| Distributions to stockholders                              |       | (13,751,539                                        | )           | (12,531,746 | ) |
| Stock option compensation                                  |       | 279,618                                            |        | — |   |
| Issuance of common stock under stock option plan           |       | 1,150,245                                          |        | 270,250 |   |
| Repayment of principal on employee notes                   |       | 129,943                                            |        | 797,429 |   |
| Shelf offering costs                                       |       | —                                             |        | (111,233 | ) |
| Decrease in net assets from capital share  transactions    |       | (12,191,733                                        | )           | (11,575,300 | ) |
|                                                       |       |                                               |        |   |   |
| Total increase  in net assets                              |       | 7,175,073                                          |        | 1,579,179 |   |
| Net assets at  beginning of year                           |       | 151,610,683                                        |        | 152,226,655 |   |
| Net assets at  end of period                               |       | $                                                  | 158,785,756 |   | $ | 153,805,834 |   |
|                                                       |       |                                               |        |   |   |

 

*THE ACCOMPANYING NOTES ARE AN INTEGRAL PARTOF THESE CONSOLIDATED FINANCIAL STATEMENTS.*

12

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**GLADSTONE CAPITAL CORPORATIONCONSOLIDATED STATEMENTS OF CASH FLOWS(UNAUDITED)**

 
| ** **                                                                                                                             | ** ** | **Nine Months Ended June 30,** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------------|------------|----------------------------------------------------|------------|
| ** **                                                                                                                             | ** ** | **2006**                                           | ** ** | **2005** | ** ** |
| **CASH  FLOWS FROM OPERATING ACTIVITIES**                                                                                              | ** ** | ** **                                         | ** ** | ** ** | ** ** |
| ** **                                                                                                                             | ** ** | ** **                                         | ** ** | ** ** | ** ** |
| Net increase in net assets resulting from operations                                                                                   |       | $                                                  | 19,366,806 |   | $ | 13,154,479 |   |
| Adjustments to reconcile net increase in net assets  resulting from operations to net cash provided by (used in) operating activities: |       |                                               |       |   |   |
| Net amortization of premiums and discounts                                                                                             |       | (144,501                                           | )          | (6,949 | ) |
| Amortization of deferred financing fees                                                                                                |       | 94,572                                             |       | 284,487 |   |
| Stock compensation                                                                                                                     |       | 279,618                                            |       | — |   |
| Realized loss on investments                                                                                                           |       | 1,329,458                                          |       | — |   |
| Unrealized (appreciation) depreciation on derivative                                                                                   |       | (65,252                                            | )          | 58,007 |   |
| Change in net unrealized (appreciation) depreciation  on investments                                                                   |       | (5,769,820                                         | )          | 298,352 |   |
| Decrease (increase) in interest receivable                                                                                             |       | 276,230                                            |       | (340,303 | ) |
| Decrease (increase) in funds due from custodian                                                                                        |       | 130,150                                            |       | (11,027,346 | ) |
| Decrease in prepaid assets                                                                                                             |       | 105,902                                            |       | 120,054 |   |
| (Increase) decrease in due from affiliate                                                                                              |       | (207,960                                           | )          | 109,639 |   |
| Increase in other assets                                                                                                               |       | (27,845                                            | )          | (11,973 | ) |
| Increase in accounts payable                                                                                                           |       | 23,449                                             |       | 158 |   |
| Increase in interest payable                                                                                                           |       | 4,685                                              |       | 100,320 |   |
| Decrease in accrued expenses and deferred  liabilities                                                                                 |       | (125,298                                           | )          | (599,277 | ) |
| (Decrease) increase in fees due to affiliate                                                                                           |       | (209,924                                           | )          | 205,900 |   |
| Increase in funds held in escrow                                                                                                       |       | 40                                                 |       | 200,000 |   |
| Increase in investment balance due to payment in  kind interest                                                                        |       | (74,701                                            | )          | (348,509 | ) |
| Net cash provided by operating activities                                                                                              |       | 14,985,609                                         |       | 2,197,039 |   |
|                                                                                                                                   |       |                                               |       |   |   |
| **CASH  FLOWS FROM INVESTING ACTIVITIES:**                                                                                             | ** ** | ** **                                         | ** ** | ** ** | ** ** |
| ** **                                                                                                                             | ** ** | ** **                                         | ** ** | ** ** | ** ** |
| Purchase of investments                                                                                                                |       | (105,076,400                                       | )          | (126,195,458 | ) |
| Principal repayments on investments                                                                                                    |       | 107,876,077                                        |       | 77,990,345 |   |
| Repayment of repurchase agreements                                                                                                     |       | —                                             |       | (21,345,997 | ) |
| Receipt of principal on notes receivable - employees                                                                                   |       | 129,943                                            |       | 797,429 |   |
| Net cash provided by (used in) investing activities                                                                                    |       | 2,929,620                                          |       | (68,753,681 | ) |
|                                                                                                                                   |       |                                               |       |   |   |
| **CASH  FLOWS FROM FINANCING ACTIVITIES:**                                                                                             | ** ** | ** **                                         | ** ** | ** ** | ** ** |
| ** **                                                                                                                             | ** ** | ** **                                         | ** ** | ** ** | ** ** |
| Borrowings from the lines of credit                                                                                                    |       | 113,090,000                                        |       | 136,800,000 |   |
| Repayments on the lines of credit                                                                                                      |       | (118,278,064                                       | )          | (122,953,547 | ) |
| Distributions paid                                                                                                                     |       | (13,751,539                                        | )          | (12,531,746 | ) |
| Exercise of employee stock options                                                                                                     |       | 1,150,245                                          |       | 270,250 |   |
| Deferred financing fees                                                                                                                |       | (173,333                                           | )          | (105,000 | ) |
| Shelf offering costs                                                                                                                   |       | —                                             |       | (111,233 | ) |
| Net cash (used in) provided by financing activities                                                                                    |       | (17,962,691                                        | )          | 1,368,724 |   |
|                                                                                                                                   |       |                                               |       |   |   |
| **NET  DECREASE IN CASH AND CASH EQUIVALENTS (1)**                                                                                     |       | (47,462                                            | )          | (65,187,918 | ) |
| **CASH  AND CASH EQUIVALENTS, BEGINNING OF PERIOD**                                                                                    |       | 503,776                                            |       | 65,954,840 |   |
| **CASH  AND CASH EQUIVALENTS, END OF PERIOD**                                                                                          |       | $                                                  | 456,314    |   | $ | 766,922 |   |
| **CASH  PAID DURING PERIOD FOR INTEREST**                                                                                              |       | $                                                  | 2,298,008  |   | $ | 1,073,417 |   |
| **CASH  PAID DURING PERIOD FOR INCOME TAXES**                                                                                          |       | $                                                  | —     |   | $ | 138,678 |   |
| **NON-CASH  FINANCING ACTIVITIES**                                                                                                     | ** ** | ** **                                         | ** ** | ** ** | ** ** |
| Notes receivable issued  in exchange for common stock associated with the exercise of employee stock  options                          |       | $                                                  | 199,980    |   | $ | 157,100 |   |

----

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

*THE ACCOMPANYING NOTES ARE AN INTEGRAL PARTOF THESE CONSOLIDATED FINANCIAL STATEMENTS.*

13

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**GLADSTONE CAPITALCORPORATIONFINANCIAL HIGHLIGHTS(UNAUDITED)**

 
| ** **                                                       | ** ** | **Three Months Ended June 30,** | ** **  |
|------------------------------------------------------------------|------------|-----------------------------------------------------|-------------|
| ** **                                                       | ** ** | **2006**                                            | ** **  | **2005** | ** ** |
| Per Share Data  (1)                                              |       |                                                |        |   |   |
| Net asset value at beginning of period                           |       | $                                                   | 13.84       |   | $ | 13.64 |   |
| *Income from investment operations:*                             | * *   | * *                                            | * *    | * * | * * |
| Net investment income (2)                                        |       | 0.42                                                |        | 0.39 |   |
| Realized (loss) gain on sale of investments (2)                  |       | (0.01                                               | )           | — |   |
| Realized gain on settlement of derivative (2)                    |       | —                                              |        | — |   |
| Net unrealized gain (loss) on investments (2)                    |       | 0.07                                                |        | (0.03 | ) |
| Net unrealized gain on derivative (2)                            |       | 0.01                                                |        | — |   |
| Total from investment operations                                 |       | 0.49                                                |        | 0.36 |   |
| Less distributions:                                              |       |                                                |        |   |   |
| Distributions from net investment income                         |       | (0.41                                               | )           | (0.39 | ) |
| Total distributions                                              |       | (0.41                                               | )           | (0.39 | ) |
| Issuance of common stock under stock option plan                 |       | 0.10                                                |        | — |   |
| Repayment of principal on notes receivable                       |       | 0.01                                                |        | — |   |
| Dilutive effect of share issuance                                |       | (0.08                                               | )           | — |   |
| Net asset value at end of period                                 |       | $                                                   | 13.95       |   | $ | 13.61 |   |
|                                                             |       |                                                |        |   |   |
| Per share market value at beginning of period                    |       | $                                                   | 21.55       |   | $ | 21.22 |   |
| Per share market value at end of period                          |       | 21.39                                               |        | 23.40 |   |
| Total return (3) (4)                                             |       | 1.11                                                | %           | 12.19 | % |
| Shares outstanding at end of period                              |       | 11,384,363                                          |        | 11,303,510 |   |
|                                                             |       |                                                |        |   |   |
| Ratios/Supplemental Data                                         |       |                                                |        |   |   |
| Net assets at end of period                                      |       | $                                                   | 158,785,756 |   | $ | 153,805,834 |   |
| Average net assets (5)                                           |       | $                                                   | 156,053,816 |   | $ | 152,484,868 |   |
| Ratio of expenses to average net assets-annualized  (6)          |       | 5.83                                                | %           | 5.23 | % |
| Ratio of net expenses to average net assets-annualized  (7)      |       | 4.45                                                | %           | 4.60 | % |
| Ratio of net investment income to average net  assets-annualized |       | 12.27                                               | %           | 11.47 | % |
|                                                             |       |                                                |        |   |   |

----

(1)          Basic per share data.

(2)             Based on weighted average basic pershare data.

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

(4)          Amounts were not annualized.

(5)          Average net assets are computed by taking the average of thebalance of net assets at the end of each month of the reporting period.

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

(7)          Ratio of net expenses to average net assets is computed usingtotal expenses net of credits from Gladstone Management and including incometax expense.

 

*THE ACCOMPANYING NOTES ARE AN INTEGRAL PARTOF THESE CONSOLIDATED FINANCIAL STATEMENTS.*

14

----

**GLADSTONE CAPITALCORPORATIONFINANCIAL HIGHLIGHTS(UNAUDITED)**

 
| ** **                                                       | ** ** | **Nine Months Ended June 30,** | ** **  |
|------------------------------------------------------------------|------------|----------------------------------------------------|-------------|
| ** **                                                       | ** ** | **2006**                                           | ** **  | **2005** | ** ** |
| Per Share Data  (1)                                              |       |                                               |        |   |   |
| Net asset value at beginning of period                           |       | $                                                  | 13.41       |   | $ | 13.50 |   |
| *Income from investment operations:*                             | * *   | * *                                           | * *    | * * | * * |
| Net investment income (2)                                        |       | 1.28                                               |        | 1.19 |   |
| Realized (loss) gain on sale of investments (2)                  |       | (0.08                                              | )           | — |   |
| Realized gain on settlement of derivative (2)                    |       | —                                             |        | — |   |
| Net unrealized gain (loss) on investments (2)                    |       | 0.51                                               |        | (0.03 | ) |
| Net unrealized gain (loss) on derivative (2)                     |       | —                                             |        | (0.01 | ) |
| Total from investment operations                                 |       | 1.71                                               |        | 1.15 |   |
| Less distributions:                                              |       |                                               |        |   |   |
| Distributions from net investment income                         |       | (1.22                                              | )           | (1.11 | ) |
| Total distributions                                              |       | (1.22                                              | )           | (1.11 | ) |
| Issuance of common stock under stock option plan                 |       | 0.10                                               |        | 0.02 |   |
| Repayment of principal on notes receivable                       |       | 0.01                                               |        | 0.07 |   |
| Dilutive effect of share issuance                                |       | (0.06                                              | )           | (0.01 | ) |
| Offering costs                                                   |       | —                                             |        | (0.01 | ) |
| Net asset value at end of period                                 |       | $                                                  | 13.95       |   | $ | 13.61 |   |
|                                                             |       |                                               |        |   |   |
| Per share market value at beginning of period                    |       | $                                                  | 22.55       |   | $ | 22.71 |   |
| Per share market value at end of period                          |       | 21.39                                              |        | 23.40 |   |
| Total return (3)(4)                                              |       | 0.35                                               | %           | 8.08 | % |
| Shares outstanding at end of period                              |       | 11,384,363                                         |        | 11,303,510 |   |
|                                                             |       |                                               |        |   |   |
| Ratios/Supplemental Data                                         |       |                                               |        |   |   |
| Net assets at end of period                                      |       | $                                                  | 158,785,756 |   | $ | 153,805,834 |   |
| Average net assets (5)                                           |       | $                                                  | 153,804,303 |   | $ | 152,067,700 |   |
| Ratio of expenses to average net assets-annualized  (6)          |       | 5.97                                               | %           | 4.90 | % |
| Ratio of net expenses to average net  assets-annualized (7)      |       | 4.44                                               | %           | 4.04 | % |
| Ratio of net investment income to average net  assets-annualized |       | 12.51                                              | %           | 11.82 | % |
|                                                             |       |                                               |        |   |   |

----

(1)             Basic per share data.

(2)             Based on weighted average basic pershare data.

(3)             Total return equals the increase ofthe ending market value over the beginning market value plus monthly dividendsdivided by the monthly beginning market value, assuming monthly dividendreinvestment.

(4)             Amounts were not annualized.

(5)             Average net assets are computed bytaking the average of the balance of net assets at the end of each month of thereporting period.

(6)             Ratio of expenses to average netassets is computed using expenses before credit from Gladstone Management andincluding income tax expense.

(7)             Ratio of net expenses to averagenet assets is computed using total expenses net of credits from GladstoneManagement and including income tax expense.

 

*THE ACCOMPANYING NOTES ARE AN INTEGRAL PARTOF THESE CONSOLIDATED FINANCIAL STATEMENTS.*

15

----

**GLADSTONE CAPITALCORPORATIONNOTES TO CONSOLIDATED FINANCIAL STATEMENTSJune 30, 2006(UNAUDITED)**

NOTE1.  ORGANIZATION

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

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

GladstoneBusiness Loan LLC, a wholly-owned subsidiary of the Company, was establishedfor the purpose of owning the Company’s portfolio of loan investments.  The financial statements of this subsidiaryare consolidated with those of the Company.

TheCompany is externally managed by Gladstone Management Corporation (“GladstoneManagement” or the “Adviser”), an unconsolidated affiliate of the Company.

NOTE2.  UNAUDITED INTERIM FINANCIALSTATEMENTS

Interimfinancial statements of the Company are prepared in accordance with accountingprinciples generally accepted in the United States of America (“GAAP”) forinterim financial information and pursuant to the requirements for reporting onForm 10-Q and Article 10 of Regulation S-X. Accordingly, certain disclosures accompanying annual financial statementsprepared in accordance with GAAP are omitted. In the opinion of management, all adjustments, consisting solely ofnormal recurring accruals, necessary for the fair statement of financialstatements for the interim periods have been included.  The current period’s results of operationsare not necessarily indicative of results that ultimately may be achieved forthe year.  The interim financialstatements and notes thereto should be read in conjunction with the financialstatements and notes thereto included in the Company’s Form 10-K for the fiscalyear ended September 30, 2005, as filed with the Securities and ExchangeCommission.

Certainamounts in the prior year’s financial statements have been reclassified toconform to the current year presentation with no effect to net increase in netassets resulting from operations.

