**UNITED STATES**

**SECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON,D.C. 20549**

 

**FORM 10-Q**

 

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

 

**FORTHE QUARTER ENDED DECEMBER 31, 2005**

 

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

 

**COMMISSIONFILE NUMBER: 814-00237**

 

**GLADSTONE CAPITAL CORPORATION**

(Exact name of registrant as specified in its charter)

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

 

Indicate by check mark whether the registrant(1) has filed all reports required to be filed by Section 13 or 15(d) ofthe Securities Exchange Act of 1934 during the preceding 12 months and (2) hasbeen subject to such filing requirements for the past 90 days. Yes ý  No o.

 

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

Yes ý  No o.

 

Indicate by check mark whether theregistrant is a shell company (as defined in Rule 12b-2 of the ExchangeAct).

Yes o  No ý .

 

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 February 3, 2006 was 11,308,510.

 

 

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**GLADSTONECAPITAL CORPORATION**

**TABLEOF CONTENTS**

 
| PART I.  | FINANCIAL INFORMATION                                                                                                           |   |
|---------------|---------------------------------------------------------------------------------------------------------------------------------|--------|
|          |                                                                                                                            |   |
| Item 1.       | Financial Statements (Unaudited)                                                                                                |   |
|          |                                                                                                                            |   |
|          | Consolidated Statements of  Assets and Liabilities as of December 31, 2005 and September 30,  2005                    |   |
|          | Consolidated Schedules of  Investments as of December 31, 2005 and September 30, 2005                                 |   |
|          | Consolidated Statements of  Operations for the three months ended December 31, 2005 and  December 31, 2004            |   |
|          | Consolidated Statements of  Changes in Net Assets for the three months ended December 31, 2005 and  December 31, 2004 |   |
|          | Consolidated Statements of  Cash Flows for the three months ended December 31, 2005 and  December 31, 2004            |   |
|          | Financial  Highlights for the three months ended December 31, 2005 and  December 31, 2004                             |   |
|          | Notes to Consolidated  Financial Statements                                                                                     |   |
|          |                                                                                                                            |   |
| Item 2.       | Management’s  Discussion and Analysis of Financial Condition and Results of Operations                                     |   |
|          |                                                                                                                            |   |
|          | Overview                                                                                                                        |   |
|          | Results of Operations                                                                                                           |   |
|          | Liquidity and  Capital Resources                                                                                                |   |
|          |                                                                                                                            |   |
| Item 3.       | Quantitative  and Qualitative Disclosure About Market Risk                                                                      |   |
|          |                                                                                                                            |   |
| Item 4.       | Controls and  Procedures                                                                                                        |   |
|          |                                                                                                                            |   |
| PART II. | OTHER INFORMATION                                                                                                               |   |
|          |                                                                                                                            |   |
| Item 1.       | Legal Proceedings                                                                                                               |   |
|          |                                                                                                                            |   |
| Item 2.       | Unregistered  Sales of Equity Securities and Use of Proceeds                                                                    |   |
|          |                                                                                                                            |   |
| Item 3.       | Defaults  Upon Senior Securities                                                                                                |   |
|          |                                                                                                                            |   |
| Item 4.       | Submission  of Matters to a Vote of Security Holders                                                                            |   |
|          |                                                                                                                            |   |
| Item 5.       | Other Information                                                                                                               |   |
|          |                                                                                                                            |   |
| Item 6.       | Exhibits                                                                                                                        |   |
|          |                                                                                                                            |   |
| SIGNATURES    |                                                                                                                            |

 

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**GLADSTONECAPITAL CORPORATION**

 

**CONSOLIDATED STATEMENTS OF ASSETS ANDLIABILITIES**

**(Unaudited)**

 
| ** **                                                                                                                               | ** ** | **December 31,  2005** | ** **  | **September 30,  2005** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------|-------------|-------------------------|------------|
| ** **                                                                                                                               | ** ** | ** **             | ** **  | ** **              | ** ** |
| ASSETS                                                                                                                                   |       |                   |        |                    |       |
| Investments at  fair value (Cost 12/31/2005:$192,181,728; 9/30/2005: $205,375,554)                                                       |       | $                      | 192,625,362 |                    | $          | 200,846,763 |   |
| Cash and cash equivalents                                                                                                                |       | 15,393,252             |        | 503,776                 |       |
| Interest  receivable – investments in debt securities                                                                               |       | 958,365                |        | 1,406,212               |       |
| Interest  receivable – officers                                                                                                     |       | 17,150                 |        | 27,067                  |       |
| Due from  custodian                                                                                                                      |       | 2,413,120              |        | 2,624,074               |       |
| Due from  affiliate                                                                                                                      |       | 300,638                |        | —                  |       |
| Deferred financing  fees                                                                                                                 |       | 43,750                 |        | 70,000                  |       |
| Prepaid assets                                                                                                                           |       | 197,125                |        | 177,848                 |       |
| Other assets                                                                                                                             |       | 157,381                |        | 137,354                 |       |
| TOTAL ASSETS                                                                                                                             |       | $                      | 212,106,143 |                    | $          | 205,793,094 |   |
|                                                                                                                                     |       |                   |        |                    |       |
| LIABILITIES                                                                                                                              |       |                   |        |                    |       |
| Accounts payable                                                                                                                         |       | $                      | 10,784      |                    | $          | 21,893 |   |
| Interest payable                                                                                                                         |       | 189,390                |        | 183,707                 |       |
| Fees due to  affiliate                                                                                                                   |       | 210,109                |        | 391,322                 |       |
| Borrowings under  lines of credit                                                                                                        |       | 55,723,723             |        | 53,034,064              |       |
| Accrued expenses  and deferred liabilities                                                                                               |       | 352,962                |        | 350,665                 |       |
| Funds held in  escrow                                                                                                                    |       | 202,164                |        | 200,760                 |       |
| Total  Liabilities                                                                                                                       |       | 56,689,132             |        | 54,182,411              |       |
| Net Assets                                                                                                                               |       | $                      | 155,417,011 |                    | $          | 151,610,683 |   |
|                                                                                                                                     |       |                   |        |                    |       |
| ANALYSIS OF NET  ASSETS                                                                                                                  |       |                   |        |                    |       |
| Common stock,  $0.001 par value, 50,000,000 shares authorized and 11,308,510 and 11,303,510  shares issued and outstanding, respectively |       | $                      | 11,309      |                    | $          | 11,304 |   |
| Capital in  excess of par value                                                                                                          |       | 164,740,025            |        | 164,610,873             |       |
| Notes receivable  – officers                                                                                                        |       | (8,722,687             | )           | (8,745,781              | )          |
| Net unrealized  appreciation/(depreciation) on investments                                                                               |       | 443,631                |        | (4,528,791              | )          |
| Unrealized  depreciation on derivative                                                                                                   |       | (254,639               | )           | (253,747                | )          |
| Realized  (loss)/gain on sale of investments                                                                                             |       | (1,138,345             | )           | 42,250                  |       |
| Distributions  less than net investment income                                                                                           |       | 337,717                |        | 474,575                 |       |
| Total Net Assets                                                                                                                         |       | $                      | 155,417,011 |                    | $          | 151,610,683 |   |
| Net Assets Per  Share                                                                                                                    |       | $                      | 13.74       |                    | $          | 13.41 |   |

 

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

 

2

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**GLADSTONECAPITAL CORPORATION**

**CONSOLIDATED SCHEDULE OF INVESTMENTS**

**ASOF DECEMBER 31, 2005**

**(UNAUDITED)**

 
| **Company (1)**                    | ** ** | **Industry**                      | ** ** | **Investment (2)**                                        | ** ** | **Cost**  | ** ** | **Fair Value** | ** ** |
|------------------------------------|------------|-----------------------------------|------------|-----------------------------------------------------------|------------|-----------|------------|----------------|------------|
|                               |       |                              |       |                                                      |       |      |       |           |       |
| Advanced Homecare Management, Inc. |       | Home health nursing services      |       | Senior Subordinated Term Debt(6)(7)  (13.7%, Due 12/2010) |       | $         | 7,500,000  |           | $          | 7,500,000 |   |
|                               |       |                              |       |                                                      |       |      |       |           |       |
| Allied Extruders, Inc.             |       | Polyethylene film manufacturer    |       | Senior Term Debt (3)(6)                                   |       | 3,900,000 |       | 3,909,750      |       |
|                               |       |                              |       | (12.3%, Due 7/2009)                                       |       |      |       |           |       |
|                               |       |                              |       |                                                      |       |      |       |           |       |
| Badanco Acquisition Corp.          |       | Manufacturing-luggage             |       | Senior Term Debt (6)                                      |       | 6,247,519 |       | 6,247,519      |       |
|                               |       |                              |       | (9.8%, Due 2/2010)                                        |       |      |       |           |       |
|                               |       |                              |       | Senior Term Debt (3)(6)(12)                               |       | 8,650,000 |       | 8,879,225      |       |
|                               |       |                              |       | (12.8%, Due 2/2010)                                       |       |      |       |           |       |
|                               |       |                              |       |                                                      |       |      |       |           |       |
| Benetech, Inc.                     |       | Dust management systems           |       | Senior Term Debt (6)                                      |       | 2,600,000 |       | 2,622,750      |       |
|                               |       | for the coal and electric utility |       | (9.3%, Due 5/2009)                                        |       |      |       |           |       |
|                               |       | industries                        |       | Senior Term Debt (3) (6)                                  |       | 3,168,750 |       | 3,212,320      |       |
|                               |       |                              |       | (12.3%, Due 5/2009)                                       |       |      |       |           |       |
|                               |       |                              |       |                                                      |       |      |       |           |       |
| Consolidated Bedding, Inc.         |       | Manufacturing-mattresses          |       | Senior Subordinated Term Debt (6)                         |       | 2,890,155 |       | 2,738,895      |       |
|                               |       |                              |       | (13.0%, Due 3/2009)                                       |       |      |       |           |       |
|                               |       |                              |       |                                                      |       |      |       |           |       |
| Country Road                       |       | Service-telecommunications        |       | Senior Subordinated Term Debt                             |       | 5,957,355 |       | 6,060,000      |       |
| Communications LLC                 |       |                              |       | (6)(7)                                                    |       |      |       |           |       |
| Country Road Management, Inc.      |       |                              |       | (11.6%, Due 7/2013)                                       |       |      |       |           |       |
|                               |       |                              |       |                                                      |       |      |       |           |       |
| Coyne International                |       | Industrial services               |       | Senior Term Debt (3) (5) (6)                              |       | 6,370,574 |       | 6,306,869      |       |
| Enterprises                        |       |                              |       | (13.0%, PIK 2%, Due 7/2007)                               |       |      |       |           |       |
|                               |       |                              |       |                                                      |       |      |       |           |       |
| Defiance Stamping                  |       | Manufacturing-trucking parts      |       | Senior Term Debt (3)(6)(13)                               |       | 6,325,000 |       | 6,358,649      |       |
| Company                            |       |                              |       | (12.3%, Due 4/2010)                                       |       |      |       |           |       |
|                               |       |                              |       |                                                      |       |      |       |           |       |
| Doe & Ingalls Management       |       | Distributor-specialty chemicals   |       | Senior Term Debt (6)                                      |       | 5,500,000 |       | 5,506,875      |       |
| LLC                                |       |                              |       | (8.8%, Due 11/2010)                                       |       |      |       |           |       |
| Doe & Ingalls of North         |       |                              |       | Senior Term Debt (3)(6)                                   |       | 4,500,000 |       | 4,500,000      |       |
| Carolina Operating LLC             |       |                              |       | (12.3%, Due 11/2010)                                      |       |      |       |           |       |
| Doe & Ingalls of Florida       |       |                              |       |                                                      |       |      |       |           |       |
| Operating LLC                      |       |                              |       |                                                      |       |      |       |           |       |
| Doe & Ingalls of Virginia      |       |                              |       |                                                      |       |      |       |           |       |
| Operating LLC                      |       |                              |       |                                                      |       |      |       |           |       |
|                               |       |                              |       |                                                      |       |      |       |           |       |
| Finn Corporation                   |       | Manufacturing-landscape           |       | Common Stock Warrants                                     |       | 37,000    |       | 694,057        |       |
|                               |       | equipment                         |       |                                                      |       |      |       |           |       |
|                               |       |                              |       |                                                      |       |      |       |           |       |
| Gammill, Inc.                      |       | Designer and assembler of         |       | Senior Term Debt (6)                                      |       | 3,389,696 |       | 3,385,459      |       |
|                               |       | quilting machines and             |       | (9.5%, Due 12/2008)                                       |       |      |       |           |       |
|                               |       | accessories                       |       | Senior Term Debt (3) (6)                                  |       | 4,631,250 |       | 4,602,305      |       |
|                               |       |                              |       | (12.0%, Due 12/2008)                                      |       |      |       |           |       |
|                               |       |                              |       |                                                      |       |      |       |           |       |
| Global Materials                   |       | Manufacturing-steel wool          |       | Senior Term Debt (3) (6)                                  |       | 5,450,000 |       | 5,422,750      |       |
| Technologies, Inc.                 |       | products and metal fibers         |       | (13.3%, Due 11/2009)                                      |       |      |       |           |       |
|                               |       |                              |       |                                                      |       |      |       |           |       |
| Infor Global Solutions Ltd.        |       | Enterprise application            |       | Senior Subordinated Term Debt (7)                         |       | 6,828,000 |       | 6,947,500      |       |
|                               |       | solutions                         |       | (11.8%, Due 5/2012)                                       |       |      |       |           |       |
|                               |       |                              |       |                                                      |       |      |       |           |       |
| John Henry Holdings, Inc.          |       | Manufacturing-packaging           |       | Senior Subordinated Term Debt(6)(7)                       |       | 7,069,330 |       | 6,993,500      |       |
|                               |       | products                          |       | (11.5%, Due 6/2011)                                       |       |      |       |           |       |
|                                    |            |                                   |            |                                                           |            |           |            |                |            |  |  |

 

3

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| **Company (1)**              | ** ** | **Industry**                | ** ** | **Investment (2)**                  | ** ** | **Cost**   | ** ** | **Fair Value** | ** ** |
|------------------------------|------------|-----------------------------|------------|-------------------------------------|------------|------------|------------|----------------|------------|
|                         |       |                        |       |                                |       |       |       |           |       |
| Mistras Holdings Corp.       |       | Nondestructive testing      |       | Senior Term Debt (3) (6)            |       | 9,666,666  |       | 9,437,083      |       |
|                         |       | instruments, systems        |       | (10.5%, Due 8/2008)                 |       |       |       |           |       |
|                         |       | and services                |       | Senior Term Debt (3) (6)            |       | 5,333,334  |       | 5,200,001      |       |
|                         |       |                        |       | (12.5%, Due 8/2008)                 |       |       |       |           |       |
|                         |       |                        |       |                                |       |       |       |           |       |
| Northern Contours            |       | Manufacturing-veneer and    |       | Senior Subordinated Term Debt (6)   |       | 7,000,000  |       | 7,000,000      |       |
| Northern Contours            |       | laminate components         |       | (11.3%, Due 5/2010)                 |       |       |       |           |       |
| of Kentucky, Inc.            |       |                        |       |                                |       |       |       |           |       |
| Norcon Holding LLC           |       |                        |       |                                |       |       |       |           |       |
| Norcon Lewis LLC             |       |                        |       |                                |       |       |       |           |       |
|                         |       |                        |       |                                |       |       |       |           |       |
| Penn Engineering &       |       | Manufacturing-fractional    |       | Senior Subordinated Term Debt (7)   |       | 5,009,167  |       | 5,050,000      |       |
| Manufacturing Corp.          |       | horsepower engines          |       | (10.5%, Due 5/2012)                 |       |       |       |           |       |
| PN Merger Sub Inc.           |       |                        |       |                                |       |       |       |           |       |
| PEM Holding Co.              |       |                        |       |                                |       |       |       |           |       |
|                         |       |                        |       |                                |       |       |       |           |       |
| Polar Corporation            |       | Manufacturing-trailer parts |       | Senior Subordinated Term Debt(6)(7) |       | 10,012,391 |       | 10,030,346     |       |
|                         |       |                        |       | (10.9%, Due 6/2010)                 |       |       |       |           |       |
|                         |       |                        |       |                                |       |       |       |           |       |
| Puerto Rico Cable            |       | Service-telecommunications  |       | Senior Subordinated Term Debt(6)(7) |       | 7,075,780  |       | 7,105,000      |       |
| Acquisition Company, Inc.    |       |                        |       | (10.8%, Due 1/2012)                 |       |       |       |           |       |
|                         |       |                        |       |                                |       |       |       |           |       |
| Santana Plastics             |       | Manufacturing-polyethylene  |       | Senior Term Debt (3)(6)             |       | 5,925,000  |       | 5,925,000      |       |
|                         |       | bathroom partitions         |       | (12.3%, Due 11/2009)                |       |       |       |           |       |
|                         |       |                        |       | Senior Term Debt (4)(6)             |       | 1,925,625  |       | 1,925,625      |       |
|                         |       |                        |       | (13.0%, Due 11/2009)                |       |       |       |           |       |
|                         |       |                        |       |                                |       |       |       |           |       |
| SCPH Holdings, Inc.          |       | Manufacturing-underwater    |       | Credit Facility (9)                 |       | —     |       | —         |       |
| Sea Con Phoenix, Inc.        |       | and harsh environment       |       | (8.8%, Due 3/2006)                  |       |       |       |           |       |
| Phoenix Optix, Inc.          |       | components                  |       | Senior Term Debt (6)                |       | 3,150,000  |       | 3,150,000      |       |
|                         |       |                        |       | (9.3%, Due 2/2010)                  |       |       |       |           |       |
|                         |       |                        |       | Senior Term Debt (3)(6)             |       | 3,000,000  |       | 3,000,000      |       |
|                         |       |                        |       | (12.3%, Due 2/2010)                 |       |       |       |           |       |
|                         |       |                        |       |                                |       |       |       |           |       |
| SCS Acquisition Corp.        |       | Service-chemically treated  |       | Credit Facility (10)                |       | —     |       | —         |       |
|                         |       | equipment distribution      |       | Senior Term Debt (8)(11)            |       | 6,625,000  |       | 6,625,000      |       |
|                         |       |                        |       | (8.4%, Due 12/2011)                 |       |       |       |           |       |
|                         |       |                        |       | Senior Term Debt (3)(8)(11)         |       | 6,625,000  |       | 6,625,000      |       |
|                         |       |                        |       | (10.4%, Due 12/2011)                |       |       |       |           |       |
|                         |       |                        |       |                                |       |       |       |           |       |
| Survey Sampling              |       | Service-telecommunications  |       | Senior Subordinated Term Debt(6)(7) |       | 2,263,568  |       | 2,264,063      |       |
|                         |       |                        |       | (11.8%, Due 5/2012)                 |       |       |       |           |       |
|                         |       |                        |       |                                |       |       |       |           |       |
| Tech Lighting LLC            |       | Manufacturing-low voltage   |       | Senior Subordinated Term Debt(6)(7) |       | 9,011,837  |       | 9,045,000      |       |
|                         |       | lighting systems            |       | (11.5%, Due 10/2010)                |       |       |       |           |       |
|                         |       |                        |       |                                |       |       |       |           |       |
| Visual Edge Technology, Inc. |       | Service-office supplies     |       | Senior Subordinated Term Debt (6)   |       | 5,000,000  |       | 5,000,000      |       |
| Graphic Enterprises, Inc.    |       | distribution                |       | (12.3%, Due 8/2011)                 |       |       |       |           |       |
| Copeco, Inc.                 |       |                        |       |                                |       |       |       |           |       |