NOTE3.  RECENT ACCOUNTING PRONOUNCEMENTS

In October 2005, theFinancial Accounting Standards Board (“FASB”) released FASB Staff PositionNo. FAS 123(R)-2 (“FSP FAS 123(R)-2”), “*PracticalAccommodation to the Application of Grant Date as Defined in FASB StatementNo. 123(R).”* FSP FAS 123(R)-2 provides guidance on theapplication of grant date as defined in Statement of Financial AccountingStandards (“SFAS”) No. 123(R)*.*The FASB addresses the notion of “mutual understanding,” specifically that amutual understanding shall be presumed to exist at the date the award isapproved in accordance with the relevant corporate governance requirements if,the award is a unilateral grant and therefore the recipient does not have theability to negotiate the terms and conditions of the award with the employerand, the key terms and conditions of the award are expected to be communicatedto an individual recipient within a relatively short time period for the dateof approval. The Company applied FSP FAS 123(R)-2 in conjunction with theadoption of SFAS No. 123(R) on October 1, 2005.

16

----

NOTE 4.  COMMON STOCK TRANSACTIONS

Asof June 30, 2005 and June 30, 2006, 50,000,000 shares of $0.001 par valuecommon stock were authorized and 11,303,510 and 11,384,363 shares wereoutstanding, respectively.

Transactionsin common stock were as follows:

|                                                   | ** ** | **Common Stock** | ** ** |
|---------------------------------------------------|------------|-----------------------|------------|
| ** **                                        | ** ** | **Shares**            | ** ** | **Amount** | ** ** |
| Balance at  September 30, 2004                    |       | 11,278,510            |       | $ | 11,279 |   |
| Issuance of  Common Stock Under Stock Option Plan |       | 25,000                |       | 25 |   |
| Balance at June  30, 2005                         |       | 11,303,510            |       | $ | 11,304 |   |
|                                              |       |                  |       |   |   |
| Balance at  September 30, 2005                    |       | 11,303,510            |       | $ | 11,304 |   |
| Issuance of  Common Stock Under Stock Option Plan |       | 80,853                |       | 81 |   |
| Balance at June 30,  2006                         |       | 11,384,363            |       | $ | 11,385 |   |

 

NOTE5. STOCK OPTIONS

In December 2004,the FASB issued SFAS No. 123 (revised 2004) (“SFAS No. 123(R)”) *Share-based Payment*. SFAS No. 123(R)replaces SFAS No. 123, *Accounting forStock-Based Compensation*and supersedes Accounting Principles Board(“APB”) Opinion No. 25, *Accounting forStock Issued to Employees* (“APBNo. 25”)*.*SFAS No. 123(R)is effective for awards that are granted, modified, or settled in cash forannual periods beginning after June 15, 2005.  The Company adopted SFASNo. 123(R) on October 1, 2005 using the modified prospectiveapproach. Under the modified prospective approach, stock-based compensationexpense will be recorded for the unvested portion of previously issued awardsthat remain outstanding at October 1, 2005 using the same estimate of thegrant date fair value and the same attribution method used to determine the proforma disclosure under SFAS No. 123. SFAS No. 123(R) also requiresthat all share-based payments to employees after October 1, 2005, includingemployee stock options, be recognized in the financial statements asstock-based compensation expense based on the fair value on the date ofgrant.  Accordingly, prior period amountshave not been restated.

In connection withthe externalization of the Company’s management, all of its officers andemployees became direct employees of Gladstone Management Corporation, ourAdviser, as of October 1, 2004, the start of fiscal year 2005.  However, these individuals continue to beeligible to receive stock options under the 2001 Plan (as defined below).  Effective October 1, 2004, the Companyaccounted for any options granted to employees of Gladstone ManagementCorporation, who qualify as leased employees of the Company under FIN 44, *“Accounting for Certain Transactions Involving Stock Compensation, anInterpretation of APB Opinion No. 25.*”

Prior to October 1,2005, the Company accounted for stock-based awards in accordance with APB No.25. For the three and nine months ended June 30, 2006, the Company recordedstock option compensation expense for the cost of stock options issued underthe Amended and Restated 2001 Equity Incentive Plan (the “2001 Plan”) of$202,296 and $279,618, respectively. The Company’s expensing of stock optionsdecreased both basic and diluted net increase to net assets resulting fromoperations per share by $0.02 for both the three and nine months ended June 30,2006.  Additionally, SFAS No. 123(R)states that any potential tax benefits associated with incentive stock optionsshould be recognized only at the time of settlement if those options settlethrough a disqualifying disposition. Thus, the related stock-based compensationexpense must be treated as a permanent difference until that time which inturn, results in an increase to the Company’s effective tax rate.  The Company does not record tax benefitsassociated with the expensing of stock options since the Company intends toqualify as a RIC under Subchapter M of the Code and as such the Company is notsubject to federal income tax on the portion of its taxable income and gainsdistributed to stockholders, provided that at least 90% of the taxable incomeis distributed.

Under the provisions ofAPB No. 25, the Company was not required to recognize compensation expensefor the cost of stock options issued under the 2001 Plan. The following tableillustrates the effect on net increase to net assets resulting from operationsand net increase to net assets resulting from operations per share for thethree and nine months ended June 30, 2005 as if the Company had applied thefair value recognition provisions of SFAS No. 123, as amended by SFASNo. 148, *Accounting for Stock-BasedCompensation-Transition and Disclosure:*

17

----

* *

|                                                                    | ** ** | **Three Months** | ** ** | **Nine Months** | ** ** |
|--------------------------------------------------------------------|------------|-----------------------|------------|----------------------|------------|
| ** **                                                         | ** ** | **Ended**             | ** ** | **Ended**            | ** ** |
| ** **                                                         | ** ** | **June 30,**     | ** ** | **June 30,**    | ** ** |
| ** **                                                         | ** ** | **2005**              | ** ** | **2005**             | ** ** |
|                                                               |       |                  |       |                 |       |
| Net increase in  net assets resulting from operations as reported: |       | $                     | 3,934,153  |                 | $          | 13,154,479 |   |
|                                                               |       |                  |       |                 |       |
| Deduct: Total  stock-based compensation expense                    |       |                  |       |                 |       |
| determined using the fair value based method for all  awards       |       | (74,042               | )          | (222,618             | )          |
|                                                               |       |                  |       |                 |       |
| Pro forma net  increase in net assets resulting from               |       | $                     | 3,860,111  |                 | $          | 12,931,861 |   |
| operations per share                                               |       |                  |       |                 |       |
|                                                               |       |                  |       |                 |       |
| As reported -  basic                                               |       | $                     | 0.35       |                 | $          | 1.17 |   |
| As reported -  diluted                                             |       | $                     | 0.34       |                 | $          | 1.13 |   |
|                                                               |       |                  |       |                 |       |
| Pro forma-basic                                                    |       | $                     | 0.34       |                 | $          | 1.15 |   |
| Pro  forma-diluted                                                 |       | $                     | 0.33       |                 | $          | 1.11 |   |
|                                                               |       |                  |       |                 |       |

 

The fair value of each option grant is estimated onthe date of grant using the Black-Scholes option pricing model, whichincorporates a risk free interest rate, an expected life, an expected volatilityfactor, and an expected dividend yield.

The following is a summary of the status of theCompany’s 2001 Plan from September 30, 2005 through June 30, 2006:

 

|                                                           | ** ** | **Shares** | ** ** | **Weighted Average  Exercise Price** | ** ** |
|-----------------------------------------------------------|------------|------------|------------|------------------------------------------------|------------|
|                                                      |       |       |       |                                           |       |
| Options  outstanding at October 1, 2005                   |       | 1,307,998  |       | $                                              | 17.81      |   |
| Granted                                                   |       | 2,500      |       | $                                              | 21.17      |   |
| Expired                                                   |       | —     |       | $                                              | —     |   |
| Exercised                                                 |       | (80,853    | )          | $                                              | 16.70      |   |
| Forfeited                                                 |       | (5,000     | )          | $                                              | 22.55      |   |
| Options  outstanding at June 30, 2006, of which 1,224,645 |       |       |       |                                           |       |
| shares are exercisable                                    |       | 1,224,645  |       | $                                              | 17.87      |   |
|                                                      |       |       |       |                                           |       |

 

The following is a detailed summary of the stockoptions outstanding at June 30, 2006:

 

|                                         | ** ** | ** **                            | ** ** | ** **                                                       | ** ** | ** **                             | ** ** |
|-----------------------------------------|------------|---------------------------------------|------------|------------------------------------------------------------------|------------|----------------------------------------|------------|
| **Range of  Exercise Prices** | ** ** | **Stock   Options  Outstanding** | ** ** | **Weighted  Average  Remaining  Contractual  Life (Years)** | ** ** | **Weighted  Average  Exercise  Price** | ** ** |
|                                    |       |                                  |       |                                                             |       |                                   |       |
| $15.00 - $21.94                         |       | 895,645                               |       | 0.25                                                             |       | $                                      | 16.02      |   |
| $22.21 - $24.39                         |       | 329,000                               |       | 0.25                                                             |       | $                                      | 22.90      |   |
| Total                                   |       | 1,224,645                             |       | 0.25                                                             |       | $                                      | 17.87      |   |

 

18

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 On December 2,2005, the Company held a special meeting of stockholders in which thestockholders voted to approve a proposal to enter into an amended and restatedinvestment advisory agreement (the “Amended Advisory Agreement”) with theAdviser and an administration agreement (the “Administration Agreement”)between the Company and Gladstone Administration LLC, a wholly-owned subsidiaryof the Adviser.  (Please refer to Note15. Advisory Agreement with Gladstone Management Corporation for furtherdiscussion.)  In connection with the approvalof the Amended Advisory Agreement, the Company ceased further option grants andwill terminate the 2001 Plan on September 30, 2006.

On May 31, 2006, all the holders of currentlyoutstanding stock options accepted the Company’s offer to amend their stockoptions and accelerate the expiration date of the outstanding options to September30, 2006.  Therefore, all currentlyoutstanding stock options must be exercised before September 30, 2006 or becomeforfeited on September 30, 2006.  Upontermination of the 2001 Plan, the Company will implement the Amended AdvisoryAgreement between the Company and the Adviser effective on October 1, 2006, thefirst day of the Company’s 2007 fiscal year.

NOTE6. INCREASE IN NET ASSETS PER SHARE RESULTING FROM OPERATIONS

Thefollowing table sets forth the computation of basic and diluted net increase innet assets per share resulting from operations for the three and nine monthsended June 30, 2006 and June 30, 2005:

 
| ** **                                                                                       | ** ** | **Three Months Ended June 30,** | ** ** | **Nine Months Ended June 30,** | ** ** |
|--------------------------------------------------------------------------------------------------|------------|-----------------------------------------------------|------------|----------------------------------------------------|------------|
| ** **                                                                                       | ** ** | **2006**                                            | ** ** | **2005**                                           | ** ** | **2006** | ** ** | **2005** | ** ** |
|                                                                                             |       |                                                |       |                                               |       |   |   |   |   |
| Numerator for  basic and diluted net increase in net assets resulting from operations per  share |       | $                                                   | 5,543,076  |                                               | $          | 3,934,153 |   | $ | 19,366,806 |   | $ | 13,154,479 |   |
|                                                                                             |       |                                                |       |                                               |       |   |   |   |   |
| Denominator for  basic weighted average shares                                                   |       | 11,337,291                                          |       | 11,299,010                                         |       | 11,317,437 |   | 11,288,784 |   |
| Dilutive effect  of stock options                                                                |       | 233,134                                             |       | 279,627                                            |       | 231,617 |   | 314,202 |   |
| Denominator for  diluted weighted average shares                                                 |       | 11,570,425                                          |       | 11,578,637                                         |       | 11,549,054 |   | 11,602,986 |   |
|                                                                                             |       |                                                |       |                                               |       |   |   |   |   |
| Basic net  increase in net assets resulting from operations per share                            |       | $                                                   | 0.49       |                                               | $          | 0.35 |   | $ | 1.71 |   | $ | 1.17 |   |
|                                                                                             |       |                                                |       |                                               |       |   |   |   |   |
| Diluted net  increase in net assets resulting from operations per share                          |       | $                                                   | 0.48       |                                               | $          | 0.34 |   | $ | 1.68 |   | $ | 1.13 |   |

 

Therewere 1,224,645 options outstanding to purchase common stock at June 30, 2006.Of these, 336,000 options were not included in the computation of dilutedearnings per share for the three and nine months ended June 30, 2006, becausethe options’ exercise prices were greater than the average market price of thecommon shares for the period, and therefore, were anti-dilutive.

NOTE7. DIVIDENDS

TheCompany is required to pay out as a dividend 90% of its ordinary income andshort-term capital gains for each taxable year in order to maintain its statusas a RIC under Subtitle A, Chapter 1 of Subchapter M of the Code.  It is the policy of the Company to pay out asa dividend up to 100% of those amounts. The amount to be paid out as a dividend is determined by the Board ofDirectors each quarter and is based on the annual earnings estimated by themanagement of the Company.  Based on thatestimate, three monthly dividends are declared each quarter.  At year-end the Company may pay a bonusdividend, in addition to the monthly dividends, to ensure that it has paid outat least 90% of its ordinary income and short-term capital gains for theyear.  Long-term capital gains arecomposed of success fees, prepayment fees and gains from the sale of securitiesheld from one year or more. The Company intends to retain long-term capitalgains from the sale of securities, if any, and not pay them out as dividends,however, the Board of Directors may decide to declare and pay out capital gainsduring any fiscal year.  If the Companydecides to retain long-term capital gains, the portion of the retained capitalgains will be subject to 35% tax.  TheCompany currently pays a monthly dividend. The tax characteristics of all dividends will be reported tostockholders on Form 1099 at the end of each calendar year.  The following table lists the per sharedividends paid for the nine months ended June 30, 2006 and June 30, 2005:

19

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| **Fiscal Year** | ** ** | **Record Date**    | ** ** | **Payment Date**   | ** ** | **Dividend  per Share** |
|-----------------|------------|--------------------|------------|--------------------|------------|-------------------------|
| 2006            |       | June 22, 2006      |       | June 30, 2006      |       | $0.135                  |
|            |       | May 22, 2006       |       | May 31, 2006       |       | $0.135                  |
|            |       | April 20, 2006     |       | April 28, 2006     |       | $0.135                  |
|            |       | March 23, 2006     |       | March 31, 2006     |       | $0.135                  |
|            |       | February 20,  2006 |       | February 28,  2006 |       | $0.135                  |
|            |       | January 19, 2006   |       | January 31, 2006   |       | $0.135                  |
|            |       | December 21,  2005 |       | December 30,  2005 |       | $0.135                  |
|            |       | November 21,  2005 |       | November 30,  2005 |       | $0.135                  |
|            |       | October 21, 2005   |       | October 31, 2005   |       | $0.135                  |
|            |       |               |       |               |       |                    |
| 2005            |       | June 16, 2005      |       | June 30, 2005      |       | $0.13                   |
|            |       | May 13, 2005       |       | May 27, 2005       |       | $0.13                   |
|            |       | April 15, 2005     |       | April 29, 2005     |       | $0.13                   |
|            |       | March 18, 2005     |       | March 31, 2005     |       | $0.12                   |
|            |       | February 11,  2005 |       | February 28,  2005 |       | $0.12                   |
|            |       | January 14, 2005   |       | January 28, 2005   |       | $0.12                   |
|            |       | December 17,  2004 |       | December 30,  2004 |       | $0.12                   |
|            |       | November 17,  2004 |       | November 30,  2004 |       | $0.12                   |
|            |       | October 18, 2004   |       | October 29, 2004   |       | $0.12                   |

 

NOTE8. INVESTMENT VALUATION

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

NOTE9. PAYMENT IN KIND INTEREST

TheCompany seeks to avoid PIK interest, however the Company had one loan in itsportfolio through March 31, 2006 that contained a PIK provision. A PIKprovision requires the borrower to accrue a payment to the Company but theborrower does not have to pay that interest until the loan is paid in full. ThePIK interest is added to the principal balance of the loan and recorded asincome to the Company even though the cash has not been received.  To maintain the Company’s status as a RIC (asdiscussed in Note 7, above), this non-cash source of income must be paid out tostockholders in the form of cash dividends, even though the Company has not yetcollected the cash. The Company recorded no PIK interest income for the threemonths ended June 30, 2006 and $63,217 for the nine months ended June 30,2006.  For the three and nine monthsended June 30, 2005, the Company recorded PIK interest income of $63,597 and$334,872, respectively.  At June 30,2006, the Company had no accrued PIK income on its statement of assets andliabilities as compared to September 30, 2005 in which the Company had accruedon its statement of assets and liabilities PIK income of $1,273,251.  On March 31, 2006, the Company’s soleinvestment that contained a PIK provision repaid in full.