 

4

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| **Company (1)**         | ** ** | **Industry**               | ** ** | **Investment (2)**                | ** ** | **Cost**  | ** **      | **Fair Value** | ** ** |
|-------------------------|------------|----------------------------|------------|-----------------------------------|------------|-----------|-----------------|----------------|------------|
|                    |       |                       |       |                              |       |      |            |           |       |
| Woven Electronics       |       | Custom electrical cable    |       | Senior Term Debt (4) (6) (14)     |       | 8,344,999 |            | 8,675,962      |       |
| Corporation             |       | assemblies                 |       | (11.5%, Due 3/2009)               |       |      |            |           |       |
|                    |       |                       |       |                              |       |      |            |           |       |
| Xspedius Communications |       | Service-telecommunications |       | Senior Subordinated Term Debt (6) |       | 5,198,732 |            | 4,678,859      |       |
| LLC                     |       |                       |       | (14.8%, Due 3/2010)               |       |      |            |           |       |
|                    |       |                       |       |                              |       |      |            |           |       |
| **Total:**              | ** ** | ** **                 | ** ** | ** **                        | ** ** | **$**     | **192,181,728** |           | **$**      | **192,625,362** | ** ** |
|                         |            |                            |            |                                   |            |           |                 |                |            |  |  |

 

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

(2) Percentage representsinterest rates in effect at December 31, 2005 and due date represents thecontractual maturity date.

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

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

(5) Has some paid in kind(PIK) interest.  Refer to Note 9 “Paymentin Kind Interest” hereto and Note 2 “Summary of Significant Accounting Policies”of the Company’s Form 10-K for the fiscal year ended September 30,2005.

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

(7) Marketable securities,such as syndicated loans, are valued based on the indicative bid price, as of December 30,2005, from the respective originating syndication agent’s trading desk.

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

(9) Availability under thecredit facility totals $500,000.  Therewere no borrowings outstanding at December 31, 2005.

(10) Availability under thecredit facility totals $2,500,000.  Therewere no borrowings outstanding at December 31, 2005.

(11) Availability under thedebt facility totals $7,500,000. The outstanding balance of the debt facilitywas $6,625,000 at December 31, 2005.

(12) Includes a success feewith a $147,725 fair value and no cost basis.

(13) Includes a success feewith a $33,649 fair value and no cost basis.

(14) Includes a success feewith a $247,513 fair value and no cost basis.

 

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

 

5

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**GLADSTONECAPITAL CORPORATION**

**CONSOLIDATEDSCHEDULE OF INVESTMENTS**

**ASOF SEPTEMBER 30, 2005**

 
| **Company (1)**                    | ** ** | **Industry**                         | ** ** | **Investment (2)**                                      | ** ** | **Cost**   | ** ** | **Fair Value** | ** ** |
|------------------------------------|------------|--------------------------------------|------------|---------------------------------------------------------|------------|------------|------------|----------------|------------|
|                               |       |                                 |       |                                                    |       |       |       |           |       |
| Advanced Homecare Management, Inc. |       | Home health nursing services         |       | Senior Subordinated Term Debt (6)  (12.6%, Due 12/2010) |       | $          | 7,500,000  |           | $          | 7,500,000 |   |
|                               |       |                                 |       |                                                    |       |       |       |           |       |
| Allied Extruders, Inc.             |       | Polyethylene film manufacturer       |       | Senior Term Debt (3)                                    |       | 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      |       | Senior Term Debt (6)                                    |       | 2,762,500  |       | 2,783,219      |       |
|                               |       | coal and electric utility industries |       | (8.7%, Due 5/2009)                                      |       |       |       |           |       |
|                               |       |                                 |       | 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)                       |       | 10,500,000 |       | 7,350,000      |       |
|                               |       |                                 |       | (13.0%, Due 2/2006)                                     |       |       |       |           |       |
|                               |       |                                 |       | Common Stock Warrants                                   |       | 37,000     |       | 682,114        |       |
|                               |       |                                 |       |                                                    |       |       |       |           |       |
| Gammill, Inc.                      |       | Designer and assembler of quilting   |       | Senior Term Debt (6)                                    |       | 3,771,427  |       | 3,771,427      |       |
|                               |       | machines and accessories             |       | (9.5%, Due 12/2008)                                     |       |       |       |           |       |
|                               |       |                                 |       | 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              |       | Senior Subordinated Term Debt(6)                        |       | 7,067,923  |       | 7,064,500      |       |
|                               |       | products                             |       | (11.0%, Due 6/2011)                                     |       |       |       |           |       |
|                                    |            |                                      |            |                                                         |            |            |            |                |            |  |  |

 

6

----

 
| **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 Debt (8) |       | 7,000,000 |       | 7,000,000      |       |
| Northern Contours             |       | laminate components                  |       | (10.7%, Due 5/2010)               |       |      |       |           |       |
| of Kentucky, Inc.             |       |                                 |       |                              |       |      |       |           |       |
| Norcon Holding LLC            |       |                                 |       |                              |       |      |       |           |       |
| Norcon Lewis LLC              |       |                                 |       |                              |       |      |       |           |       |
|                          |       |                                 |       |                              |       |      |       |           |       |
| Penn Engineering &        |       | Manufacturing-fractional             |       | Senior Subordinated Term Debt (8) |       | 5,009,524 |       | 5,050,000      |       |
| Manufacturing Corp.           |       | horsepower engines                   |       | (10.0%, Due 5/2012)               |       |      |       |           |       |
| PN Merger Sub Inc.            |       |                                 |       |                              |       |      |       |           |       |
| PEM Holding Co.               |       |                                 |       |                              |       |      |       |           |       |
|                          |       |                                 |       |                              |       |      |       |           |       |
| Polar Corporation             |       | Manufacturing-trailer parts          |       | Senior Subordinated Term Debt (6) |       | 8,609,566 |       | 8,627,500      |       |
|                          |       |                                 |       | (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 Debt (7) |       | 5,029,188 |       | 5,037,500      |       |
|                          |       | processing                           |       | (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 and         |       | Credit Facility (9)               |       | —    |       | —         |       |
| Sea Con Phoenix, Inc.         |       | harsh environment components         |       | (8.0%, Due 3/2006)                |       |      |       |           |       |
| Phoenix Optix, Inc.           |       |                                 |       | Senior Term Debt (3)(6)           |       | 3,237,500 |       | 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            |       | Senior Subordinated Term Debt (6) |       | 9,012,452 |       | 9,067,500      |       |
|                          |       | lighting systems                     |       | (10.4%, Due 10/2010)              |       |      |       |           |       |
|                          |       |                                 |       |                              |       |      |       |           |       |
| Visual Edge Technology, Inc.  |       | Service-office supplies distribution |       | Senior Subordinated Term Debt     |       | 5,000,000 |       | 5,000,000      |       |
| Graphic Enterprises, Inc.     |       |                                 |       | (11.7%, Due 8/2011)               |       |      |       |           |       |
| Copeco, Inc.                  |       |                                 |       |                              |       |      |       |           |       |

 

7

----

 
| **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 |       | Service-telecommunications |       | Senior Subordinated Term Debt (6) |       | 5,972,727 |            | 4,479,545      |       |
| LLC                     |       |                       |       | (14.3%, Due 3/2010)               |       |      |            |           |       |
|                    |       |                       |       |                              |       |      |            |           |       |
| **Total:**              | ** ** | ** **                 | ** ** | ** **                        | ** ** | **$**     | **205,375,554** | ** **     | **$**      | **200,846,763** | ** ** |
|                         |            |                            |            |                                   |            |           |                 |                |            |  |  |

 

----

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

(2) Percentage representsinterest rates in effect at September 30, 2005 and due date represents thecontractual maturity date.

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

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

(5) Has some paid in kind(PIK) interest.  Refer to Note 2 “Summaryof Significant Accounting Policies” of the Company’s Form 10-K for thefiscal year ended September 30, 2005.

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

(7) Marketable securities,such as syndicated loans, are valued based on the indicative bid price, as of September 30,2005, from the respective originating syndication agent’s trading desk.

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

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

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

(11) Non-income producing at September 30,2005.

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

 

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

 

8

----

 

**GLADSTONECAPITAL CORPORATION**

**CONSOLIDATED STATEMENTS OF OPERATIONS**

**(UNAUDITED)**

 
| ** **                                                              | ** ** | **Three Months  Ended  December 31,  2005** | ** ** | **Three Months  Ended  December 31,  2004** | ** ** |
|-------------------------------------------------------------------------|------------|---------------------------------------------|------------|---------------------------------------------|------------|
|                                                                    |       |                                        |       |                                        |       |
| INVESTMENT INCOME                                                       |       |                                        |       |                                        |       |
| Interest income – investments                                      |       | $                                           | 5,847,107  |                                        | $          | 5,707,343 |   |
| Interest income – cash and cash equivalents                        |       | 8,912                                       |       | 16,340                                      |       |
| Interest income – notes receivable from employees                  |       | 107,093                                     |       | 114,718                                     |       |
| Prepayment fees and other income                                        |       | 67,207                                      |       | 240,000                                     |       |
| Total investment income                                                 |       | 6,030,319                                   |       | 6,078,401                                   |       |
|                                                                    |       |                                        |       |                                        |       |
| EXPENSES                                                                |       |                                        |       |                                        |       |
| Loan servicing (Refer to Note 12)                                       |       | 715,415                                     |       | 530,952                                     |       |
| Management fee (Refer to Notes 12 and 15)                               |       | 268,701                                     |       | 327,302                                     |       |
| Professional fees                                                       |       | 122,466                                     |       | 238,722                                     |       |
| Amortization of deferred financing fees                                 |       | 26,250                                      |       | 91,912                                      |       |
| Interest expense                                                        |       | 652,078                                     |       | 171,730                                     |       |
| Stockholder related costs                                               |       | 128,935                                     |       | 71,769                                      |       |
| Directors fees                                                          |       | 24,000                                      |       | 27,000                                      |       |
| Insurance expense                                                       |       | 50,777                                      |       | 46,272                                      |       |
| Stock option compensation                                               |       | 43,257                                      |       | —                                      |       |
| General and administrative exepnses                                     |       | 55,789                                      |       | 43,160                                      |       |
| Expenses before credit from Gladstone Management                        |       | 2,087,668                                   |       | 1,548,819                                   |       |
| Credit to management fee for fees collected by  Gladstone Management    |       |                                        |       |                                        |       |
| (Refer to Note 15)                                                      |       | (550,000                                    | )          | (286,500                                    | )          |
| Total expenses net of credit to management fee                          |       | 1,537,668                                   |       | 1,262,319                                   |       |
|                                                                    |       |                                        |       |                                        |       |
| NET INVESTMENT INCOME BEFORE INCOME TAXES                               |       | 4,492,651                                   |       | 4,816,082                                   |       |
| Income tax expense                                                      |       | 50,237                                      |       | 138,678                                     |       |
| NET INVESTMENT INCOME                                                   |       | 4,442,414                                   |       | 4,677,404                                   |       |
|                                                                    |       |                                        |       |                                        |       |
| REALIZED AND UNREALIZED GAIN/(LOSS) ON  INVESTMENTS:                    |       |                                        |       |                                        |       |
| Realized (loss)/gain on sale of investments                             |       | (1,180,595                                  | )          | 9,750                                       |       |
| Unrealized depreciation on derivative                                   |       | (892                                        | )          | (24,811                                     | )          |
| Net unrealized appreciation on investments                              |       | 4,972,422                                   |       | 282,605                                     |       |
| Net gain on investments                                                 |       | 3,790,935                                   |       | 267,544                                     |       |
|                                                                    |       |                                        |       |                                        |       |
| NET INCREASE IN NET ASSETS RESULTING FROM OPERATIONS                    |       | $                                           | 8,233,349  |                                        | $          | 4,944,948 |   |
|                                                                    |       |                                        |       |                                        |       |
| NET INCREASE IN NET ASSETS RESULTING FROM OPERATIONS  PER COMMON SHARE: |       |                                        |       |                                        |       |
| Basic                                                                   |       | $                                           | 0.73       |                                        | $          | 0.44 |   |
| Diluted                                                                 |       | $                                           | 0.71       |                                        | $          | 0.43 |   |
|                                                                    |       |                                        |       |                                        |       |
| WEIGHTED AVERAGE SHARES OF COMMON STOCK OUTSTANDING:                    |       |                                        |       |                                        |       |
| Basic                                                                   |       | 11,306,510                                  |       | 11,278,510                                  |       |
| Diluted                                                                 |       | 11,573,620                                  |       | 11,615,796                                  |       |

 

*THE ACCOMPANYING NOTESARE AN INTEGRAL PART TO THESE CONSOLIDATED FINANCIAL STATEMENTS.*

 

9

----

 

**GLADSTONECAPITAL CORPORATION**

**CONSOLIDATED STATEMENTS OF CHANGES IN NETASSETS**

 

**(UNAUDITED)**

 
| ** **                                              | ** ** | **Three Months Ended December 31,** | ** **  |
|---------------------------------------------------------|------------|-------------------------------------|-------------|
| ** **                                              | ** ** | **2005**                            | ** **  | **2004** | ** ** |
| *Operations:*                                           |       |                                |        |   |   |
| Net investment income                                   |       | $                                   | 4,442,414   |   | $ | 4,677,404 |   |
| Net realized (loss)/gain on sale of investments         |       | (1,180,595                          | )           | 9,750 |   |
| Unrealized depreciation on derivatives                  |       | (892                                | )           | (24,811 | ) |
| Net unrealized appreciation on investments              |       | 4,972,422                           |        | 282,605 |   |
| Net increase in net assets from operations              |       | 8,233,349                           |        | 4,944,948 |   |
|                                                    |       |                                |        |   |   |
| *Capital transactions:*                                 |       |                                |        |   |   |
| Distributions to stockholders                           |       | (4,579,272                          | )           | (4,060,263 | ) |
| Stock option compensation                               |       | 43,257                              |        | — |   |
| Issuance of common stock under stock option plan        |       | 85,900                              |        | — |   |
| Repayment of principal on employee notes                |       | 23,094                              |        | 150,000 |   |
| Shelf offering costs                                    |       | —                              |        | (111,233 | ) |
| Decrease in net assets from capital share  transactions |       | (4,427,021                          | )           | (4,021,496 | ) |
|                                                    |       |                                |        |   |   |
| Total increase in net assets                            |       | 3,806,328                           |        | 923,452 |   |
| Net assets at beginning of year                         |       | 151,610,683                         |        | 152,226,655 |   |
| Net assets at end of year                               |       | $                                   | 155,417,011 |   | $ | 153,150,107 |   |

 

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

 

10

----

 