20

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NOTE10. REPURCHASE AGREEMENT

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

The Company had nooutstanding repurchase agreement at June 30, 2006 or at September 30, 2005.  On October 1, 2004, the Company repaid anoutstanding repurchase obligation from September 30, 2004 and this repayment isreflected in the Consolidated Statement of Cash Flows for the nine months endedJune 30, 2005.

NOTE11. CONTRACTUAL OBLIGATIONS

Asof June 30, 2006, the Company was a party to a signed and non-binding termsheet for two potential investments and was due to fund another investment forthe Company’s portfolio.  The Companyexpects to fund these potential investments as follows:

 
| ** **                       | ** ** | ** ** | ** ** | **Payment Due by Period** | ** ** |
|----------------------------------|------------|------------|------------|------------------------------------------|------------|
| **Contractual Obligations** | ** ** | **Total**  | ** ** | **Less than 1 Year**      | ** ** | **1-3 Years** | ** ** | **3-5 Years** | ** ** | **More than 5 Years** | ** ** |
|                             |       |       |       |                                     |       |   |   |   |   |   |   |
| Investments                      |       | $          | 24,900,000 |                                     | 24,900,000 |   | — |   | — |   | — |   |
| Total                            |       | $          | 24,900,000 |                                     | $          | 24,900,000 |   | $ | — |   | $ | — |   | $ | — |   |
|                                  |            |            |            |                                          |            |  |  |  |  |  |  |  |  |  |  |  |

 

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

NOTE12. LINES OF CREDIT

InJune 2004, the Company entered into a $15.0 million line of credit agreementwith Branch Banking and Trust Company (“BB&T Agreement”), which originallymatured in June 2005 and had been extended through December 31, 2006.  On June 22, 2006, the Company terminated theBB&T Agreement due to infrequent borrowings. Interest on outstandingborrowings was based upon the one month London Interbank Offered Rate (“LIBOR”)plus 2.5% per annum.  The unused portionof the line of credit was subject to a fee of 0.2% per annum during the periodin which the BB&T Agreement was outstanding.

Through itswholly-owned subsidiary Gladstone Business Loan LLC (“Business Loan”), theCompany has a $100 million revolving credit facility (the “DB Facility”) withDeutsche Bank AG, as administrative agent, pursuant to which Business Loan haspledged the loans it holds to secure future advances by certain institutionallenders. The interest rate charged on the advances under the DB Facility isbased on LIBOR, the Prime Rate or the Federal Funds Rate, depending on marketconditions, and adjusts periodically. In May 2006, the Company renewed the DBFacility through May 25, 2007.  Inconnection with the renewal, the credit facility was amended to reduce the equitycontribution from $100.0 million to $50.0 million.  As of June 30, 2006, the outstandingprincipal balance under the DB Facility was approximately $47.8 million at aninterest rate of 5.2%.  Availableborrowings are subject to various constraints imposed by Deutsche Bank AG,based on the aggregate loan balance pledged by Business Loan, which varies asloans are added and repaid, regardless of whether such repayments are earlyprepayment or are made as contractually required.  At June 30, 2006, the remaining borrowingcapacity available under the DB Facility was approximately $52.2 million.

The DB Facilitycontains covenants that require Business Loan to maintain its status as aseparate entity; prohibit certain significant corporate transactions (such asmergers, consolidations, liquidations or dissolutions); and restrict materialchanges to the Company’s credit and collection policies.  The DB Facility also restricts some of theterms and provisions (including interest rates, terms to 

21

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maturity and paymentsschedules) and limits the borrower and industry concentrations of loans thatare eligible to secure advances.  As ofJune 30, 2006, Business Loan was in compliance with all of the facilitycovenants.

The administrativeagent also requires that any interest or principal payments on pledged loans beremitted directly by the borrower into a lockbox account with the Bank of NewYork as custodian.  Deutsche Bank AG isalso the trustee of the account and once a month remits the collected funds tothe Company. At June 30, 2006, the amount due from custodian was $2,493,924 andat September 30, 2005, the amount due from custodian was $2,624,074.

GladstoneManagement, the Company’s affiliated external adviser also services the loanspledged under the DB Facility.  As acondition to this servicing arrangement, the Company executed a performanceguaranty pursuant to which it guaranteed that the Adviser would comply fullywith all of its obligations under the DB Facility.  The performance guaranty requires that the Companymaintain a minimum net worth of $100 million and to maintain “asset coverage”with respect to “senior securities representing indebtedness” of at least 200%,in accordance with Section 18 of the 1940 Act.  As of June 30, 2006, the Company was in compliancewith all covenants under the performance guaranty.  The Adviser services these loans for anannual fee of 1.5% of the monthly aggregate outstanding loan balance of theloans pledged under the DB Facility. Effective in April 2006, the Adviser’s Board of Directors voluntarilyagreed to waive, on a temporary basis, the annual servicing fee rate for thosesenior syndicated loans in which the Company already has a second lien positionto 0.5%.  For the three and nine monthsended June 30, 2006, the Company recorded loan servicing fees of $693,965 and$2,144,024, respectively, as compared to $687,971 and $1,804,465 for the threeand nine months ended June 30, 2005, respectively.  At June 30, 2006, the Company owed $181,398of unpaid loan servicing fees to Gladstone Management, which are recorded infees due to Adviser.  At September 30,2005, the Company owed $207,619 in loan servicing fees to Gladstone Management,recorded in fees due to Adviser.

Loan servicingfees received by Gladstone Management are credited to the Company’s advisoryfee payable to Gladstone Management under the advisory agreement between theCompany and Gladstone Management. Accordingly, the advisory fee payable by the Company to GladstoneManagement for the three months ended June 30, 2006 and June 30, 2005 wasreduced by $693,965 and $687,971, respectively, for three months ended March31, 2006 and March 31, 2005 was reduced by $734,644 and $585,542, respectively,and for the three months ended December 31, 2005 and December 31, 2004, wasreduced by $715,415 and $530,952, respectively, in respect of these loanservicing fees received by Gladstone Management.

NOTE13. INTEREST RATE CAP AGREEMENT

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

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

In February 2004, theCompany entered into an interest rate cap agreement with a notional amount of$35.0 million at a cost of $304,000.  Theinterest rate cap agreement’s current notional amount is $19.8 million and ithas a current fair value of approximately $115,505 which is recorded in otherassets on the Company’s consolidated balance sheet at June 30, 2006.  At September 30, 2005, the interest rate capagreement had a fair value of $50,253. The Company records changes in the fair value of the interest rate capagreement monthly based on the current market valuation at month end asunrealized depreciation or appreciation on derivative on the Company’sconsolidated statement of operations. The interest rate cap agreement expiresin February 2009. The agreement provides that the Company’s floating interestrate or cost of funds on a portion of the portfolio’s borrowings will be cappedat 5% when the LIBOR rate is in excess of 5%. During the three and nine months ended June 30, 2006, the Companyrecorded $1,367 of income from the interest rate cap agreement recorded as arealized gain on the settlement of derivative on the Company’s consolidatedstatements of operations.

NOTE14. SERVICES TO PORTFOLIO COMPANIES

The1940 Act requires that a business development company make available managerialassistance to its portfolio companies. The 1940 Act defines managerialassistance as the service made available to a portfolio company to provide “significantguidance and counsel concerning the management, operations, or businessobjectives and policies of a portfolio company.” The Company offers managerialassistance and other services to its portfolio companies through its externalinvestment adviser, Gladstone Management. Neither the Company nor its external investment adviser, GladstoneManagement, charges a fee for managerial assistance.  Gladstone Management also offers a widevariety of services to the portfolio companies such as investment bankingservices, arranging bank financing, arranging equity financing, structuringfinancing from multiple lenders and investors, reviewing existing creditfacilities, restructuring existing loans, raising equity and debt capital,turnaround management, merger and acquisition services and recruiting 

22

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newmanagement personnel.  GladstoneManagement charges a fee for these services and credits the funds received fromportfolio companies for these other services to the Company as a credit againstthe investment advisory fee due from the Company under the investment advisoryagreement.  Such fees are normally paidin part at the time of signing a non-binding letter of intent, with theremainder paid upon completion of the services, and are generallynon-recurring.

WhileGladstone Management receives all fees in connection with the Company’sinvestments, such fees received by Gladstone Management are credited to theCompany as a reduction of the advisory fee payable to Gladstone Managementunder the advisory agreement between the Company and Gladstone Management.  For the three months ended June 30, 2006 andJune 30, 2005, Gladstone Management received $539,000 and $240,600,respectively, for fees rendered to portfolio companies, for the three monthsended March 31, 2006 and March 31, 2005, Gladstone Management received $673,000and $450,000, respectively, of such fees and for the three months endedDecember 31, 2005 and December 31, 2004, Gladstone Management received $550,000and $286,500, respectively, of such fees. None of these fees were formanagerial assistance even though Gladstone Management provided managerialassistance to many of the Company’s portfolio companies.  Accordingly, the advisory fee payable by theCompany to Gladstone Management for the three months ended June 30, 2006 andJune 30, 2005 was reduced by $539,000 and $240,600, respectively, for the threemonths ended March 31, 2006 and March 31, 2005 was reduced by $673,000 and$450,000, respectively, and for the three months ended December 31, 2005 andDecember 31, 2004 was reduced by $550,000 and $286,500, respectively, inrespect of these fees received by Gladstone Management.

NOTE15. ADVISORY AGREEMENT WITH GLADSTONE MANAGEMENT CORPORATION

EffectiveOctober 1, 2004, the Company entered into an advisory agreement with GladstoneManagement, an unconsolidated affiliate of the Company, whereby GladstoneManagement serves as an external adviser to the Company.  As compensation for the services of GladstoneManagement, the Company pays Gladstone Management an annual advisory fee of1.25% of total assets (as reduced by cash and cash equivalents pledged tocreditors), payable in quarterly computed increments of 0.3125%, and an annualadministrative fee of 0.75% of total assets (as reduced by cash and cashequivalents pledged to creditors), payable in quarterly computed increments of0.1875%, for a total annual fee of 2.0% (0.50% quarterly) of total assets (asreduced by cash and cash equivalents pledged to creditors).  In April 2006, the Adviser’s Board ofDirectors voluntarily agreed to waive, on a temporary basis, the annualadvisory fee from 1.25% to 0.5% (0.125% quarterly) for those senior syndicatedloans in which the Company holds a second lien position as well. The Companycontinues to pay direct expenses including, but not limited to, directors’fees, legal and accounting fees, stockholder related expenses, and directorsand officers insurance.

GladstoneManagement services the loans held by Business Loan, in return for which,Gladstone Management receives a servicing fee with respect to senior syndicatedloans, for which there is a second lien position in the portfolio, of 0.5%annual fee and with respect to all other loans a 1.5% annual fee based on themonthly aggregate balance of loans held by Business Loan.  Since the Company owns these loans, all loanservicing fees paid to Gladstone Management are also credited directly againstthe 2% management fee.  These creditsreduce the amount of the investment advisory fee and are shown above the directcredits line item in the table below. For the three months ended June 30, 2006, March 31, 2006 and December31, 2005, these loan servicing fees totaled $693,965, $734,644 and $715,415,respectively, as compared to the loan servicing fees for the three months endedJune 30, 2005, March 31, 2005 and December 31, 2004 of $687,971, $585,542 and$530,952, respectively, all of which were credited against the 2% managementfee in order to derive the management fee which is presented as the line itemmanagement fee in the consolidated statement of operations.  Under the advisory agreement, GladstoneManagement also provides the managerial assistance and other services to theCompany’s portfolio companies.  To theextent that Gladstone Management receives any fees directly from a portfoliocompany for such services, Gladstone Management credits these fees directlyagainst the 2% management fee and these amounts are shown in the table below asa credit to the management fee.  For thethree months ended June 30, 2006, March 31, 2006 and December 31, 2005,Gladstone Management recorded $539,000, $673,000 and $550,000, respectively ofsuch fees and credited this amount against the 2% management fee received fromthe Company, as compared such fees for June 30, 2005, March 31, 2005 and December31, 2004 of $240,600, $450,000 and $286,500, these credits are reflected on theconsolidated statement of operations as credit to management fees for feescollected by Gladstone Management. Overall, the management fee due to Gladstone Management cannot exceed 2%of total assets (as reduced by cash and cash equivalents pledged to creditors)during any given fiscal year.

Thefollowing tables set forth the quarterly computation of the management fee forthe three months ended June 30, 2006, March 31, 2006 and December 31, 2005 andfor the three months ended June 30, 2005, March 31, 2005 and December 31, 2004,based on the quarterly increment of 0.50% (0.3125% quarterly advisory fee and0.1875% quarterly administrative fee):

23

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| ** **                                                          | ** ** | **Three Months Ended**      | ** **  |
|---------------------------------------------------------------------|------------|-----------------------------|-------------|
| **Fee:**                                                            | ** ** | **June 30, 2006** | ** **  | **March 31, 2006** | ** ** | **December 31, 2005** | ** ** |
| Total assets at                                                     |       | $                           | 207,265,095 |   | $ | 217,404,695 |   | $ | 211,823,244 |   |
| Less: Senior  syndicated loans subject to reduced fee               |       | (3,018,897                  | )(a)        | — |   |   |   |
| Less: Borrowings  under line of credit at                           |       | —                      |        | — |   | (15,000,000 | )(d) |
| Total assets  subject to quarterly fee of 0.50% as of               |       | 204,246,198                 |        | 217,404,695 |   | 196,823,244 |   |
| Quarterly fee  rate                                                 |       | 0.50                        | %           | 0.50 | % | 0.50 | % |
| Management fee  before senior syndicated loan advisory fee          |       | 1,021,231                   |        | 1,087,023 |   | 984,116 |   |
| Total senior  syndicated loan advisory fee at quarterly rate 0.125% |       | 3,774                       | (b)         | — |   | — |   |
| Gross management  fee before loan servicing fee credit              |       | 1,025,005                   |        | 1,087,023 |   | 984,116 |   |
| Less: loan  servicing fee from Gladstone Business Loan LLC          |       | 693,965                     |        | 734,644 |   | 715,415 |   |
| Management fee before  credit:                                      |       | 331,040                     |        | 352,379 |   | 268,701 |   |
|                                                                |       |                        |        |   |   |   |   |
| **Direct Credit to Management  Fee:**                               | ** ** | ** **                  | ** **  | ** ** | ** ** | ** ** | ** ** |
| Fee revenue recorded by  Gladstone Management:                      |       | 539,000                     |        | 673,000 |   | 550,000 |   |
| Net management fee for  the three months ended (c):                 |       | $                           | (207,960    | ) | $ | (320,621 | ) | $ | (281,299 | ) |

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

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*(a)**          InApril 2006, the Adviser’s Board of Directors waived on a temporary basis, theannual advisory fee from 1.25% to 0.5% (0.125% quarterly) for those seniorsyndicated loans in which the Company also holds a syndicated second lienposition.*

*(b)**          Thisamount represents the reduced quarterly advisory fee applicable only to thesenior syndicated loans.*

*(c)**           Ifthe amount presented is in parentheses it denotes the amount is due back to theCompany from the Adviser; if the amount is positive, it indicates that theCompany owes the Adviser the amount.*

*(d)**          Thisamount represents borrowings under one of the Company’s lines of credit thatwere held in cash and cash equivalents as of December 31, 2005.  The $15.0 million was to be used to fund anew loan investment, however the investment did not fund until January2006.  Solely for the purposes ofcalculating the amount of the management fee due to Gladstone Management, theCompany treats any such amounts as “cash and cash equivalents pledged tocreditors” under the terms of the Company’s advisory agreement with GladstoneManagement.  As a result, such amountsare deducted from the Company’s total assets for purposes of computing theasset base upon which the management fee is determined.*

*(e)**           Thisamount represents borrowings under one of the Company’s lines of credit thatwere held in cash and cash equivalents as of March 31, 2005 and December 31,2004, for the purpose of satisfying the Company’s asset diversificationrequirements under the Code.  Solely forthe purposes of calculating the amount of the management fee due to GladstoneManagement, the Company treats any such amounts as “cash and cash equivalentspledged to creditors” under the terms of the Company’s advisory agreement withGladstone Management.  As a result, suchamounts are deducted from the Company’s total assets for purposes of computingthe asset base upon which the management fee is determined.*

On December 2, 2005, theCompany’s stockholders approved a proposal to enter into the Amended AdvisoryAgreement with the Adviser and the Administration Agreement between the Companyand the Administrator.