**GLADSTONECAPITAL CORPORATION**

**CONSOLIDATED STATEMENTS OF CASH FLOWS**

**(UNAUDITED)**

 
| ** **                                                                                                                    | ** ** | **Three Months Ended December 31,** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------------------|------------|
| ** **                                                                                                                    | ** ** | **2005**                            | ** ** | **2004** | ** ** |
| **CASH FLOWS FROM OPERATING ACTIVITIES**                                                                                      |       |                                |       |   |   |
|                                                                                                                          |       |                                |       |   |   |
| Net increase in net assets resulting from operations                                                                          |       | $                                   | 8,233,349  |   | $ | 4,944,948 |   |
| Adjustments to reconcile net increase in net assets  resulting from  operations to net cash provided by operating activities: |       |                                |       |   |   |
| Net amortization of premiums and discounts                                                                                    |       | 32,641                              |       | 455 |   |
| Amortization of deferred financing fees                                                                                       |       | 26,250                              |       | 91,912 |   |
| Stock compensation                                                                                                            |       | 43,257                              |       | — |   |
| Realized loss on investments                                                                                                  |       | 1,180,595                           |       | — |   |
| Unrealized depreciation on derivative                                                                                         |       | 892                                 |       | 24,811 |   |
| Change in net unrealized appreciation                                                                                         |       | (4,972,422                          | )          | (282,605 | ) |
| Decrease (increase) in interest receivable                                                                                    |       | 457,764                             |       | (67,382 | ) |
| Decrease in funds due from custodian                                                                                          |       | 210,954                             |       | 31,270 |   |
| (Increase) decrease in prepaid assets                                                                                         |       | (19,277                             | )          | 1,958 |   |
| (Increase) decrease in due from affiliate                                                                                     |       | (300,638                            | )          | 30,401 |   |
| Increase in other assets                                                                                                      |       | (20,919                             | )          | (40,097 | ) |
| (Decrease) increase in accounts payable                                                                                       |       | (11,109                             | )          | 137,112 |   |
| Increase (decrease) in interest payable                                                                                       |       | 5,683                               |       | (22,189 | ) |
| Increase (decrease) in accrued expenses and deferred  liabilities                                                             |       | 2,297                               |       | (633,367 | ) |
| (Decrease) increase in fees due to affiliate                                                                                  |       | (181,213                            | )          | 36,400 |   |
| Increase in funds held in escrow                                                                                              |       | 1,404                               |       | — |   |
| Increase in investment balance due to payment in  kind interest                                                               |       | (33,022                             | )          | (140,090 | ) |
| Net cash provided by operating activities                                                                                     |       | 4,656,486                           |       | 4,113,537 |   |
|                                                                                                                          |       |                                |       |   |   |
| **CASH FLOWS FROM INVESTING ACTIVITIES:**                                                                                     |       |                                |       |   |   |
|                                                                                                                          |       |                                |       |   |   |
| Purchase of investments                                                                                                       |       | (26,688,457                         | )          | (46,949,500 | ) |
| Principal repayments on investments                                                                                           |       | 38,702,066                          |       | 25,975,707 |   |
| Repayment of repurchase agreements                                                                                            |       | —                              |       | (21,345,997 | ) |
| Receipt of principal on notes receivable - employees                                                                          |       | 23,094                              |       | 150,000 |   |
| Net cash provided by (used in) investing activities                                                                           |       | 12,036,703                          |       | (42,169,790 | ) |
|                                                                                                                          |       |                                |       |   |   |
| **CASH FLOWS FROM FINANCING ACTIVITIES:**                                                                                     |       |                                |       |   |   |
|                                                                                                                          |       |                                |       |   |   |
| Borrowings from the lines of credit                                                                                           |       | 41,925,000                          |       | 50,400,000 |   |
| Repayments on the lines of credit                                                                                             |       | (39,235,341                         | )          | (50,743,547 | ) |
| Distributions paid                                                                                                            |       | (4,579,272                          | )          | (4,060,263 | ) |
| Exercise of employee stock options                                                                                            |       | 85,900                              |       | — |   |
| Shelf offering costs                                                                                                          |       | —                              |       | (111,233 | ) |
| Net cash used in financing activities                                                                                         |       | (1,803,713                          | )          | (4,515,043 | ) |
|                                                                                                                          |       |                                |       |   |   |
| **NET INCREASE (DECREASE) IN CASH AND CASH  EQUIVALENTS (1)**                                                                 |       | 14,889,476                          |       | (42,571,296 | ) |
| **CASH AND CASH EQUIVALENTS, BEGINNING OF PERIOD**                                                                            |       | 503,776                             |       | 65,954,840 |   |
| **CASH AND CASH EQUIVALENTS, END OF PERIOD**                                                                                  |       | $                                   | 15,393,252 |   | $ | 23,383,544 |   |
|                                                                                                                          |       |                                |       |   |   |
| **CASH PAID DURING PERIOD FOR INTEREST**                                                                                      |       | $                                   | 646,934    |   | $ | 139,763 |   |
| **CASH PAID DURING PERIOD FOR INCOME TAXES**                                                                                  |       | $                                   | —     |   | $ | 138,678 |   |

 

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

 

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

 

11

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**GLADSTONECAPITAL CORPORATION**

**FINANCIALHIGHLIGHTS**

**(UNAUDITED)**

 
| ** **                                                       | ** ** | **Three Months  Ended  December 31,  2005** | ** **  | **Three Months  Ended  December 31,  2004** | ** ** |
|------------------------------------------------------------------|------------|---------------------------------------------|-------------|---------------------------------------------|------------|
|                                                             |       |                                        |        |                                        |       |
| Per Share Data (1)                                               |       |                                        |        |                                        |       |
| Net asset value at beginning of period                           |       | $                                           | 13.41       |                                        | $          | 13.50 |   |
| *Income from investment operations:*                             |       |                                        |        |                                        |       |
| Net investment income (2)                                        |       | 0.39                                        |        | 0.41                                        |       |
| Realized (loss)/gain on sale of investments (2)                  |       | (0.10                                       | )           | —                                      |       |
| Net unrealized gain on investments (2)                           |       | 0.44                                        |        | 0.03                                        |       |
| Net unrealized (loss) on derivatives (2)                         |       | —                                      |        | —                                      |       |
| Total from investment operations                                 |       | 0.73                                        |        | 0.44                                        |       |
| Less distributions:                                              |       |                                        |        |                                        |       |
| Distributions from net investment income                         |       | (0.41                                       | )           | (0.36                                       | )          |
| Total distributions                                              |       | (0.41                                       | )           | (0.36                                       | )          |
| Issuance of common stock under stock option plan                 |       | 0.01                                        |        | —                                      |       |
| Offering costs                                                   |       | —                                      |        | (0.01                                       | )          |
| Repayment of principal on notes receivable                       |       | —                                      |        | 0.01                                        |       |
| Net asset value at end of period                                 |       | $                                           | 13.74       |                                        | $          | 13.58 |   |
|                                                             |       |                                        |        |                                        |       |
| Per share market value at beginning of period                    |       | $                                           | 22.55       |                                        | $          | 22.71 |   |
| Per share market value at end of period                          |       | 21.38                                       |        | 23.70                                       |       |
| Total Return (3)(4)                                              |       | -3.44                                       | %           | 5.94                                        | %          |
| Shares outstanding at end of period                              |       | 11,308,510                                  |        | 11,278,510                                  |       |
|                                                             |       |                                        |        |                                        |       |
| Ratios/Supplemental Data                                         |       |                                        |        |                                        |       |
| Net assets at end of period                                      |       | $                                           | 155,417,011 |                                        | $          | 153,150,107 |   |
| Average net assets                                               |       | $                                           | 150,961,590 |                                        | $          | 151,429,917 |   |
| Ratio of expenses to average net assets-annualized  (5)          |       | 5.66                                        | %           | 4.46                                        | %          |
| Ratio of net expenses to average net assets-annualized  (6)      |       | 4.21                                        | %           | 3.70                                        | %          |
| Ratio of net investment income to average net  assets-annualized |       | 11.77                                       | %           | 12.36                                       | %          |

 

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(1)     Basic per share data.

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

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

(4)     Amounts were not annualized.

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

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

 

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

 

12

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**GLADSTONECAPITAL CORPORATION**

 

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

 

**December 31,2005**

 

**(UNAUDITED)**

 

NOTE1.  ORGANIZATION

 

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

 

GladstoneCapital Advisers, Inc. is a wholly-owned subsidiary of the Company.  The financial statements of this subsidiary areconsolidated 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 accompanyingannual financial statements prepared in accordance with GAAP are omitted.  In the opinion of management, all adjustments,consisting solely of normal recurring accruals, necessary for the fairstatement of financial statements for the interim periods have beenincluded.  The current period’s resultsof operations are not necessarily indicative of results that ultimately may beachieved for the year.  The interimfinancial statements and notes thereto should be read in conjunction with thefinancial statements and notes thereto included in the Company’s Form 10-Kfor the fiscal year ended September 30, 2005, as filed with the Securitiesand Exchange Commission.

 

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, the Financial Accounting Standards Board (“FASB”)released FASB Staff Position No. FAS 123(R)-2 (“FSP FAS 123(R)-2”), “*Practical Accommodation to the Application of GrantDate as Defined in FASB Statement No. 123(R).”* FSP FAS 123(R)-2provides guidance on the application of grant date as defined in Statement ofFinancial Accounting Standards (“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 are expected to be communicated to an individual recipient within arelatively short time period for the date of approval. The Company applied FSPFAS 123(R)-2 in conjunction with the adoption of SFAS No. 123(R) on October 1,2005.

 

13

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NOTE4.  COMMON STOCK TRANSACTIONS

 

Asof December 31, 2004 and December 31, 2005, 50,000,000 shares of$0.001 par value common stock were authorized and 11,278,510 and 11,308,510,respectively, shares were outstanding.

 

Transactionsin common stock were as follows:

 
| ** **                                       | ** ** | **Common Stock** | ** ** |
|--------------------------------------------------|------------|------------------|------------|
| ** **                                       | ** ** | **Shares**       | ** ** | **Amount** | ** ** |
| Balance at September 30, 2004                    |       | 11,278,510       |       | $ | 11,279 |   |
|                                             |       | —           |       | — |   |
| Balance at December 31, 2004                     |       | 11,278,510       |       | $ | 11,279 |   |
|                                             |       |             |       |   |   |
| Balance at September 30, 2005                    |       | 11,303,510       |       | $ | 11,304 |   |
| Issuance of Common Stock Under Stock Option Plan |       | 5,000            |       | 5 |   |
| Balance at December 31, 2005                     |       | 11,308,510       |       | $ | 11,309 |   |

 

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 for Stock-Based Compensation*and supersedesAccounting Principles Board (“APB”) Opinion No. 25, *Accounting for Stock Issued to Employees* (“APB No. 25”)*.*SFAS No. 123(R) is effectivefor awards that are granted, modified, or settled in cash for annual periodsbeginning after June 15, 2005.  The Company adopted SFAS No. 123(R)on October 1, 2005 using the modified prospective approach. Under themodified prospective approach, stock-based compensation expense will be recordedfor the unvested portion of previously issued awards that remain outstanding atOctober 1, 2005 using the same estimate of the grant date fair value andthe same attribution method used to determine the pro forma disclosure underSFAS No. 123. SFAS No. 123(R) also requires that all share-basedpayments to employees after October 1, 2005, including employee stockoptions, be recognized in the financial statements as stock-based compensationexpense based on the fair value on the date of grant.  Accordingly, prior period amounts have notbeen restated.