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The Amended AdvisoryAgreement provides for an annual base management fee equal to 2% of the Company’sassets and an income-based incentive fee which will reward the Adviser if theCompany’s quarterly net investment income (before giving effect to theincentive fee) exceeds 1.75% of net assets. The agreement also provides for an annual capital gains-based incentivefee, whereby the Adviser will receive an annual fee equal to 20% of the Company’srealized capital gains (net of realized capital losses and unrealized capitaldepreciation since inception of the Company). Under the Administration Agreement, the Company will pay separately forits allocable portion of the Administrator’s overhead expenses in performingits obligations, including rent, and the Company’s allocable portion of thesalaries and benefits expenses of its chief financial officer, chief complianceofficer and controller and their respective staffs.

In connection with theapproval of the Amended Advisory Agreement, the Company will terminate the 2001Plan.  On May 31, 2006, all the holdersof outstanding stock options accepted the Company’s offer to amend theirexisting stock options and accelerate the contractual expiration date of theoutstanding options to September 30, 2006. The Amended Advisory Agreement and the Administration Agreement willbecome effective on October 1, 2006, the first day of the 2007 fiscal year.

NOTE16. FEDERAL AND STATE INCOME TAXES

TheCompany has historically operated, and intends to continue to operate, in amanner to qualify for treatment as a RIC under Subchapter M of the Code.  As a RIC, the Company is not subject tofederal or state income tax on the portion of its taxable income and gainsdistributed to stockholders.  To qualifyas a RIC, the Company is required to distribute to its stockholders at least90% of investment company taxable income, as defined by the Code and, as such,no income tax provisions have been recorded for the individual companies ofGladstone Capital Corporation and Gladstone Business Loan LLC.

During the nine monthsended June 30, 2006, Gladstone Capital Corporation recorded approximately$50,000 in connection with penalties incurred on misclassified revenue on itsfiscal year 2004 corporate tax return.

GladstoneCapital Advisers, Inc., a wholly-owned subsidiary of Gladstone CapitalCorporation, is subject to federal and state income taxation on the income ithas recorded, such as fees received from portfolio companies, resulting inaggregate federal and state income taxes of $138,678 during the nine monthsended June 30, 2005.

NOTE17. RELATED PARTY TRANSACTIONS

TheCompany provides loans to employees of the Adviser for the exercise of optionsunder the 2001 Plan.  The loans requirethe quarterly payment of interest at the market rate in effect at the date ofissue, have varying terms not exceeding nine years and have been recorded as areduction of net assets.  The loans areevidenced by full recourse notes that are due upon maturity or 60 daysfollowing termination of employment, and the shares of common stock purchasedwith the proceeds of the loan are posted as collateral.  During the nine months ended June 30, 2006,the Company issued one loan to an employee for $199,980 and received principalrepayments of $129,943 in connection with the full repayment of one loan and apartial repayment on another loan.  Duringthe nine months ended June 30, 2005, the Company extended one loan for $157,100and received principal repayments of $797,429. The Company recognized interest income from all employee stock optionloans of $108,877 and $323,003 for the three and nine months ended June 30,2006, respectively, as compared to $108,065 and $336,382 for the three and ninemonths ended June 30, 2005, respectively.

NOTE18. SUBSEQUENT EVENTS

In July 2006, the Company funded ActivStyle, a distributor ofconsumable medical products, for approximately $5.7 million and purchased anadditional $1.5 million participation in Bresnan Communications, LLC.  Also, Advanced Homecare Management, Inc.repaid its entire investment of $7.5 million and the Company reentered theinvestment for $5.0 million.

In July 2006, the Company’s Board of Directors declared thefollowing monthly dividends:
| **Fiscal Year** | ** ** | **Record Date**     | ** ** | **Payment Date**    | ** ** | **Dividend per   Share** |
|-----------------|------------|---------------------|------------|---------------------|------------|--------------------------|
| 2006            |       | September 21,  2006 |       | September 29,  2006 |       | $0.14                    |
|            |       | August 23, 2006     |       | August 31, 2006     |       | $0.14                    |
|            |       | July 21, 2006       |       | July 31, 2006       |       | $0.14                    |

 

 

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

**All statements containedherein, other than historical facts, may constitute “forward-looking statements”within the meaning of Section 27A of the Securities Act of 1933, as amended,and Section 21E of the Securities Exchange Act of 1934, as amended. Thesestatements may relate to, among other things, future events or our futureperformance or financial condition. In some cases, you can identifyforward-looking statements by terminology such as “may,” “might,” “believe,” “will,”“provided,” “anticipate,” “future,” “could,” “growth,” “plan,” “intend,” “expect,”“should,” “would,” “if,” “seek,” “possible,” “potential,” “likely” or thenegative of such terms or comparable terminology. These forward-lookingstatements involve known and unknown risks, uncertainties and other factorsthat may cause our actual results, levels of activity, performance orachievements to be materially different from any future results, levels ofactivity, performance or achievements expressed or implied by suchforward-looking statements. Such factors include, among others: (1) adversechanges in interest rates; (2) our failure or inability to establish ormaintain referral arrangements with leveraged buyout funds and venture capitalfunds to generate loan opportunities; (3) the loss of one or more of ourexecutive officers, in particular David Gladstone, Terry Lee Brubaker, orGeorge Stelljes III; (4) our inability to extend, refinance or maintain ourcredit facilities on terms reasonably acceptable to us, if at all in futureequity capital resources; (5) our inability to successfully securitize our loanportfolio on terms reasonably acceptable to us, if at all; (6) the decision ofour competitors to aggressively seek to make senior and subordinated loans tosmall and medium-sized businesses on terms more favorable than we intend toprovide; and (7) those factors listed under the caption “Risk Factors” of theAnnual Report on Form 10-K as filed with the Securities and Exchange Commissionon December 13, 2005 and under Part II, Item 1A of this Form 10-Q. We cautionreaders not to place undue reliance on any such forward-looking statements,which are made pursuant to the Private Securities Litigation Reform Act of 1995and, as such, speak only as of the date made. We undertake no obligation topublicly update or revise any forward-looking statements, whether as a resultof new information, future events or otherwise, after the date of this Form 10-Q**.

*The following analysisof our financial condition and results of operations should be read inconjunction with our financial statements and the notes thereto containedelsewhere in this report.*

**OVERVIEW**

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

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

Our loans typically rangefrom $5 million to $15 million, generally mature in no more than seven yearsand accrue interest at a fixed or variable rate that exceeds the prime rate. Someof our loans may contain 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 “payment in kind” or “PIK” interest, and,when earned, we record PIK interest as interest income and add the PIK interestto the principal balance of the loans. We seek to avoid PIK interest with allpotential investments under review. We currently do not hold any investmentswith PIK and therefore, there was no PIK accrued on our balance sheet as ofJune 30, 2006.

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Because our loans willgenerally be subordinated debt of private companies who typically cannot orwill not expend the resources to have their debt securities rated by a creditrating agency, we expect that most, if not all, of the debt securities weacquire will be unrated. We cannot accurately predict what ratings these loansmight receive if they were in fact rated, and therefore we cannot determinewhether or not they could be considered to be “investment grade” quality.

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

Original issue discounts(“OID”) arise when we extend a loan and receive an equity interest in theborrower at the same time.  To the extentthat the price paid for the equity is not at market value, the Company mustallocate part of the price paid for the loan, to the value of the equity.  Then the amount allocated to the equity, theOID, must be amortized over the life of the loan.  As with PIK interest, the amortization of OIDalso produces income that must be recognized for purposes of satisfying theregulated investment company (“RIC”) distribution requirements, whereas thecash is received, if at all, when the equity instrument is sold.

In addition, as abusiness development company under the 1940 Act, we are required to makeavailable significant managerial assistance to our portfolio companies.Effective October 1, 2004, our investment adviser, Gladstone ManagementCorporation (“Gladstone Management” or the “Adviser”) began to provide theseservices on our behalf through its officers who are also our officers.  In addition, Gladstone Management providesother services to our portfolio companies, for which it receives fees, inconnection with our investments.  Thefees for these services are generally paid to Gladstone Management in part atthe time a prospective portfolio company signs a non-binding term sheet with us(as further described in the following paragraph), with the remainder paid atthe closing of the investment. These fees are generally non-recurring, howeverin some instances they may have a recurring component which is also paid toGladstone Management.  Any fees receivedfor other services, with the exception of the recurring fees, by GladstoneManagement are currently credited against the management advisory fee payableto Gladstone Management pursuant to the terms of our advisory agreement, whichhas the effect of reducing our expenses to the extent of any such fees receivedby Gladstone Management.  The specificother services Gladstone Management provides vary by portfolio company, butgenerally include a wide variety of services to the portfolio companies such asinvestment banking services, arranging bank financing, arranging equityfinancing structuring financing from multiple lenders and investors, reviewingexisting credit facilities, restructuring existing loans, raising equity anddebt capital, turnaround management, merger and acquisition services andrecruiting new management personnel.  Inaddition, the Adviser provides managerial assistance to portfolio companies. Todate the Adviser has not charged for these managerial assistance services,however if the Adviser does provide such managerial assistance the Adviser willcredit the managerial assistance fees to the management advisory fee due from usto the Adviser.

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

In the event that weexpend significant effort in considering and negotiating a potential investmentthat ultimately is not consummated, we generally will seek reimbursement fromthe proposed borrower for our reasonable expenses incurred in connection withthe proposed transaction.  Any amountscollected for expenses incurred by Gladstone Management in connection withunconsummated investments will be reimbursed to Gladstone Management. Amountscollected for these expenses incurred by us will be reimbursed to us and willbe recognized as “other income” in the period in which such reimbursement isreceived.  Also, in the event that wehave incurred significant legal fees in connection with the transaction, wewill typically seek reimbursement for these expenses from the proposedborrower.  However, there can be noguarantee that we will be successful in collecting any such reimbursements.

The only significantcontinuing revenue associated with the investments we have already closed isinterest income and, potentially, capital gains realized in connection with theliquidation of any associated equity interest (e.g., warrants).

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During the nine monthsended June 30, 2006, we extended, directly or through participations,approximately $105.1 million of new loans to a total of 17 companies.  Also, during the nine months ended June 30,2006, six borrowers repaid loans ahead of contractual maturity at par value, wesold or were repaid in full on eight syndicated loans, and sold three loaninvestments at a loss for an aggregate return of capital of approximately $96.5million and we received scheduled contractual principal repayments ofapproximately $11.3 million, for total principal repayments of approximately$107.9 million.  Since our initial publicoffering in August 2001, we have made 110****differentloans to, or investments in, 62****companiesfor a total of approximately $471.3****million,before giving effect to principal repayments on investments and divestitures.

We are continuouslyworking toward the consummation of more investments. These prospective loansare subject to, among other things, the satisfactory completion of our duediligence investigation of each borrower, acceptance of terms and structure andobtaining necessary consents. With respect to each prospective loan, we willonly agree to provide the loan if, among other things, the results of our duediligence investigations are satisfactory, the terms and conditions of the loanare acceptable and all necessary consents are received. Our management hasinitiated its due diligence investigations of the potential borrowers, howeverwe cannot assure you that we will not discover facts in the course ofcompleting our due diligence that would render a particular investmentimprudent or that any of these loans will actually be made.

**External Adviser**

Pursuant to our advisoryagreement with Gladstone Management, we pay the Adviser an annual advisory feeof 1.25% of our total assets (as reduced by cash and cash equivalents pledgedto creditors), payable in quarterly computed increments of 0.3125%, and anannual administrative fee of 0.75% of our total assets (as reduced by cash andcash equivalents pledged to creditors), payable in quarterly computedincrements of 0.1875%. This fee is then directly reduced by the amount of loanservicing fees paid to the Adviser and any other fees received by the Adviserfrom our borrowers and potential borrowers. In April 2006, the Adviser’s Board of Directors reduced the annualadvisory fee of 1.25% to 0.5% for those senior syndicated loans in which wealready have a syndicated second lien position. We continue to pay direct expenses including, but not limited to,directors’ fees, legal and accounting fees, stockholder related expenses, anddirectors and officers insurance.

GladstoneManagement services our loan portfolio pursuant to a loan servicing agreementwith Gladstone Business Loan LLC (“Business Loan”) in return for a 1.5% annualfee, based on the monthly aggregate outstanding loan balance of the loanspledged under the facility.  Effective inApril 2006, the Advisor’s Board of Directors voted to reduce the portion of theannual fee to 0.5% for those senior syndicated loans in which we already have asyndicated second lien position.  For thethree months ended June 30, 2006 and June 30, 2005 we incurred $693,965 and$687,971, respectively and for the nine months ended June 30, 2006 and June 30,2005, we incurred $2,144,024 and $1,804,465, respectively, in loan servicingfees.

For the three monthsended June 30, 2006, the gross management fee, before reductions for loanservicing fees and other fees was approximately $1.0 million.  After being reduced by loan servicing fees ofapproximately $694,000 and other fees received by Gladstone Management of$539,000, our net management fee for the three months ended June 30, 2006 was acredit of approximately $208,000.  Forthe three months ended June 30, 2005, the gross management fee, before reductionsfor loan servicing fees and other fees was approximately $1.0 million.  After being reduced by loan servicing fees ofapproximately $688,000 and other fees received by Gladstone Management of$241,000, our net management fee for the three months ended June 30, 2005 wasapproximately $118,000.  For the threemonths ended March 31, 2006, the gross management fee, before reductions forloan servicing fees and other fees was approximately $1.1 million.  After being reduced by loan servicing fees ofapproximately $735,000 and other fees received by Gladstone Management of$673,000, our net management fee for the three months ended March 31, 2006 wasa credit of approximately $321,000.  Forthe three months ended March 31, 2005, the gross management fee, beforereductions for loan servicing fees and other fees was approximately$976,000.  After being reduced by loanservicing fees of approximately $586,000 and other fees received by GladstoneManagement of $450,000, our net management fee for the three months ended March31, 2005 was a credit of approximately $60,000. For the three months ended December 31, 2005 and December 31, 2004, thegross management fee, before reductions for loan servicing fees and other feeswas approximately $984,000 and $858,000, respectively.  After being reduced by loan servicing fees ofapproximately $715,000 and $531,000, respectively, and other fees received byGladstone Management of approximately $550,000 and $286,500, respectively, our netmanagement fees for the three months ended December 31, 2005 and December 31,2004 was a credit of $281,299 and $40,802, respectively.  Since the fees are computed quarterly it isnecessary to sum the three quarters in order to derive the year to date managementfee, therefore for the nine months ended June 30, 2006 and June 30, 2005 grossmanagement fees before reductions were approximately $3.1 million and $2.9million, respectively, and the aggregate net management fees after reductionswere a credit of approximately $810,000 and an expense of approximately $99,000,respectively, for the nine months ended June 30, 2006 and June 30, 2005.

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On December 2, 2005, ourstockholders approved a proposal to enter into an amended and restatedinvestment advisory agreement (the “Amended Advisory Agreement”) with GladstoneManagement and an administration agreement (the “Administration Agreement”)between the Company and Gladstone Administration, LLC (the “Administrator”), awholly-owned subsidiary of the Adviser.

The AmendedAdvisory Agreement provides for an annual base management fee equal to 2% ofour assets and an income-based incentive fee which will reward the Adviser ifour quarterly net investment income (before giving effect to the incentive fee)exceeds 1.75% of our net assets.  Theagreement also provides for an annual capital gains-based incentive fee,whereby the Adviser will receive an annual fee equal to 20% of our realizedcapital gains (net of realized capital losses and unrealized capitaldepreciation since inception of the Company). Under the Administration Agreement, we will pay separately for ourallocable portion of the Administrator’s overhead expenses in performing ourobligations, including rent, and our allocable portion of the salaries andbenefits expenses of our chief financial officer, chief compliance officer andcontroller and their respective staffs.

The Amended AdvisoryAgreement and Administration Agreement will not become effective as long as theAmended and Restated 2001 Equity Incentive Plan (the “2001 Plan”) is in effector as long as there are any outstanding stock options.  In connection with the approval of theAmended Advisory Agreement, and pursuant to an offer approved by our Board of Directors onApril 11, 2006, we extended an offer to the then current stock option holdersto amend the terms of all outstanding stock options under the Plan toaccelerate the contractual expiration date of these options to September 30,2006.  The offer was filed with the U.S.Securities and Exchange Commission (the “SEC”) on April 12, 2006, was conductedin accordance with the federal tender offer rules and regulations, and wasconditioned upon the acceptance by 100% of the current stock optionholders.  On May 31, 2006, 100% of thecurrent stock option holders accepted the offer.  The acceptance of this offer enables theimplementation of the Amended Advisory Agreement and Administration Agreementon October 1, 2006, the first day of the first fiscal quarter following theSeptember 30, 2006 amended contractual expiration date of the stock options.  The current investment advisory agreementwith Gladstone Management will continue in effect until these new agreementsbecome effective at the start of fiscal year 2007.

Our Board of Directorsalso accelerated in full the vesting of all outstanding options other thanoptions held by the non-employee Directors effective April 11, 2006.  This action resulted in accelerated vestingof 34,500 outstanding options.

As of July 18, 2006 thereare 1,186,663 outstanding options under the 2001 Plan, and no further optionswill be granted. The shares underlying these stock options have been registeredunder the Securities Act of 1933 (as amended). 1,156,663 of these options are now vested with the remaining 30,000,which are held by our non-employee directors, scheduled to terminate onSeptember 30, 2006 prior to their vesting. Upon exercise, the holders of these options will be able to publiclyresell their shares without restriction. Sales of substantial amounts of our common stock in the public market,pursuant to the registration statement, such option exercises, under Rule 144or otherwise, or the availability of such shares for sale, including as aresult of the recent actions taken by our Board of Directors to facilitate theimplementation of the Amended Advisory Agreement and Administration Agreement,could adversely affect the prevailing market prices for our common stock, andcould dilute the interests of existing stockholders. This would be particularlythe case if a significant number of option holders elect not to “exercise andhold” their options, but rather seek to monetize their option holdings throughbroker-assisted cashless exercises. If this occurs, it could impair our abilityto raise additional capital through the sale of equity securities should wedesire to do so.

In addition, the Board ofDirectors of the Adviser has voluntarily agreed to waive, on a temporary basis,certain fees paid by us to the Adviser under the advisory agreement.  We currently pay 1.25% of our total assets (asreduced by cash and cash equivalents pledged to creditors) and the waiverprovides that the 1.25% will be reduced to 0.5% for the portion of total assetsthat consists of investments in senior syndicated loans for which we also havea second lien position.

**Off-Balance Sheet Arrangements**

We do not have anysignificant off-balance sheet arrangements as defined in Item 303(a)(4)(ii) ofSEC Regulation S-K as of June 30, 2006.

**Recent Accounting Pronouncements**

***FSP FAS 123(R)-2***

In October 2005, theFinancial Accounting Standards Board (“FASB”) released FASB Staff PositionNo. FAS 123(R)-2 (“FSP FAS 123(R)-2”), “*PracticalAccommodation to the Application of Grant Date as Defined in FASB StatementNo. 123(R).”* FSP FAS 123(R)-2 provides guidance on theapplication of grant date as defined in SFAS No. 123(R)*.* The FASB addresses the notion of “mutualunderstanding,” specifically that a mutual understanding shall be presumed toexist at the date the award is approved in accordance with the relevantcorporate governance requirements if, the award is a unilateral grant andtherefore the recipient does not have the ability to negotiate the terms andconditions of the award with the employer and, the key terms and conditions ofthe award 

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are expected to becommunicated to an individual recipient within a relatively short time periodfor the date of approval. We applied FSP FAS 123(R)-2 in conjunction with ouradoption of SFAS No. 123(R) on October 1, 2005.

**CriticalAccounting Policies**

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

**InvestmentValuation**

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

*General Valuation Policy:*We value our investment portfolio each quarter. We carry our investments at fairvalue, as determined in good faith by our Board of Directors.  Securities that are publicly traded, if any,are valued at the closing price of the exchange or securities market on whichthey are listed on the valuation date. Securities which are not traded on apublic exchange or securities market, but for which a limited market exists andthat have been rated by a nationally recognized statistical ratingorganizations (“NRSRO”), such as certain participations in syndicated loans,are valued at the indicative bid price offered by the syndication agent on thevaluation date.

Debt and equitysecurities that are not publicly traded, for which a limited market does notexist, or for which a limited market exists but that have not been rated by aNRSRO (or for which we have various degrees of trading restrictions) are valuedat fair value as determined in good faith by our Board of Directors.  In making the good faith determination of thevalue of these securities, we start with the cost basis of the security, whichincludes the amortized original issue discount, and PIK interest, if any.  We then apply the methods set out below in “ValuationMethods.”  Members of our portfoliomanagement team prepare the valuations of our investments in portfoliocompanies using the most recent portfolio company financial statements andforecasts.  These individuals alsoconsult with portfolio company senior management and ownership to obtainfurther updates on the portfolio company’s performance, including informationsuch as industry trends, new product development, and other operationalissues.  Due to the uncertainty inherentin the valuation process, such estimates of fair value may differ significantlyfrom the values that would have been obtained had a ready market for the securitiesexisted, and the differences could be material. Additionally, changes in the market environment and other events thatmay occur over the life of the investments may cause the gains or lossesultimately realized on these investments to be different than the valuationscurrently assigned.  There is no singlestandard for determining fair value in good faith, as fair value depends uponcircumstances of each individual case. In general, fair value is the amount that we might reasonably expect toreceive upon the current sale of the security.

We currently engageStandard & Poor’s Loan Evaluation Service (“S&P”) to help evaluate thevalue of the majority of our loan securities (other than those which arepublicly traded or for which a limited market exists, as described above), aswell as for evaluations on success fees (conditional interest included in someloan securities).  We and S&P onlyevaluate the value of a success fee if the probability of receiving the successfee on a given loan is above 6-8%, a threshold of significance, in which case avalue is assigned.  Upon completing ourcollection of data with respect to the investments (including the informationdescribed under “Credit Information,” the risk ratings of the loans describedunder “Loan Grading and Risk Rating” and the factors described under “ValuationMethods”), this valuation data is presented to S&P.  S&P makes its independent assessment ofthe data that we have assembled and assesses its own data to determine marketvalues for the securities.  With regardto its work, S&P has issued the following paragraph:

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

With our assessment andS&P value estimates as a backdrop, our Board of Directors votes to acceptor not accept the analyses and values recommended by management andS&P.  At June 30, 2006 and September30, 2005, the Board of Directors elected to accept the valuations recommendedby S&P on the loans in our portfolio as denoted on the Schedule ofInvestments as of June 30, 2006 and September 30, 2005 in our consolidatedfinancial statements. Subsequent to September 30, 2005, the fair value ofour investment in 

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ARI Holdings, Inc. wasreduced from the value proposed by S&P because the investment was sold inNovember 2005 at a value less than that indicated by S&P on September 30,2005.  Our Board of Directors determinedto reduce the value proposed by S&P to the value of the sale price and assuch the sale price of the investment is reflected in the fair value on ourSchedule of Investments as of September 30, 2005 in our consolidated financialstatements.

Because there is a delaybetween when we close a loan and when the loan can be evaluated by S&P, newloans are not valued immediately by S&P; rather, the Board of Directorsmakes its own determination about the value of these loans in accordance withour valuation policy.  These new loansare usually valued at par.  BecauseS&P does not provide values for mortgage loans or equity securities, ourBoard of Directors also determines the fair value of these investments usingour valuation policy without the input of S&P.  At June 30, 2006, we had one mortgage loan inour portfolio at a cost basis of $1.0 million and warrants with a cost basis of$37,000.

*Credit Information:*****We monitor a wide variety of key creditstatistics that provide information regarding our portfolio companies to helpus assess credit quality and portfolio performance.  We require our portfolio companies to provideannual audited and either monthly or quarterly unaudited 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.  For those investments for which S&Pprepares valuation recommendations, we provide this credit information toS&P for its use in preparing its recommendations.  For those investments for which S&P doesnot prepare valuation recommendations, management uses this credit informationin connection with its preparation of valuation recommendations.

*Loan Grading and Risk Rating:*****Aspart of our valuation procedures we risk rate all of our loans.  Our risk rating system uses a scale of0 to 10.  This system is used to estimatethe probability of default on our debt securities and the probability of lossif there is a default.  These types ofsystems are referred to as risk rating systems and are used by banks and ratingagencies.  The risk rating system coversboth qualitative and quantitative aspects of the business and the securities wehold.  For those investments for which S&P prepares valuationrecommendations, we compile this information and provide it to S&P for itsconsideration in determining its valuation recommendations.  For those investments for which S&P doesnot prepare valuation recommendations, management uses this information todevelop its own valuation recommendations.

We seek to have our riskrating system mirror the risk rating systems of major risk rating organizationssuch as those provided by NRSRO as defined in Rule 2a-7 under the 1940 Act.While we seek to mirror the NRSRO systems, we cannot provide any assurance thatour risk rating system provides the same risk rating as a NRSRO. The followingchart is an estimate of the relationship of our risk rating system to thedesignations used by two NRSROs as they risk rate debt securities of majorcompanies.  Because we have establishedour system to rate debt securities of companies that are unrated by any NRSRO,there can be no assurance that the correlation to the NRSRO set out below isaccurate.  We believe our risk ratingwould be significantly higher than a typical NRSRO risk rating because the riskrating of the typical NRSRO is designed for larger businesses that can affordto pay an NRSRO to rate their securities. However, our risk rating has been designed to risk rate the securitiesof smaller businesses that are not rated by a typical NRSRO. Therefore, when weuse our risk rating on larger business securities, the risk rating is higherthan a typical NRSRO rating.  The primarydifference between our risk rating and the rating of a typical NRSRO is thatour risk rating uses more quantitative determinants and includes qualitativedeterminants that are not used in the NRSRO rating.  It is our understanding that most debtsecurities of middle market companies do not exceed the grade of BBB on a NRSROscale, so there would be no debt securities in the middle market that wouldmeet the definition of AAA, AA or A. Therefore, our scale begins with the designation BBB as the best riskrating.

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| **Company’s  System** | ** ** | **First  NRSRO** | ** ** | **Second  NRSRO** | ** ** | **Gladstone Capital’s Description (a)**                                                         |
|----------------------------|------------|------------------|------------|-------------------|------------|------------------------------------------------------------------------------------------------------|
| **>10**                 |       | Baa2             |       | BBB               |       | Probability of Default (PD during the next ten years  is 4% and the Expected Loss (EL) is 1% or less |
| **10**                     |       | Baa3             |       | BBB-              |       | PD is 5% and the EL is 1% to 2%                                                                      |
| **9**                      |       | Ba1              |       | BB+               |       | PD is 10% and the EL is 2% to 3%                                                                     |
| **8**                      |       | Ba2              |       | BB                |       | PD is 16% and the EL is 3% to 4%                                                                     |
| **7**                      |       | Ba3              |       | BB-               |       | PD is 17.8% and the EL is 4% to 5%                                                                   |
| **6**                      |       | B1               |       | B+                |       | PD is 22% and the EL is 5% to 6.5%                                                                   |
| **5**                      |       | B2               |       | B                 |       | PD is 25% and the EL is 6.5% to 8%                                                                   |
| **4**                      |       | B3               |       | B-                |       | PD is 27% and the EL is 8% to 10%                                                                    |
| **3**                      |       | Caa1             |       | CCC+              |       | PD is 30% and the EL is 10% to 13.3%                                                                 |
| **2**                      |       | Caa2             |       | CCC               |       | PD is 35% and the EL is 13.3% to 16.7%                                                               |
| **1**                      |       | Caa3             |       | CC                |       | PD is 65% and the EL is 16.7% to 20%                                                                 |
| **0**                      |       | N/a              |       | D                 |       | PD is 85% or there is a Payment Default: and the EL  is greater than 20%                             |

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*(a)**          Thedefault 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 onour risk rating scale.*

The above scale gives anindication of the probability of default and the magnitude of the loss if thereis a default. The following table lists the risk ratings for all of the debtsecurities outstanding at June 30, 2006, March 31, 2006, December 31, 2005 andSeptember 30, 2005:

| Rating           | ** ** | **June 30,  2006** | ** ** | **March 31,  2006** | ** ** | **Dec. 31,  2005** | ** ** | **Sept. 30,  2005** | ** ** |
|------------------|------------|-------------------------|------------|--------------------------|------------|-------------------------|------------|--------------------------|------------|
| Average          | ** ** | **6.9**                 | ** ** | **7.1**                  | ** ** | **7.1**                 | ** ** | **7.0**                  | ** ** |
| Weighted Average | ** ** | **6.8**                 | ** ** | **7.1**                  | ** ** | **7.2**                 | ** ** | **7.1**                  | ** ** |
| Highest          | ** ** | **9.0**                 | ** ** | **9.0**                  | ** ** | **9.0**                 | ** ** | **9.0**                  | ** ** |
| Lowest           | ** ** | **4.0**                 | ** ** | **4.0**                  | ** ** | **5.0**                 | ** ** | **5.0**                  | ** ** |

 

Our policy is to stopaccruing interest on an investment if we determine that interest is no longercollectible.  Currently, none of ourinvestments are on non-accrual.  At June30, 2006, no payments were past due on any of our debt securities.  At September 30, 2005, ARI Holdings, Inc. waspast due on its payments and was placed on non-accrual.  This investment was sold in November 2005 atan approximate loss of $1.1 million.  Wedo not risk rate our equity securities.

*Valuation Methods:*  For debt securities, we first determine ifthe debt security is publicly traded (i.e., if it is listed on an exchange orsecurities market).  If it is publiclytraded, then we determine the value based on the closing price for the securityon the exchange or securities market on which it is listed on the valuationdate.  If the security is not publiclytraded, but a limited market for the security exists, such as for syndicatedloans, and if the security has been rated by a NRSRO, then we value the loan atthe indicative bid price offered by the syndication agent on the valuationdate.  At June 30, 2006, none of the debtsecurities in our portfolio were publicly traded and there was a limited marketfor eight debt securities in our portfolio. At September 30, 2005, none of the debt securities in our portfolio werepublicly traded and there was a limited market for 12 debt securities in ourportfolio.

For debt securities thateither are not publicly traded, for which there is no market, or for whichthere is a market but have not been rated by a NRSRO, we begin with the riskrating designation of the security described above.  Using the risk rating designation above, weseek to determine the value of the security as if we intended to currently sellthe security.  To determine the currentsale price of the security, we consider some or all of the following factors:

•                    financialstanding of the issuer of the security;

•                    comparison ofthe business and financial plan of the issuer with actual results;

•                    the cost ofthe security;

•                    the size ofthe security held as it relates to the liquidity of the market for suchsecurities;

•                    contractualrestrictions on the disposition of the security;

•                    pending publicoffering of the issuer of the security;

•                    pendingreorganization activity affecting the issuer, such as mergers or debtrestructuring;

•                    reportedprices of similar securities of the issuer or comparable issuers;

•                    ability of theissuer to obtain needed financing;

•                    changes in theeconomy affecting the issuer;

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•                    recentpurchases or sale of a security of the issuer;

•                    pricing byother buyers or sellers of similar securities;

•                    financialstatements of the borrower;

•                    reports fromportfolio company senior management and ownership;

•                    the type ofsecurity;

•                    cost at dateof purchase;

•                    size ofholding;

•                    discount frommarket value of unrestricted securities of the same class at the time ofpurchase;

•                    specialreports prepared by analysts;

•                    information asto any transactions or offers with respect to the security;

•                    existence ofmerger proposals or tender offers affecting the securities;

•                    thecollateral;

•                    the issuer’sability to make payments;

•                    the currentand forecasted earnings of the issuer;

•                    sales to thirdparties of similar securities;

•                    statisticalratios compared to lending standards;

•                    statisticalratios compared to other similar securities; and

•                    otherpertinent factors.

For those debt securitiesfor which S&P prepares valuation recommendations, we provide the foregoinginformation to S&P for its use in preparing its recommendations.