 

In connection with the externalization of the Company’s management, allof its officers and employees became direct employees of Gladstone ManagementCorporation 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-basedawards in accordance with APB No. 25. For the three months ended December 31,2005, the Company recorded stock option compensation expense for the cost ofstock options issued under the Amended and Restated 2001 Equity Incentive Plan(the “2001 Plan”) of $43,257. The Company’s expensing of stock optionsdecreased both basic and diluted net increase to net assets resulting fromoperations per share by $0.004 for the three months ended December 31,2005.  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 of APB No. 25, the Company was not requiredto recognize compensation expense for the cost of stock options issued underthe Company’s 2001 Plan. The following table illustrates the effect on net increaseto net assets resulting from operations and net increase to net assetsresulting from operations per share for the three months ended December 31,2004 as if the Company had applied the fair value recognition provisions ofSFAS No. 123, as amended by SFAS No. 148, *Accounting for Stock-Based Compensation-Transition and Disclosure:*

 

14

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| ** **                                                                                                  | ** ** | **Three Months  Ended  December 31,  2004** | ** ** |
|-------------------------------------------------------------------------------------------------------------|------------|---------------------------------------------|------------|
|                                                                                                        |       |                                        |       |
| Net increase in net assets resulting from operations  as reported:                                          |       | $                                           | 4,944,948  |   |
|                                                                                                        |       |                                        |       |
| Deduct: Total stock-based compensation expense  determined using the fair value based method for all awards |       | (72,355                                     | )          |
|                                                                                                        |       |                                        |       |
| Pro forma net increase in net assets resulting from  operations per share                                   |       | $                                           | 4,872,593  |   |
|                                                                                                        |       |                                        |       |
| As reported - basic                                                                                         |       | $                                           | 0.44       |   |
| As reported - diluted                                                                                       |       | $                                           | 0.43       |   |
|                                                                                                        |       |                                        |       |
| Pro forma-basic                                                                                             |       | $                                           | 0.43       |   |
| Pro forma-diluted                                                                                           |       | $                                           | 0.42       |   |

 

The fair value ofeach option grant is estimated on the date of grant using the Black-Scholesoption pricing model, which incorporates a risk free interest rate, an expectedlife, an expected volatility factor, and an expected dividend yield.  The Company did not grant any options duringthe three months ended December 31, 2005.

 

The following is asummary of the status of the Company’s 2001 Plan from September 30, 2005through December 31, 2005:

 
| ** **                                                                           | ** ** | **Shares** | ** ** | **Weighted Average  Exercise Price** | ** ** |
|--------------------------------------------------------------------------------------|------------|------------|------------|--------------------------------------|------------|
|                                                                                 |       |       |       |                                 |       |
| Options outstanding at October 1, 2005                                               |       | 1,307,998  |       | $                                    | 17.81      |   |
| Granted                                                                              |       | —     |       | $                                    | —     |   |
| Expired                                                                              |       | —     |       | $                                    | —     |   |
| Exercised                                                                            |       | (5,000     | )          | $                                    | 17.18      |   |
| Forfeited                                                                            |       | (5,000     | )          | $                                    | 22.55      |   |
| Options outstanding at December 31, 2005, of which  1,297,998 shares are exercisable |       | 1,297,998  |       | $                                    | 17.80      |   |

 

The following is adetailed summary of the stock options outstanding at December 31, 2005:

 
| **Range  of  Exercise Prices** | ** ** | **Stock  Options  Outstanding** | ** ** | **Weighted  Average  Remaining  Contractual  Life (Years)** | ** ** | **Weighted  Average  Exercise  Price** | ** ** |
|--------------------------------|------------|---------------------------------|------------|-------------------------------------------------------------|------------|----------------------------------------|------------|
|                           |       |                            |       |                                                        |       |                                   |       |
| $15.00 - $21.94                |       | 968,998                         |       | 6.23                                                        |       | $                                      | 16.06      |   |
| $22.21 - $24.39                |       | 329,000                         |       | 8.39                                                        |       | $                                      | 22.90      |   |
| Total                          |       | 1,297,998                       |       | 6.78                                                        |       | $                                      | 17.80      |   |

 

15

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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 theapproval of the Amended Advisory Agreement, the Company will terminate the 2001Plan, and seek agreement from all holders of stock options to exercise orterminate their options within a limited period of time.  The stockholders voted to replace the 2001Plan with an incentive fee component of the advisory fee in place between theCompany and the Adviser.  The newincentive fee will take effect on the later of October 1, 2006, the firstday of fiscal year 2007 or the first day of the fiscal quarter following thetermination or exercise of the last outstanding stock options under the 2001Plan.  As of December 31, 2005, noformal plan has been enacted and therefore, there is no change in the remainingcontractual lives of the outstanding options.

 

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 months ended December 31,2005 and December 31, 2004:

 
| ** **                                                                                      | ** ** | **Three Months  Ended  December 31,  2005** | ** ** | **Three Months  Ended  December 31,  2004** | ** ** |
|-------------------------------------------------------------------------------------------------|------------|---------------------------------------------|------------|---------------------------------------------|------------|
|                                                                                            |       |                                        |       |                                        |       |
| Numerator for basic and diluted net increase in  net assets resulting from operations per share |       | $                                           | 8,233,349  |                                        | $          | 4,944,948 |   |
|                                                                                            |       |                                        |       |                                        |       |
| Denominator for basic weighted average shares                                                   |       | 11,306,510                                  |       | 11,278,510                                  |       |
| Dilutive effect of stock options                                                                |       | 267,110                                     |       | 337,286                                     |       |
| Denominator for diluted weighted average shares                                                 |       | 11,573,620                                  |       | 11,615,796                                  |       |
|                                                                                            |       |                                        |       |                                        |       |
| Basic net increase in net assets resulting from  operations per share                           |       | $                                           | 0.73       |                                        | $          | 0.44 |   |
|                                                                                            |       |                                        |       |                                        |       |
| Diluted net increase in net assets resulting from  operations per share                         |       | $                                           | 0.71       |                                        | $          | 0.43 |   |

 

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 fee 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.  The Company currently pays a monthlydividend.  The tax characteristics of alldividends will be reported to stockholders on Form 1099 at the end of eachcalendar year.  The following table liststhe per share dividends paid for the three months ended December 31, 2005and December 31, 2004:

 
| **Fiscal  Year** | ** ** | **Record Date**    | ** ** | **Payment Date**   | ** ** | **Dividend per Share** | ** ** |
|------------------|------------|--------------------|------------|--------------------|------------|------------------------|------------|
| 2006             |       | Dec. 21, 2005 |       | Dec. 30, 2005 |       | $                      | 0.135      |   |
|             |       | Nov. 21, 2005 |       | Nov. 30, 2005 |       | $                      | 0.135      |   |
|             |       | Oct. 21, 2005 |       | Oct. 31, 2005 |       | $                      | 0.135      |   |
|             |       |               |       |               |       |                   |       |
| 2005             |       | Dec. 17, 2004 |       | Dec. 30, 2004 |       | $                      | 0.12       |   |
|             |       | Nov. 17, 2004 |       | Nov. 30, 2004 |       | $                      | 0.12       |   |
|             |       | Oct. 18, 2004 |       | Oct. 29, 2004 |       | $                      | 0.12       |   |

 

16

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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 amortized originalissue discount plus payment in kind (“PIK”) interest, if any, unless adversefactors lead to a determination of a lesser valuation.  In valuing convertible debt, equity, successor exit fees or other equity like securities, the Board of Directors determinesthe fair value based on the collateral, the issuer’s ability to make payments,the earnings of the issuer, sales to third parties of similar securities, thecomparison to publicly traded securities, discounted cash flow and otherpertinent factors.  Due to the uncertaintyinherent in the valuation process, such estimates of fair value may differsignificantly from the values that would have resulted had a ready market forthe securities existed, and the differences could be material. Additionally,changes in the market environment and other events that may occur over the lifeof the investments may cause the gains ultimately realized on these investmentsto be different than the valuation currently assigned.  Because there is a lag between when theCompany closes a loan and when the loan can be evaluated by S&P, new loansare not valued immediately by S&P; rather, the Board of Directors makes itsown determination about the value of the loan in accordance with the Company’svaluation policy without the input of S&P. Because S&P does not perform independent valuations of mortgageloans or equity securities, the Board of Directors also determines the fairvalue of these investments without the input of S&P.  The Board of Directors considers a number ofqualitative and quantitative factors in current market conditions whenperforming valuations.

 

NOTE9. PAYMENT IN KIND INTEREST

 

TheCompany seeks to avoid payment in kind (“PIK”) interest, however the Company hasone loan in its portfolio that contains a PIK provision. A PIK provisionrequires the borrower to accrue a payment to the Company but the borrower doesnot have to pay that interest until the loan is paid in full. The PIK interestis added to the principal balance of the loan and recorded as income to theCompany even though the cash has not been received.  To maintain the Company’s status as a RIC (asdiscussed in Note 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. For the three months ended December 31, 2005, theCompany recorded PIK interest income of $32,510 and for the three months ended December 31,2004, the Company recorded PIK interest income of $140,963.  At December 31, 2005 and September 30,2005, the Company had accrued on its balance sheets, a total in PIK income of $1,027,884and $1,273,251 respectively.  The Companydoes not hold any investments issued at original issue discount andaccordingly, has not realized any original issue discount income for the three monthsended December 31, 2005 or December 31, 2004.