For convertible debt,equity, success fees or other equity-like securities, we first determine ifthere is any market for the security.  Ifthere is a market, then we determine the value based on the market prices forthe security, even if that market is not robust.  At June 30, 2006 and September 30, 2005 therewas no market for any of the equity securities we owned.  If there is no market for the equitysecurities, then we use the same information we would use for a debt securityvaluation described above, except risk-rating, as well as standard valuationtechniques used by major valuation firms to value the equity securities ofprivate companies.  These valuation techniquesconsist of: discounted cash flow of the expected sale price in the future,valuation of the securities based on recent sales in comparable transactions,and a review of similar companies that are publicly traded and the marketmultiple of their equity securities.  AtJune 30, 2006 and September 30, 2005 we had $37,000 invested, at cost, inequity securities compared to our debt portfolio with a cost basis of$201,428,621 and $205,338,554, respectively.

At June 30, 2006, we hadtotal unrealized appreciation of $1,782,643, which was mainly composed ofunrealized appreciation of $1,010,778 on our warrants of Finn Corporation,$235,543 of unrealized appreciation on our senior term debt in GQM AcquisitionCorporation, $133,000 of unrealized appreciation on our senior subordinatedterm debt investment in Visual Edge Technology, Inc.  This unrealized appreciation was offset byunrealized depreciation of $541,614, most notably composed of unrealizeddepreciation of $332,084 on our senior term debt investments in MistrasHoldings Corporation and unrealized depreciation of $122,678 on our seniorsubordinated term debt investment in Consolidated Bedding, Inc.  In the aggregate, we recorded net unrealizedappreciation of $1,241,029 on our total investment portfolio.

AtSeptember 30, 2005, we had total unrealized depreciation of $6,231,296, whichwas mainly composed of unrealized depreciation in our senior subordinated termdebt investment in Finn Corporation (excluding the warrants) of $3,150,000(which was repaid in full in December 2005), our senior subordinated term debtinvestment in Xspedius Communications of $1,493,182, and our senior term debtin ARI Holdings, Inc. of $1,053,939 (which was subsequently sold at theSeptember 30, 2005 reflected fair value), partially offset by unrealizedappreciation, most notably on the value of our warrants of Finn Corporation,which had an unrealized appreciation of $645,114 and our senior term debtinvestment in Woven Electronics Corporation, which had unrealized appreciationof $431,436.  This aforementionedunrealized appreciation plus unrealized appreciation of $625,955 on certainother investments, primarily in our originated loan investments and certainsyndicate participations, most notably Infor Global Solutions, which hadunrealized appreciation of $248,750, resulted in overall net unrealizeddepreciation of $4,528,791.

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**Tax Status**

*Federal Income Taxes*

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

**Revenue Recognition**

*Interest Income Recognition*

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

*Payment in Kind Interest*

In the future, wemay once again hold some loans in our portfolio which contain a PIK interestprovision. The PIK interest, computed at the contractual rate specified in eachloan agreement, is added to the principal balance of the loan and recorded asinterest income. To maintain our status as a RIC, this non-cash source ofincome must be paid out to stockholders in the form of dividends, even thoughwe have not yet collected the cash.

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** **

**RESULTS OF OPERATIONS**

*Comparisonof the three months ended June 30, 2006 to the three months ended June 30, 2005*

**Investment Income**

Investment income for thethree months ended June 30, 2006 was approximately $6.5 million as compared toapproximately $6.1 million for the three months ended June 30, 2005.  Interest income from our investment portfolioincreased from June 30, 2005 due to the increase in new loans of $122.7million, offset by principal repayments and investment sales of approximately$117.9 million.

Interest income from ourinvestments in debt securities of private companies was approximately $5.8million for the three months ended June 30, 2006 which is consistent withapproximately $5.8 million for the three months ended June 30, 2005, whichincluded approximately $64,000 of PIK interest. This****was primarily a result of a modest net increase ininvestments of approximately $4.8 million over June 30, 2005.  This increase consisted of $122.7 million ofnew investments, offset by principal repayments and investment sales ofapproximately $117.9 million.

The annualized weightedaverage yield on our portfolio for the three months ended June 30, 2006 was11.7%, there was no PIK interest accrued during the three months ended June 30,2006. The annualized weighted average yield on our portfolio for the threemonths ended June 30, 2005 was 11.4% (without giving effect to PIK interest)and 11.8% (after giving effect to PIK interest).

Interest income frominvested cash and cash equivalents for the three months ended June 30, 2006 wasapproximately $8,000, as compared to approximately $8,000 for the three monthsended June 30, 2005.

For the three monthsended June 30, 2006 and June 30, 2005, we recorded approximately $109,000 and$108,000, respectively, in interest income from loans to our employees in connectionwith the exercise of employee stock options.

For the three monthsended June 30, 2006, we recorded approximately $630,000 of prepayment fees andother income as compared to $245,000 for the three months ended June 30,2005.  The income for both periodsconsisted of prepayment penalty fees received upon the full repayment ofcertain loan investments ahead of contractual maturity and prepayment feesreceived upon the early unscheduled principal repayments ahead of scheduledpayment dates which, in both instances, were based on a percentage of theoutstanding principal amount of the loan at the date of prepayment.

**OperatingExpenses**

Operating expenses forthe three months ended June 30, 2006 were approximately $1.7 million, ascompared to approximately $1.8 million for the three months ended June 30,2005. Operating expenses for the three months ended June 30, 2006 reflected asignificant increase in interest expense, professional fees, and stockholderrelated costs.

Loan servicingfees of approximately $694,000 were incurred for the three months ended June30, 2006 as compared to approximately $688,000 for the three months ended June30, 2005.  These fees were incurred inconnection with a loan servicing agreement between Gladstone Business Loan LLC(“Business Loan”) and Gladstone Management, which is based on the size of theportfolio.  These fees were directlycredited against the amount of the management fee due to Gladstone Management.

EffectiveOctober 1, 2004, we entered into an advisory agreement with GladstoneManagement whereby Gladstone Management serves as our external adviser.  As compensation for the services of GladstoneManagement, we pay Gladstone Management an annual advisory fee of 1.25% oftotal assets (as reduced by cash and cash equivalents pledged to creditors),payable in quarterly computed increments of 0.3125%, and an annualadministrative fee of 0.75% of total assets (as reduced by cash and cashequivalents pledged to creditors), payable in quarterly computed increments of0.1875%, for a total fee of 2% of total assets (as reduced by cash and cashequivalents pledged to creditors). Effective in April 2006, GladstoneManagement’s Board of Directors agreed to voluntarily waive the advisory fee ona temporary basis by reducing the 1.25% annual fee to 0.5% per annum applicableonly to the senior syndicated loans in which we already have a second lienposition.  We continue to pay directexpenses including, but not limited to, directors’ fees, legal and accountingfees, stockholder related expenses, and directors and officers insurance.  Under the advisory agreement, GladstoneManagement provides managerial assistance and other services to our portfoliocompanies and likewise Gladstone Management directly receives any fees for suchservices.  Any such fees are crediteddirectly against the 2% management fee payable to Gladstone Management.  The 2% management fee is also directlyreduced by the amount of the monthly loan servicing fees we pay to GladstoneManagement.

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Overall,the management fee due to Gladstone Management cannot exceed 2% of total assets(as reduced by cash and cash equivalents pledged to creditors) during any givenfiscal year.

Thefollowing table sets forth the computation of the management fee for the threemonths ended June 30, 2006 and June 30, 2005, based on the quarterly incrementof 0.50% (0.3125% quarterly advisory fee plus 0.1875% quarterly administrativefee):
| ** **                                                          | ** ** | **Three Months Ended** | ** **  |
|---------------------------------------------------------------------|------------|----------------------------------|-------------|
| ** **                                                          | ** ** | **June 30, 2006**      | ** **  | **June 30, 2005** | ** ** |
| **Fee:**                                                            |       |                             |        |   |   |
| Total assets at                                                     |       | $                                | 207,265,095 |   | $ | 209,320,463 |   |
| Less: Senior  syndicated loans subject to reduced fee               |       | (3,018,897                       | )(a)        | — |   |
| Less: Borrowings  under line of credit at                           |       | —                           |        | — |   |
| Total assets  subject to quarterly fee of 0.50% as of               |       | 204,246,198                      |        | 209,320,463 |   |
| Quarterly fee  rate                                                 |       | 0.50                             | %           | 0.50 | % |
| Management fee  before senior syndicated loan advisory fee          |       | 1,021,231                        |        | 1,046,602 |   |
| Total senior  syndicated loan advisory fee at quarterly rate 0.125% |       | 3,774                            |  (b)   | — |   |
| Gross management  fee before loan servicing fee credit              |       | 1,025,005                        |        | 1,046,602 |   |
| Less: loan  servicing fee from Gladstone Business Loan LLC          |       | 693,965                          |        | 687,971 |   |
| Management fee before credit:                                       |       | 331,040                          |        | 358,631 |   |
|                                                                |       |                             |        |   |   |
| **Direct Credit to Management  Fee:**                               |       |                             |        |   |   |
| Fee revenue  recorded by Gladstone Management:                      |       | 539,000                          |        | 240,600 |   |
| Net management  fee for the three months ended (c):                 |       | $                                | (207,960    | ) | $ | 118,031 |   |
|                                                                |       |                             |        |   |   |

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*(a)**          InApril 2006, the Adviser’s Board of Directors waived on a temporary basis theannual advisory fee from 1.25% to 0.5% (0.125% quarterly) for those seniorsyndicated loans in which the Company also holds a syndicated second lienposition.*

*(b)**          Thisamount represents the reduced quarterly advisory fee applicable only to thesenior syndicated loans.*

*(c)**           Ifthe amount presented is in parentheses it denotes the amount is due back to usfrom the Adviser; if the amount is positive, it indicates that we owe theAdviser the stated amount.*

Professional fees,consisting primarily of legal and audit fees, for the three months ended June30, 2006 were approximately $166,000 as compared to approximately $134,000 forthe three months ended June 30, 2005. The increase is due primarily to an increase in non-reimbursable legalfees associated with the stock option tender offer.

Amortization of deferredfinancing costs, in connection with our lines of credit, was approximately$36,000 for the three months ended June 30, 2006 and approximately $101,000 forthe three months ended June 30, 2005. The decrease is due to the completion of the amortization cycle relatedto certain deferred financing costs.

Interest expense for thethree months ended June 30, 2006 was approximately $702,000 as compared toapproximately $563,000 for the three months ended June 30, 2005.   This increase is primarily a result ofincreased borrowings under our line of credit during the three months endedJune 30, 2006, which borrowings were used, in part, to finance our increasedinvestments, of which these borrowings remained outstanding for longer periodsof time and an increase in the interest rates on our borrowings.

Stockholder related costsfor the three months ended June 30, 2006 were approximately $28,000, ascompared to approximately $16,000 for the three months ended June 30,2005.  Stockholder related costs includesuch recurring items as transfer agent fees, securities fees, and electronicfiling fees and increased during the three months ended June 30, 2006 mainly inassociation with the stock option tender offer.

Directors’ fees for thethree months ended June 30, 2006 were approximately $28,000, as compared toapproximately $27,000 for the three months ended June 30, 2005 due to theaddition of a new director in December 2005.

Insurance expense for thethree months ended June 30, 2006 was approximately $51,000, as compared toapproximately $44,000 for the three months ended June 30, 2005. The increase isprimarily the result of an increase in the amortization of our directors andofficers insurance premiums.

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Stock option compensationexpense for the three months ended June 30, 2006 was approximately$202,000.  This is the result of theadoption of the Statement of Financial Accounting Standards No. 123 (revised2004) (“SFAS No. 123(R)”) *Share-basedPayment*. SFAS No. 123(R) replaces SFAS No. 123, *Accounting for Stock-Based Compensation*andsupersedes Accounting Principles Board (“APB”) Opinion No. 25, *Accounting for Stock Issued to Employees* (“APB No. 25”)*.*SFAS No. 123(R) is effective for awards thatare granted, modified, or settled in cash for annual periods beginning afterJune 15, 2005.  The Company adopted SFASNo. 123(R) on October 1, 2005 using the modified prospectiveapproach. Under the modified prospective approach, stock-based compensationexpense will be recorded for the unvested portion of previously issued awardsthat remain outstanding at October 1, 2005 using the same estimate of thegrant date fair value and the same attribution method used to determine the proforma disclosure under SFAS No. 123. SFAS No. 123(R) also requiresthat all share-based payments to employees after October 1, 2005, includingemployee stock options, be recognized in the financial statements asstock-based compensation expense based on the fair value on the date ofgrant.  There was no stock optioncompensation expense recorded for the three months ended June 30, 2005.

Other expenses were approximately$35,000 for the three months ended June 30, 2006, as compared to approximately$64,000 for the three months ended June 30, 2005.  The expenses primarily represent directexpenses such as travel related specifically to our portfolio companies, loanevaluation services for our portfolio companies, press releases and backupservicer expenses.

**Realized Gain (Loss) on Sale ofInvestments**

During the three monthsended June 30, 2006, we realized a net loss of approximately $101,000 as aresult of the repayment in full of some syndicated loans that containedunamortized premiums.  There were norealized gains or losses on sale of investments during the three months endedJune 30, 2005.

**Realized Gain on Settlement ofDerivative**

During the three monthsended June 30, 2006, we received our first interest rate cap agreement paymentas a result of the one month LIBOR exceeding 5%.  There was no realization during the threemonths ended June 30, 2005 as the one month LIBOR was below 5%.

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

During the three monthsended June 30, 2006, we recorded net unrealized appreciation of approximately$41,000 due to an increase in the fair market value of our interest rate capagreement, as compared to unrealized depreciation of approximately $49,000during the three months ended June 30, 2005. The increase in the fair market value is attributable to the one monthLIBOR exceeding 5% which is when we would start to receive payments.

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

For the three monthsended June 30, 2006, we recorded net unrealized appreciation on investments ofapproximately $813,000 as compared to net unrealized depreciation ofapproximately $389,000, for the three months ended June 30, 2005.  The unrealized appreciation increased duringthe three months ended June 30, 2006 mainly in part to the increase in thevalue of the Finn Corporation warrant.

**Net Increase in Net Assets from Operations**

Overall, we realized a net increase in net assets resulting fromoperations of approximately $5.5 million for the three months ended June 30,2006.  Based on a weighted-average of11,337,291 (basic) and 11,570,425 (diluted) shares outstanding, our netincrease in net assets from operations per weighted-average common share forthe three months ended June 30, 2006 was $0.49 (basic) and $0.48 (diluted).

For the three months ended June 30,2005, we realizeda net increase in net assets resulting from operations of approximately $3.9million.  Based on a weighted-average of11,299,010 (basic) and 11,578,637 (diluted) shares outstanding, our netincrease in net assets resulting from operations per weighted-average commonshare for the three months ended June 30, 2005 was $0.35 (basic) and $0.34(diluted).

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*Comparisonof the nine months ended June 30, 2006 to the nine months ended June 30, 2005*

**Investment Income**

Investment income for thenine months ended June 30, 2006 was approximately $19.6 million as compared toapproximately $18.1 million for the nine months ended June 30, 2005.  The increase is mainly attributable to anincrease in interest income from our investment portfolio which had newinvestments of $122.7 million, offset by principal repayments and investmentsales of approximately $117.9 million, for net new investments of $4.8 millionfrom June 30, 2005 through June 30, 2006.

Interest income from ourinvestments in debt securities of private companies was approximately $18.5million, including approximately $556,000 of success fees from the fullrepayment of Woven Electronics Corporation and $63,000 of PIK interest, for thenine months ended June 30, 2006 as compared to approximately $16.7 million forthe nine months ended June 30, 2005, which included approximately $335,000 ofPIK interest. This increase****was primarily a result of a netincrease in investments of approximately $4.8 million over June 30, 2005.  There was also an increase in investmentsthat are variable rate or that the variable rate has exceeded the floor whichcontributed to the growth in interest income.

The annualized weightedaverage yield on our portfolio for the nine months ended June 30, 2006 was12.3% (without giving effect to PIK interest) and 12.3% (after giving effect toPIK interest). The annualized weighted average yield on our portfolio for thenine months ended June 30, 2005 was 12.5% (without giving effect to PIKinterest) and 12.6% (after giving effect to PIK interest). The decline is dueto the early repayments of principal balances on certain loans, which hadhigher interest rates.

Interest income frominvested cash and cash equivalents for the nine months ended June 30, 2006 wasapproximately $22,000, as compared to approximately $29,000 for the nine monthsended June 30, 2005. This decrease****wasprimarily a result of a decrease in invested cash and cash equivalents.

For the nine months endedJune 30, 2006 and June 30, 2005, we recorded approximately $323,000 and$336,000, respectively, in interest income from loans to our employees inconnection with the exercise of employee stock options.

For the nine months endedJune 30, 2006, we recorded approximately $711,000 of prepayment fees and otherincome as compared to $1.1 million for the nine months ended June 30,2005.  The income for both periods consistedof prepayment penalty fees received upon the full repayment of certain loaninvestments ahead of contractual maturity and prepayment fees received upon theearly unscheduled principal repayments ahead of scheduled payment dates which,in both instances, were based on a percentage of the outstanding principalamount of the loan at the date of prepayment.

**OperatingExpenses**

Operating expenses forthe nine months ended June 30, 2006 were approximately $5.1 million, ascompared to approximately $4.5 million for the nine months ended June 30, 2005.Operating expenses for the nine months ended June 30, 2006 reflected asignificant increase in interest expense, loan servicing fees, stockholderrelated costs and stock option compensation expense.

Loan servicingfees of approximately $2.1 million were incurred for the nine months ended June30, 2006 as compared to approximately $1.8 million for the nine months endedJune 30, 2005.  These fees were incurredin connection with a loan servicing agreement between Gladstone Business LoanLLC (“Business Loan”) and Gladstone Management, which is based on the size ofthe portfolio.  These fees were directlycredited against the amount of the management fee due to Gladstone Management.

EffectiveOctober 1, 2004, we entered into an advisory agreement with GladstoneManagement whereby Gladstone Management serves as our external adviser.  As compensation for the services of GladstoneManagement, we pay Gladstone Management an annual advisory fee of 1.25% oftotal assets (as reduced by cash and cash equivalents pledged to creditors),payable in quarterly computed increments of 0.3125%, and an annualadministrative fee of 0.75% of total assets (as reduced by cash and cashequivalents pledged to creditors), payable in quarterly computed increments of0.1875%, for a total fee of 2% of total assets (as reduced by cash and cashequivalents pledged to creditors). Effective in April 2006, GladstoneManagement’s Board of Directors voluntarily waived the advisory fee on atemporary basis by reducing the 1.25% annual fee to 0.5% per annum applicableonly to the senior syndicated loans in which we already have a second lienposition. We continue to pay direct expenses including, but not limited to,directors’ fees, legal and accounting fees, stockholder related expenses, anddirectors and officers insurance.  Underthe advisory agreement, Gladstone Management provides managerial assistance andother services to our portfolio companies and likewise Gladstone Managementdirectly receives any fees for such services. Any such fees are credited directly against the 2% management feepayable to Gladstone Management.  The 2%management fee is also directly reduced by the amount of the monthly loanservicing fees we pay to Gladstone Management.

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Overall,the management fee due to Gladstone Management cannot exceed 2% of total assets(as reduced by cash and cash equivalents pledged to creditors) during any givenfiscal year.

Thefollowing table sets forth the computation of the management fee for the ninemonths ended June 30, 2006 and June 30, 2005, based on the quarterly incrementof 0.50% (0.3125% quarterly advisory fee plus 0.1875% quarterly administrativefee) and the reduced fee for senior syndicated loans of 0.125% per quarter:
| ** **                                                          | ** ** | **Three Months Ended** | ** **  |
|---------------------------------------------------------------------|------------|----------------------------------|-------------|
| ** **                                                          | ** ** | **June 30,  2006**          | ** **  | **March 31,  2006** | ** ** | **December 31,  2005** | ** ** |
| **Fee:**                                                            |       |                             |        |   |   |   |   |
| Total assets at                                                     |       | $                                | 207,265,095 |   | $ | 217,404,695 |   | $ | 211,823,244 |   |
| Less: Senior  syndicated loans subject to reduced fee               |       | (3,018,897                       | )(a)        | — |   |   |   |
| Less: Borrowings  under line of credit at                           |       | —                           |        | — |   | (15,000,000 | )(d) |
| Total assets  subject to quarterly fee of 0.50% as of               |       | 204,246,198                      |        | 217,404,695 |   | 196,823,244 |   |
| Quarterly fee  rate                                                 |       | 0.50                             | %           | 0.50 | % | 0.50 | % |
| Management fee  before senior syndicated loan advisory fee          |       | 1,021,231                        |        | 1,087,023 |   | 984,116 |   |
| Total senior  syndicated loan advisory fee at quarterly rate 0.125% |       | 3,774                            |  (b)   | — |   | — |   |
| Gross management  fee before loan servicing fee credit              |       | 1,025,005                        |        | 1,087,023 |   | 984,116 |   |
| Less: loan  servicing fee from Gladstone Business Loan LLC          |       | 693,965                          |        | 734,644 |   | 715,415 |   |
| Management fee before credit:                                       |       | 331,040                          |        | 352,379 |   | 268,701 |   |
|                                                                |       |                             |        |   |   |   |   |
| **Direct  Credit to Management Fee:**                               |       |                             |        |   |   |   |   |
| Fee revenue  recorded by Gladstone Management:                      |       | 539,000                          |        | 673,000 |   | 550,000 |   |
| Net management fee for  the three months ended (c):                 |       | $                                | (207,960    | ) | $ | (320,621 | ) | $ | (281,299 | ) |

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

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*(a)**          InApril 2006, the Adviser’s Board of Directors waived on a temporary basis theannual advisory fee from 1.25% to 0.5% (0.125% quarterly) for those seniorsyndicated loans in which the Company also holds a syndicated second lienposition.*

*(b)**          Thisamount represents the reduced quarterly advisory fee applicable only to thesenior syndicated loans.*

*(c)**           Ifthe amount presented is in parentheses it denotes the amount is due back to usfrom the Adviser; if the amount is positive, it indicates that we owe theAdviser the stated amount.*

*(d)**          Thisamount represents borrowings under one of our lines of credit that were held incash and cash equivalents as of December 31, 2005.  The $15.0 million was to be used to fund anew loan investment, however the investment did not fund until January2006.  Solely for the purposes ofcalculating the amount of the management fee due to Gladstone Management, wetreat any such amounts as “cash and cash equivalents pledged to creditors”under the terms of our advisory agreement with Gladstone Management.  As a result, such amounts are deducted fromour total assets for purposes of computing the asset base upon which themanagement fee is determined.*

*(e)**           Thisamount represents borrowings under one of our lines of credit that were held incash and cash equivalents as of March 31, 2005 and December 31, 2004, for thepurpose of satisfying our asset diversification requirements under theCode.  Solely for the purposes ofcalculating the amount of the management fee due to Gladstone Management, wetreat any such amounts as “cash and cash equivalents pledged to creditors”under the terms of our advisory agreement with Gladstone Management.  As a result, such amounts are deducted fromour total assets for purposes of computing the asset base upon which themanagement fee is determined.*

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*                           Professionalfees, consisting primarily of legal and audit fees, for the nine months endedJune 30, 2006 were approximately $400,000 as compared to approximately $529,000for the nine months ended June 30, 2005. The decrease is due primarily to a decrease in non-reimbursable legalfees.*

Amortization of deferredfinancing costs, in connection with our lines of credit, was approximately$95,000 for the nine months ended June 30, 2006 and approximately $284,000 forthe nine months ended June 30, 2005.  Thedecrease is due to the completion of the amortization cycle related to certaindeferred financing costs.

Interest expense for thenine months ended June 30, 2006 was approximately $2.3 million as compared toapproximately $1.2 million for the nine months ended June 30, 2005.   This increase is primarily a result ofincreased borrowings under our lines of credit during the nine months endedJune 30, 2006, which borrowings were used, in part, to finance our increasedinvestments, borrowings remaining outstanding for longer periods of time and anincrease in the interest rates on our borrowings.

Stockholder related costsfor the nine months ended June 30, 2006 were approximately $273,000, ascompared to approximately $193,000 for the nine months ended June 30,2005.  Stockholder related costs includesuch recurring items as transfer agent fees, securities fees, and electronicfiling fees.  The increase is due mainlyto the printing and mailing of the special proxy statement in connection withthe special meeting of stockholders, the printing and mailing of the annualreport to stockholders and the annual proxy to stockholders, and the filingfees associated with the stock option tender offer.

Directors’ fees for thenine months ended June 30, 2006 were $82,000, as compared to approximately$78,000 for the nine months ended June 30, 2005 due to the addition of a newdirector in December 2005.

Insurance expense for thenine months ended June 30, 2006 was approximately $152,000, as compared toapproximately $134,000 for the nine months ended June 30, 2005. The increase isprimarily the result of an increase in the amortization of our directors andofficers insurance premiums.

Stock option compensationexpense for the nine months ended June 30, 2006 was approximately$280,000.  This is the result of theadoption of SFAS No. 123(R) *Share-basedPayment*. SFAS No. 123(R) replaces SFAS No. 123, *Accounting for Stock-Based Compensation*andsupersedes Accounting Principles Board (“APB”) Opinion No. 25, *Accounting for Stock Issued to Employees* (“APB No. 25”)*.*SFAS No. 123(R) is effective for awards thatare granted, modified, or settled in cash for annual periods beginning afterJune 15, 2005.  The Company adopted SFASNo. 123(R) on October 1, 2005 using the modified prospectiveapproach. Under the modified prospective approach, stock-based compensationexpense will be recorded for the unvested portion of previously issued awardsthat remain outstanding at October 1, 2005 using the same estimate of thegrant date fair value and the same attribution method used to determine the proforma disclosure under SFAS No. 123. SFAS No. 123(R) also requiresthat all share-based payments to employees after October 1, 2005,including employee stock options, be recognized in the financial statements asstock-based compensation expense based on the fair value on the date ofgrant.  There was no stock optioncompensation expense recorded for the nine months ended June 30, 2005.

Other expenses wereapproximately $152,000 for the nine months ended June 30, 2006, as compared toapproximately $177,000 for the nine months ended June 30, 2005.  The expenses primarily represent directexpenses such as travel related specifically to our portfolio companies, loanevaluation services for our portfolio companies, press releases and backupservicer expenses.

**Income Tax Expense**

During the nine monthsended June 30, 2006, Gladstone Capital Corporation recorded approximately$50,000 in connection with penalties incurred on misclassified revenue on itsfiscal year 2004 corporate tax return.

Gladstone CapitalAdvisers, Inc., a wholly-owned subsidiary of Gladstone Capital Corporation, issubject to federal and state income taxation on the income it has recorded suchas managerial assistance and other fees. During the nine months ended June 30, 2005, Gladstone Capital Advisersincurred aggregate federal and state income taxes of $138,678 resulting fromtaxable income it received during the 2004 fiscal year.  Following the externalization of ourmanagement effective October 1, 2004 substantially all revenues previouslyreceived by Gladstone Capital Advisers are now received by GladstoneManagement.  As a result, we do notanticipate incurring significant tax expense as a result of the activities ofGladstone Capital Advisers in the future.

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**Realized (Loss) Gain on Sale ofInvestments**

During the nine monthsended June 30, 2006, we sold our investments in ARI Holdings, Inc. and MarcalPaper Mills, Inc. for an aggregate loss of approximately $1.18 million and wererepaid on several syndicated loans which contained unamortized premiums ofapproximately $149,000, partially offset by gains of approximately $426,000 onthe sale of some syndicated loans and the repayment in full of some syndicatedloans which contained unamortized discounts, for a total net realized loss ofapproximately $904,000.  During the ninemonths ended June 30, 2005, we sold our $975,000 syndicated participation inBurt’s Bees, Inc. for a gain of $9,750 and we sold our $2.0 million syndicatedparticipation in Marietta Corp. for a gain of $20,000, for a total net realizedgain of approximately $30,000.

**Realized Gain on Settlement ofDerivative**

During the nine monthsended June 30, 2006, we received our first interest rate cap agreement paymentas a result of the one month LIBOR exceeding 5%.  There was no realization during the ninemonths ended June 30, 2005 as the one month LIBOR was below 5%.

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

During the nine monthsended June 30, 2006, we recorded net unrealized appreciation of approximately$65,000 due to an increase in the fair market value of our interest rate capagreement, as compared to unrealized depreciation of approximately $58,000during the nine months ended June 30, 2005.

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

For the nine months endedJune 30, 2006, we recorded net unrealized appreciation on investments ofapproximately $5.8 million as compared to net unrealized depreciation ofapproximately $298,000, for the nine months ended June 30, 2005.  The unrealized appreciation is mainlyattributable to the early repayment or sale of loans that were underperformingas of September 30, 2005, most notably Finn Corporation and ARI Holdings, Inc.,as well as the unrealized appreciation on the Finn Corporation warrantcurrently still in our portfolio.

**Net Increase in Net Assets from Operations**

Overall, we realized a net increase in net assets resulting from operationsof approximately $19.3 million for the nine months ended June 30, 2006.  Based on a weighted-average of 11,317,437(basic) and 11,549,054 (diluted) shares outstanding, our net increase in netassets from operations per weighted-average common share for the nine monthsended June 30, 2006 was $1.71 (basic) and $1.68 (diluted).

For the nine months ended June 30, 2005,we realized anet increase in net assets resulting from operations of approximately $13.2million for the nine months ended June 30, 2005.  Based on a weighted-average of 11,288,784(basic) and 11,602,986 (diluted) shares outstanding, our net increase in netassets from operations per weighted-average common share for the nine monthsended June 30, 2005 was $1.17 (basic) and $1.13 (diluted).

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** **

**LIQUIDITY AND CAPITAL RESOURCES**

At June 30, 2006, we hadinvestments in debt securities of, or loans to, 29 private companies, totalingapproximately $201.5 million (cost basis) of total assets.

During the nine monthsended June 30, 2006 and June 30, 2005, the following investment activityoccurred:

| Quarter Ended | ** ** | **New  Investments** | ** **  | **Principal  Repayments** | ** ** | **Net Gain/(Loss)  on Disposal** | ** ** |
|--------------------|------------|----------------------|-------------|---------------------------|------------|--------------------------------------------|------------|
|               |       |                 |        |                      |       |                                       |       |
| June 30, 2006      |       | $                    | 39,916,834  |                      | $          | 44,358,944                                 |       | $ | (100,850 | ) |
| March 31, 2006     |       | 38,471,109           |        | 24,815,067                |       | 377,500                                    |       |
| December 31,  2005 |       | 26,688,457           |        | 38,702,066                |       | (1,180,595                                 | )          |
|               |       | $                    | 105,076,400 |                      | $          | 107,876,077                                |       | $ | (903,945 | ) |
|               |       |                 |        |                      |       |                                       |       |
| June 30, 2005      |       | $                    | 34,732,083  |                      | $          | 18,154,720                                 |       | $ | — |   |
| March 31, 2005     |       | 44,513,875           |        | 33,859,918                |       | 20,000                                     |       |
| December 31,  2004 |       | 46,949,500           |        | 25,975,707                |       | 9,750                                      |       |
|               |       | $                    | 126,195,458 |                      | $          | 77,990,345                                 |       | $ | 29,750 |   |
|               |       |                 |        |                      |       |                                       |       |

 

The following table summarizes the contractual principalamortization and maturity of our investment portfolio by fiscal year:

| Fiscal Year Ended September 30, | ** ** | **Amount**  | ** **  |
|-----------------------------------------------------|------------|-------------|-------------|
|                                                |       |        |        |
| 2006                                                |       | $           | 2,532,673   |   |
| 2007                                                |       | 10,216,270  |        |
| 2008                                                |       | 23,415,615  |        |
| 2009                                                |       | 24,354,132  |        |
| 2010                                                |       | 36,118,831  |        |
| Thereafter                                          |       | 104,828,100 |        |
|                                                |       | $           | 201,465,621 |   |
|                                                |       |        |        |

 

Net cash provided by operating activities for the nine monthsended June 30, 2006, consisting primarily of the items described in “Results ofOperations”, was approximately $15.0 million as compared to net cash providedby operating activities of approximately $2.2 million for the nine months endedJune 30, 2005.  Net cash provided byinvesting activities was approximately $2.9 million for the nine months endedJune 30, 2006 and mainly consisted of the net repayment of investments ofapproximately $2.8 million, as compared to net cash used in investingactivities of approximately $68.8 million for the nine months ended June 30,2005, which consisted mainly of new investments of $126.2 million and therepayment of a repurchase agreement of approximately $21.3 million, partiallyoffset by principal repayments of approximately $78.0 million.  Net cash used in financing activities for thenine months ended June 30, 2006 was approximately $18.0 million and mainlyconsisted of repayments of borrowings on the line of credit of approximately$118.3 million and approximately $13.8 million for the payment ofdividends.  These outflows were partiallyoffset by approximately $113.1 million of cash received from borrowings on theline of credit and the exercise of stock options for approximately $1.2 million.  Net cash provided by financing activities wasapproximately $1.4 million for the nine months ended June 30, 2005 andconsisted primarily of cash provided from borrowings on our lines of credit,net of repayments, of approximately $13.8 million and the exercise of stockoptions which provided approximately $270,000, offset by the payment ofdividends of approximately $12.5 million.