 

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

 

The Company had no outstanding repurchase agreement at December 31,2005 or at September 30, 2005.  On October 1,2004, the Company repaid an outstanding repurchase obligation from September 30,2004 and this repayment is reflected in the Consolidated Statement of CashFlows for the three months ended December 31, 2004.

 

17

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NOTE11. CONTRACTUAL OBLIGATIONS

 

Asof December 31, 2005, the Company was a party to a signed and non-binding termsheet for one potential investment 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                 |       | 22,500,000 |       | 22,500,000                |       |   |   |   |   |   |   |
| Total                       |       | $          | 22,500,000 |                      | $          | 22,500,000 |   | $ | — |   | $ | — |   | $ | — |   |
|                             |            |            |            |                           |            |  |  |  |  |  |  |  |  |  |  |  |

 

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 creditagreement with Branch Banking and Trust Company (“BB&T Agreement”), whichoriginally matured in June 2005 and has been extended through December 31,2006.  Interest on outstanding borrowingsis based upon the one month London Interbank Offered Rate (“LIBOR”) plus 2.5% perannum.  The unused portion of the line ofcredit is subject to a fee of 0.2% per annum. The BB&T Agreement requires the Company to meet and maintain certaincovenants and ratios with respect to leverage and liquidity. As of December 31,2005, there were no borrowings outstanding under the BB&T line of creditand $15.0 million of available borrowings. At December 31, 2005 the Company was in compliance with allcovenants under the BB&T Agreement.

 

Through its wholly-owned subsidiary Gladstone Business Loan LLC (“BusinessLoan”), the Company has a $100 million revolving credit facility (the “DBFacility”) with Deutsche Bank AG, as administrative agent, pursuant to whichBusiness Loan has pledged the loans it holds to secure future advances bycertain institutional lenders. The interest rate charged on the advances underthe DB Facility is based on LIBOR, the Prime Rate or the Federal Funds Rate,depending on market conditions, and adjusts periodically. In May 2005, theCompany renewed the DB Facility through May 26, 2006.  As of December 31, 2005, the outstandingprincipal balance under the DB Facility was approximately $55.7 million at aninterest rate of 4.3%.  Availableborrowings are subject to various constraints imposed by Deutsche Bank AG, basedon the aggregate loan balance pledged by Business Loan, which varies as loansare added and repaid, regardless of whether such repayments are earlyprepayment or are made as contractually required.  At December 31, 2005, the remaining borrowingcapacity available under the DB Facility was approximately $16.8 million.

 

The DB Facility contains covenants that require Business Loan tomaintain its status as a separate entity; prohibit certain significantcorporate transactions (such as mergers, consolidations, liquidations ordissolutions); and restrict material changes to the Company’s credit andcollection policies.  The DB Facilityalso restricts some of the terms and provisions (including interest rates,terms to maturity and payments schedules) and limits the borrower and industryconcentrations of loans that are eligible to secure advances.  As of December 31, 2005, Business Loanwas in compliance with all of the facility covenants.

 

The administrative agent also requires that any interest or principalpayments on pledged loans be remitted directly by the borrower into a lockboxaccount with the Bank of New York as custodian. Deutsche Bank AG is also the trustee of the account and once a monthremits the collected funds to the Company. At December 31, 2005, theamount due from custodian was $2,413,120 and at September 30, 2005, theamount due from custodian was $2,624,074.

 

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Effective July 12, 2004, Gladstone Management, the Company’saffiliated external adviser also services the loans pledged under the DB Facility.  As a condition to this servicing arrangement,the Company executed a performance guaranty pursuant to which it guaranteedthat Gladstone Management would comply fully with all of its obligations underthe DB Facility.  The performance guarantyrequires the Company to maintain a minimum net worth of $100 million and to maintain“asset coverage” with respect to “senior securities representing indebtedness”of at least 200%, in accordance with Section 18 of the 1940 Act.  As of December 31, 2005, the Company wasin compliance with all covenants under the performance guaranty.  Gladstone Management services these loans foran annual fee of 1.5% of the monthly aggregate outstanding loan balance of theloans pledged under the DB Facility.  Forthe three months ended December 31, 2005, the Company recorded loanservicing fees of $715,415, as compared to $530,952 for the three months ended December 31,2004.  At December 31, 2005, theCompany owed $210,109 of unpaid loan servicing fees to Gladstone Management,which are recorded in fees due to affiliate. At September 30, 2005, the Company owed $207,619 in loan servicingfees to Gladstone Management, recorded in fees due to affiliate.

 

Loan servicing fees received by Gladstone Management are credited tothe Company’s advisory fee payable to Gladstone Management under the advisory agreementbetween the Company and Gladstone Management. Accordingly, the advisory fee payable by the Company to GladstoneManagement for the three months ended December 31, 2005 and December 31,2004, was reduced 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 DB Facility, the Company has an interest rate capagreement that effectively limits the interest rate on a portion of theborrowings under the line of credit.

 

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

 

In February 2004, the Company entered into an interest rate capagreement with a notional amount of $35.0 million at a cost of $304,000.  The interest rate cap agreement’s currentnotional amount is $25.6 million and it has a current fair value of approximately$49,361 which is recorded in other assets on the Company’s consolidated balancesheet at December 31, 2005.  At September 30,2005, the interest rate cap agreement had a fair value of $50,253.  The Company records changes in the fair valueof the interest rate cap agreement monthly based on the current marketvaluation at month end as unrealized depreciation or appreciation on derivativeon the Company’s consolidated statement of operations. The interest rate capagreement expires in February 2009. The agreement provides that theCompany’s floating interest rate or cost of funds on a portion of the portfolio’sborrowings will be capped at 5% when the LIBOR rate is in excess of 5%.

 

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 banking services,arranging bank financing, arranging equity financing, structuring financingfrom multiple lenders and investors, reviewing existing credit facilities,restructuring existing loans, raising equity and debt capital, turnaroundmanagement, merger and acquisition services and recruiting new managementpersonnel.  Gladstone Management chargesa fee for these services and credits the funds received from portfoliocompanies for these other services to the Company as a credit against theinvestment advisory fee due from the Company under the investment advisoryagreement.  Such fees are normally paidin part at the time of signing a non-binding letter of intent, with theremainder paid upon completion of the services, and are generallynon-recurring.

 

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 December 31,2005 and December 31, 2004, Gladstone Management received $550,000 and $286,500,respectively for fees for services rendered to portfolio companies. None ofthese fees were for managerial assistance even though Gladstone Managementprovided managerial assistance to many of the Company’s portfolio companies.  Accordingly, the advisory fee payable by theCompany to Gladstone Management for the three months ended December 31,2005 and December 31, 2004 was reduced by $550,000 and $286,500,respectively, in respect of these fees received by Gladstone Management.

 

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NOTE15. ADVISORY AGREEMENT WITH GLADSTONE MANAGEMENT CORPORATION

 

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

 

GladstoneManagement services the loans held by Business Loan, in return for which,Gladstone Management receives a 1.5% annual fee based on the monthly aggregatebalance of loans held by Business Loan. Since the Company owns these loans, all loan servicing fees paid toGladstone Management are also credited directly against the 2% managementfee.  These credits reduce the amount ofthe investment advisory fee and are shown above the direct credits line item inthe table below.  For the three monthsended December 31, 2005 and December 31, 2004, these loan servicingfees totaled $715,415 and $530,952, respectively, all of which were creditedagainst the 2% management fee in order to derive the management fee which ispresented as the line item management fee in the consolidated statement ofoperations.  Under the advisoryagreement, Gladstone Management also provides the managerial assistance andother services to the Company’s portfolio companies.  To the extent that Gladstone Management receivesany fees directly from a portfolio company for such services, GladstoneManagement credits these fees directly against the 2% management fee and theseamounts are shown in the table below as a credit to the management fee.  For the three months ended December 31,2005 and December 31, 2004, Gladstone Management recorded $550,000 and $286,500,respectively, of such fees and credited this amount against the 2% managementfee received from the Company and reflected on the consolidated statement ofoperations as credit to management fees for fees collected by GladstoneManagement.  Overall, the management feedue to Gladstone Management cannot exceed 2% of total assets (as reduced bycash and cash equivalents pledged to creditors) during any given fiscal year.