During the nine months ended June 30, 2006, cash and cashequivalents decreased from approximately $504,000 to approximately $456,000.

Subsequent to June 30, 2006, we funded a loan investment in theaggregate amount of $5.7 million and purchased an additional $6.5 millionsyndicate participation using borrowings from our line of credit and receivedan early repayment of approximately $7.5 million, of which the net proceedswere used to pay down the line of credit.

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In order toqualify as a regulated investment company and to avoid corporate level tax onthe income we distribute to our stockholders, we are required, under SubchapterM of the Internal Revenue Code, to distribute at least 90% of our ordinaryincome and short-term capital gains to our stockholders on an annual basis. Inaccordance with these requirements, we declared and paid monthly cash dividendsof $0.135 per common share for January, February, March, April, May, and June2006, October, November, and December 2005 and $0.12 per common share forOctober, November and December 2004 and January, February, and March 2005,$0.13 for April, May, and June 2005, and $0.135 for July, August and September2005.  In July 2006, our Board ofDirectors declared a monthly dividend of $0.14 per common share for each July,August, and September 2006.

We anticipate continuingto borrow funds and, from time to time issuing additional equity securities toobtain additional capital to make further investments. To this end, we have aneffective registration statement on file with the SEC that would permit us toissue, through one or more transactions, up to an aggregate of $48.8 million insecurities, which may consist of shares of our common stock, preferred stock,and/or debt securities.

**Revolving Credit Facilities**

Through ourwholly-owned subsidiary, Business Loan, we have a $100 million revolving creditfacility (the “DB Facility”) with Deutsche Bank AG, as administrative agent,which currently matured on May 26, 2006 and was renewed and extended throughMay 27, 2007.  In connection with therenewal, the credit facility was amended to reduce the equity contribution from$100.0 million to $50.0 million. Pursuant to the DB Facility, Business Loan has pledged the loans itholds to secure future advances by certain institutional lenders.  Interest rates charged on the advances underthe DB Facility will be based on LIBOR, the Prime Rate or the Federal FundsRate, depending on market conditions, and will adjust periodically.  As of June 30, 2006, our outstandingprincipal balance under the DB Facility was approximately $47.8 million at aninterest rate of 5.2%.  Availableborrowings are subject to various constraints imposed by Deutsche Bank AG,based on the aggregate loan balance pledged by Business Loan, which varies asloans are added and repaid, regardless of whether such repayments are earlyprepayment or are made as contractually required.  At June 30, 2006, the remaining borrowingcapacity available under the DB Facility was approximately $52.2 million.  In October 2005, our Board of Directorsapproved a resolution to seek to increase this credit facility to $150 millionif the need should arise in the future.

The DB Facilitycontains covenants that, among other things, require Business Loan to maintainits status as a separate entity; prohibit certain significant corporatetransactions (such as mergers, consolidations, liquidations or dissolutions);and restrict material changes to our credit and collection policies.  The DB Facility also restricts some of theterms and provisions (including interest rates, terms to maturity and paymentsschedules) and limits the borrower and industry concentrations of loans thatare eligible to secure advances.  As ofJune 30, 2006, Business Loan was in compliance with all of the DB Facilitycovenants.  We currently intend tosecuritize all of the loans held by Business Loan and to use the proceeds fromthe securitization to pay down any amounts then outstanding under the revolvingcredit facility.  However, there can beno assurance that we will be able to successfully securitize any of these loanson terms acceptable to us, if at all.

The administrativeagent also requires that any interest or principal payments on pledged loans beremitted directly by the borrower into a lockbox account with the Bank of NewYork as custodian.  Deutsche Bank AG isalso the trustee of the account and once a month remits the collected funds tothe Company. For the nine months ended June 30, 2006, the amount due fromcustodian decreased by approximately $130,000.

GladstoneManagement, our affiliated external adviser, services the loans pledged underthe DB Facility.  As a condition to thisservicing arrangement, we executed a performance guaranty pursuant to which weguaranteed that Gladstone Management would comply fully with all of itsobligations under the facility. The performance guaranty requires us tomaintain a minimum net worth of $100 million and to maintain “asset coverage”with respect to “senior securities representing indebtedness” of at least 200%,in accordance with Section 18 of the 1940 Act.  As of June 30, 2006, we were in compliancewith our covenants under the performance guaranty.

The DB facility isavailable for general corporate purposes.

We also had a$15.0 million line of credit agreement with Branch Banking and Trust Company (“BB&TAgreement”) which originally matured on June 1, 2005.  The line of credit was subsequently modifiedfor quarterly extensions and in December 2005, it was modified to extend thematurity date through December 31, 2006. On June 22, 2006, we terminated the BB&T Agreement due to infrequentborrowings. Interest on outstanding borrowings was based upon the one monthLIBOR plus 2.5% per annum.  The unusedportion of the line of credit was subject to a fee of 0.2% per annum during theperiod in which the BB&T Agreement was outstanding.

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** **

**ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKETRISK.**

We are subject tofinancial market risks, including changes in interest rates.  We expectthat ultimately approximately 20% of the loans in our portfolio will be made atfixed rates and approximately 80% will be made at variable rates. Currently our portfolio has approximately 69% of the total loan portfoliocost basis at variable rates with a floor, approximately 3% of the total loanportfolio cost basis at a variable rate with a floor and ceiling, and theremaining 28% of the total loan portfolio cost basis at variable rates withouta floor or ceiling.

We have a $100 millionrevolving credit facility, based on variable rates, with Deutsche Bank AG whichmatured in May 2006 and was extended and amended through May 2007.

In February 2004, we entered into an interest rate capagreement in order to fulfill an obligation under our line of credit to enterinto certain hedging transactions in connection with our borrowings under theline of credit.  We purchased this interest rate cap agreement with anotional amount of $35 million (which is amortized quarterly) for a one-time,up-front payment of $304,000.  The interest rate cap agreement entitles usto receive payments, if any, equal to the amount by which interest payments onthe current notional amount at onemonth LIBOR exceed the payments on the current notional amount at 5%. The cap expires in February 2009.  This interest rate cap agreementeffectively caps our interest payments on our line of credit borrowing, up tothe notional amount of the interest rate cap, at five percent.  Thismitigates our exposure to increases in interest rates on our borrowings on ourlines of credit, which are at variable rates. At June 30, 2006, the cap agreement had a fair market value of $115,505and a current notional amount of $19.8 million. At June30, 2006, the one month LIBOR rate was approximately 5.33%.

To illustrate the potential impact of changes ininterest rates on our net increase in net assets resulting from operations, wehave performed the following analysis, which assumes that our balance sheetremains constant and no further actions beyond the interest rate cap agreementare taken to alter our existing interest rate sensitivity.  Under this analysis, a hypothetical increasein the one month LIBOR by 1% would increase our net increase in net assetsresulting from operations by approximately $1.7 million or 8.0%, over the nexttwelve months, compared to the net increase in net assets resulting fromoperations for the twelve months ended June 30, 2006.  A hypothetical decrease in the one monthLIBOR by 1% would decrease net increase in net assets resulting from operationsby approximately $1.7 million, or 8.0%, over the next twelve months, comparedto the net increase in net assets resulting from operations for the twelve monthsended June 30, 2006.  Although managementbelieves that this analysis is indicative of our existing interest ratesensitivity, it does not adjust for potential changes in credit quality, sizeand composition of our loan portfolio on the balance sheet and other businessdevelopments that could affect net increase in net assets resulting fromoperations.  Accordingly, no assurancescan be given that actual results would not differ materially from the resultsunder this hypothetical analysis.

In the event that wesecuritize a portion of our loan portfolio, we believe that we will likely berequired to enter into further hedging arrangements in the future with respectto securitized loans.  While hedgingactivities may mitigate our exposure to adverse fluctuations in interest rates,certain hedging transactions that we may enter into in the future, such asinterest rate swap agreements, may also limit our ability to participate in thebenefits of lower interest rates with respect to our portfolio of investments.

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

**ITEM 4. CONTROLS AND PROCEDURES.**

As of June 30, 2006, we, including our Chief Executive Officer andChief Financial Officer, evaluated the effectiveness of the design andoperation of our disclosure controls and procedures.  Based on that evaluation, our management,including the Chief Executive Officer and Chief Financial Officer, concludedthat our disclosure controls and procedures were effective in timely alertingmanagement, including the Chief Executive Officer and Chief Financial Officer,of material information about us required to be included in periodic Securitiesand Exchange Commission filings. However, in evaluating the disclosure controls and procedures,management recognized that any controls and procedures, no matter how well designedand operated can provide only reasonable assurance of achieving the desiredcontrol objectives, and management necessarily was required to apply itsjudgment in evaluating the cost-benefit relationship of possible controls andprocedures.

There have been no changes in our internal control over financialreporting that occurred during the quarter ended June 30, 2006, that havematerially affected, or are reasonably likely to materially affect, ourinternal control over financial reporting.

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** **

**PART II—OTHERINFORMATION**

**ITEM 1. LEGAL PROCEEDINGS.**

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

**ITEM 1A. RISK FACTORS.**

Our business is subjectto certain risks and events that, if they occur, could adversely affect ourfinancial condition and results of operations and the trading price of ourcommon stock. For a discussion of these risks, please refer to the “RiskFactors” section of our Annual Report on Form 10-K for the fiscal year endedSeptember 30, 2005, filed by us with the Securities and Exchange Commission onDecember 13, 2005. In connection with our preparation of this quarterly report,management has reviewed and considered these risk factors and has determinedthat the following risk factors should be read in connection with the existingrisk factors disclosed in our Annual Report on Form 10-K for the fiscal yearended September 30, 2005.

***The recent acceleration of vesting of all outstandingoptions except those of our non-employee directors, coupled with the newexpiration dates of our outstanding options, could result in significantselling pressure from option holders, which could reduce our stock price.***

As a result of the recentvesting acceleration of the majority of our outstanding options and the recentamendment of all of our outstanding options to shorten the remaining exerciseperiod of these options to September 30, 2006, there could be significantdownward pressure on our common stock price. This would be particularly thecase if a significant number of option holders elect not to “buy and hold,” butrather seek to monetize their option holdings (e.g., through a broker-assistedcashless exercise). This downward pressure could reduce the current marketprice of our common stock and dilute the interests of existing stockholders.

Additional risks anduncertainties not presently known to us or that we currently deem immaterialalso may impair our business operations. If any of the risks actually occur,our business could be harmed. In that event, the trading price of our commonstock could decline.

***Atthe start of the 2007 fiscal year, the Amended Advisory Agreement withGladstone Management Corporation and the Administration Agreement withGladstone Administration LLC will become effective and could potentially reduceour net investment income.***

The Amended AdvisoryAgreement provides for an annual base management fee equal to 2% of our assetsand an income-based incentive fee which will reward our Adviser, GladstoneManagement Corporation, if our quarterly net investment income (before givingeffect to the incentive fee) exceeds 1.75% of our net assets.  The agreement also provides for an annual capitalgains-based incentive fee, whereby the Adviser will receive an annual fee equalto 20% of our realized capital gains (net of realized capital losses andunrealized capital depreciation since inception of the Company).  Under the Administration Agreement, we willpay separately for our allocable portion of the Administrator’s overheadexpenses in performing our obligations, including rent, and our allocableportion of the salaries and benefits expenses of our chief financial officer,chief compliance officer and controller and their respective staffs.

These additional feescould potentially reduce our net investment income which is the basis for ourdividend declaration.

**ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OFPROCEEDS.**

Not applicable.

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

Not applicable.

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**ITEM 4. SUBMISSIONOF MATTERS TO A VOTE OF SECURITY HOLDERS.**

No matters were submitted to a vote ofsecurity holders during the three months ended June 30, 2006.

**ITEM 5. OTHER INFORMATION.**

Not applicable

**ITEM 6.  EXHIBITS**

See the exhibit index.

**SIGNATURE**

Pursuant to the requirements of theSecurities Exchange Act of 1934, the registrant has duly caused this report tobe signed on its behalf by the undersigned thereunto duly authorized.
|        | ** ** | **GLADSTONE CAPITAL  CORPORATION** |
|--------|------------|------------------------------------|
|   |       |                               |   |   |
|   |       |                               |   |   |
|   |       | By:                                |   | /s/ HARRY BRILL |
|   |       |                               |   | Harry Brill |
|   |       |                               |   | Chief Financial  Officer |

 

Date: August 1, 2006

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** **

**EXHIBIT INDEX**
| Exhibit | ** ** | **Description**                                                                                                                                                                                                                                                                                                            |
|---------|------------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|    |       |                                                                                                                                                                                                                                                                                                                       |
| 3.1     |       | Articles of  Amendment and Restatement of the Articles of Incorporation, incorporated by  reference to Exhibit a.2 to Pre-Effective Amendment No. 1 to the Registration  Statement on Form N-2 (File No. 333-63700), filed July 27, 2001.                                                                                  |
|    |       |                                                                                                                                                                                                                                                                                                                       |
| 3.2     |       | By-laws,  incorporated by reference to Exhibit b to Pre-Effective Amendment No. 1 to  the Registration Statement on Form N-2 (File No. 333-63700), filed July 27,  2001.                                                                                                                                                   |
|    |       |                                                                                                                                                                                                                                                                                                                       |
| 3.3     |       | Amendment to  by-laws, incorporated by reference to Exhibit 3.3 to the Company’s Quarterly  Report on Form 10-Q for the quarter ended December 31, 2003 (File No.  814-00237), filed February 17, 2004.                                                                                                               |
|    |       |                                                                                                                                                                                                                                                                                                                       |
| 10.1    |       | Amended and  Restated Credit Agreement by and among Gladstone Business Loan LLC, Deutsche  Bank AG, and certain other parties, dated as of May 26, 2006, incorporated by  reference to Exhibit 10.1 to the Company’s Current Report on Form 8-K (File  No. 814-00237), filed on May 30, 2006.                         |
|    |       |                                                                                                                                                                                                                                                                                                                       |
| 10.2    |       | Joint Directors  Nonqualified Excess Plan of Gladstone Commercial Corporation, Gladstone  Capital Corporation and Gladstone Investment Corporations, dated as of July  11, 2006, incorporated by reference to Exhibit 10.1 to the Company’s Current  Report on Form 8-K (File No. 814-00237), filed on July 12, 2006. |
|    |       |                                                                                                                                                                                                                                                                                                                       |
| 10.3    |       | Custodian  Agreement between Gladstone Capital Corporation and The Bank of New York,  dated as of May 5, 2006.                                                                                                                                                                                                             |
|    |       |                                                                                                                                                                                                                                                                                                                       |
| 11      |       | Computation of  Per Share Earnings (included in the notes to the unaudited financial  statements contained in this report).                                                                                                                                                                                                |
|    |       |                                                                                                                                                                                                                                                                                                                       |
| 31.1    |       | Certification of  Chief Executive Officer pursuant to section 302 of The Sarbanes-Oxley Act of  2002.                                                                                                                                                                                                                      |
|    |       |                                                                                                                                                                                                                                                                                                                       |
| 31.2    |       | Certification of  Chief Financial Officer pursuant to section 302 of The Sarbanes-Oxley Act of  2002.                                                                                                                                                                                                                      |
|    |       |                                                                                                                                                                                                                                                                                                                       |
| 32.1    |       | Certification of  Chief Executive Officer pursuant to section 906 of The Sarbanes-Oxley Act of  2002.                                                                                                                                                                                                                      |
|    |       |                                                                                                                                                                                                                                                                                                                       |
| 32.2    |       | Certification of  Chief Financial Officer pursuant to section 906 of The Sarbanes-Oxley Act of  2002.                                                                                                                                                                                                                      |

 

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

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