 

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

 
| ** **                                                 | ** ** | **December 31, 2005** | ** **  | **December 31, 2004** | ** ** |
|------------------------------------------------------------|------------|-----------------------|-------------|-----------------------|------------|
| **Fee:**                                                   | ** ** | ** **            | ** **  | ** **            | ** ** |
| Total assets at                                            |       | $                     | 211,823,244 |                  | $          | 194,085,591 |   |
| Less: Borrowings under line of credit at                   |       | (15,000,000           | )(a)        | (22,435,000           | )(b)       |
| Total assets subject to fee as of                          |       | 196,823,244           |        | 171,650,591           |       |
| Quarterly fee rate                                         |       | 0.50                  | %           | 0.50                  | %          |
| Gross management fee before loan servicing fee  credit     |       | 984,116               |        | 858,254               |       |
| Less: loan servicing fee from Gladstone Business  Loan LLC |       | 715,415               |        | 530,952               |       |
| Management fee before credit:                              |       | 268,701               |        | 327,302               |       |
| **Direct Credit to Management Fee:**                       |       |                  |        |                  |       |
| Fee revenue recorded by Gladstone Management:              |       | 550,000               |        | 286,500               |       |
| Net management fee for the three months ended (c):         |       | $                     | (281,299    | )                     | $          | 40,802 |   |

 

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*(a) **This amount represents borrowings under one of the Company’s lines of creditthat were 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 January 2006.  Solely for the purposes of calculating theamount of the management fee due to Gladstone Management, the Company treatsany such amounts as “cash and cash equivalents pledged to creditors” under theterms of the Company’s advisory agreement with Gladstone Management.  As a result, such amounts are deducted from theCompany’s total assets for purposes of computing the asset base upon which themanagement fee is determined.*

 

*(b) **This amount represents borrowings under one of the Company’s lines ofcredit that were held in cash and cash equivalents as of December 31, 2004,for the purpose of satisfying the Company’s asset diversification requirementsunder the Code.  Solely for the purposesof calculating the amount of the management fee due to Gladstone Management,the Company 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.*

 

*(c)  If the amount presented is in parenthesesit denotes the amount is due back to the Company from the Adviser; if theamount is positive, it indicates that the Company owes the Adviser the amount.*

 

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On December 2, 2005, the Company’s stockholders approved aproposal to enter into an amended and restated investment advisory agreement(the “Amended Advisory Agreement”) with Gladstone Management (the “Adviser”)and an administration agreement (the “Administration Agreement”) between theCompany and Gladstone Administration, LLC (the “Administrator”), a wholly-ownedsubsidiary of the Adviser.

 

The Amended Advisory Agreement provides for an annual base managementfee equal to 2% of the Company’s assets and an income-based incentive fee whichwill reward the Adviser if the Company’s quarterly net investment income(before giving effect to the incentive fee) exceeds 1.75% of net assets.  The agreement also provides for a capitalgains-based incentive fee, whereby the Adviser will receive a fee equal to 20%of the Company’s realized capital gains (net of realized capital losses andunrealized capital depreciation).  Underthe Administration Agreement, the Company will pay separately for its allocableportion of the Administrator’s overhead expenses in performing its obligations,including rent, and the Company’s allocable portion of the salaries andbenefits expenses of its chief financial officer, chief compliance officer andcontroller and their respective staffs.

 

In connection with the approval of the Amended Advisory Agreement, theCompany will terminate the 2001 Plan, and seek agreement from all holders ofstock options to exercise or terminate their options within a limited period oftime.  The Amended Advisory Agreement andthe Administration Agreement will become effective upon the later of (i) October 1,2006, or (ii) the first day of the first fiscal quarter following the datethat all existing stock options are exercised. The Amended Advisory Agreementand Administration Agreement will not become effective as long as the 2001 Planis in effect or as long as there are any outstanding stock options.  The current investment advisory agreementwith Gladstone Management will continue in effect until these new agreementsbecome effective.

 

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 three months ended December 31, 2005, Gladstone CapitalCorporation recorded approximately $50,000 in connection with penaltiesincurred on misclassified revenue on its fiscal 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 in aggregatefederal and state income taxes of $138,678 during the three months ended December 31,2004.

 

NOTE17. SUBSEQUENT EVENTS

 

In January 2006, the Companyextended a $15.0 million loan to Westlake Hardware, Inc., a regionalhardware store chain, a $6.5 million loan to Thibaut, Inc., a designer andmarketer of higher quality wallpaper, and a $6.0 million loan to RCS Management, Inc.,a supplier of respiratory therapy equipment.  The Company also purchased a $2.5 millionsyndicated loan participation in Network Solutions LLC.  These investments were funded using proceedsfrom borrowings under the DB Facility.

 

In January 2006, the Company’sBoard of Directors declared the following monthly dividends:

 
| **Fiscal  Year** | ** ** | **Record Date**     | ** ** | **Payment Date**    | ** ** | **Dividend per Share** | ** ** |
|------------------|------------|---------------------|------------|---------------------|------------|------------------------|------------|
| 2006             |       | March 23, 2006 |       | March 31, 2006 |       | $                      | 0.135      |   |
|             |       | Feb. 20, 2006  |       | Feb. 28, 2006  |       | $                      | 0.135      |   |
|             |       | Jan. 19, 2006  |       | Jan. 31, 2006  |       | $                      | 0.135      |   |

 

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**ITEM 2. MANAGEMENT’SDISCUSSION AND ANALYSIS OF FINANCIAL CONDITION 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, asamended, and Section 21E of the Securities Exchange Act of 1934, asamended. These statements may relate to, among other things, future events orour future performance 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 maintainour credit facilities on terms reasonably acceptable to us, if at all in futureequity capital resources; (5) our inability to successfully securitize ourloan portfolio on terms reasonably acceptable to us, if at all; (6) thedecision of our competitors to aggressively seek to make senior andsubordinated loans to small and medium-sized businesses on terms more favorablethan we intend to provide; and (7) those factors listed under the caption “RiskFactors” of the Annual Report on Form 10-K as filed with the Securitiesand Exchange Commission on December 13, 2005. We caution readers not toplace undue reliance on any such forward-looking statements, which are madepursuant to the Private Securities Litigation Reform Act of 1995 and, as such,speak only as of the date made. We undertake no obligation to publicly updateor revise any forward-looking statements, whether as a result of newinformation, future events or otherwise, after the date of this Form 10-Q**.

 

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

 

We seek out small and medium-sized businesses that meet certaincriteria, including (1) the potential for growth in cash flow, (2) adequateassets for loan collateral, (3) experienced management teams with asignificant ownership interest in the borrower, (4) profitable operationsbased on the borrower’s cash flow, (5) reasonable capitalization of theborrower (usually by buyout funds or venture capital funds) and (6) thepotential to realize appreciation and gain liquidity in our equity position, ifany. We anticipate that liquidity in our equity position will be achievedthrough a merger or acquisition of the borrower, a public offering by theborrower or by exercise of our right to require the borrower to buy back itswarrants. We lend to borrowers that need funds to finance growth, restructuretheir balance sheets or effect a change of control.

 

Our loans typically range from $5 million to $15 million, mature in nomore than seven years and accrue interest at a fixed or variable rate thatexceeds the prime rate. A number of our loans have a provision that calls for someportion of the interest payments to be deferred and added to the principalbalance so that the interest is paid, together with the principal, at maturity.This form of deferred interest is often called “payment in kind” or “PIK”interest, and, when earned, we record PIK interest as interest income and addthe PIK interest to the principal balance of the loans. We seek to avoid PIKinterest with all potential investments under review. The amount of cost basis PIKinterest accrued on our balance sheet as of December 31, 2005 wasapproximately $1,028,000.

 

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

 

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

 

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

 

In addition, as a business development company under the 1940 Act, weare required to make available significant managerial assistance to ourportfolio companies. Effective October 1, 2004, our investment adviser,Gladstone Management Corporation (“Gladstone Management” or the “Adviser”)began to provide these services on our behalf through its officers who are alsoour officers.  In addition, GladstoneManagement provides other services to our portfolio companies, for which itreceives fees, in connection with our investments.  The fees for these services are generally paidto Gladstone Management in part at the time a prospective portfolio companysigns a non-binding term sheet with us (as further described in the followingparagraph), with the remainder paid at the closing of the investment. Thesefees are generally non-recurring, however in some instances they may have a recurringcomponent which is also paid to Gladstone Management.  Any such fees received, with the exception ofthe recurring fees, by Gladstone Management are credited against the managementadvisory fee payable to Gladstone Management pursuant to the terms of ouradvisory agreement, which has the effect of reducing our expenses to the extentof any such fees received by Gladstone Management.  The specific services Gladstone Managementprovides vary by portfolio company, but generally include a wide variety ofservices to the portfolio companies such as investment banking services,arranging bank financing, arranging equity financing structuring financing frommultiple lenders and investors, reviewing existing credit facilities,restructuring existing loans, raising equity and debt capital, turnaroundmanagement, merger and acquisition services and recruiting new managementpersonnel.

 

Prior to making an investment, we ordinarily enter into a non-bindingterm sheet with the potential borrower. These non-binding term sheets aregenerally subject to a number of conditions, including but not limited to thesatisfactory completion of our due diligence investigations of the potentialborrower’s business and reaching agreement on the legal documentation for theloan. Upon execution of the non-binding term sheet, the potential borrower generallypays Gladstone Management a non-refundable fee for its services renderedthrough the date of the non-binding term sheet. Prior to the externalization ofour management on October 1, 2004, we recognized this as fee revenue uponexecution of the non-binding term sheet. Effective October 1, 2004, 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 we expend significant effort in considering andnegotiating a potential investment that ultimately is not consummated, wegenerally will seek reimbursement from the proposed borrower for our reasonableexpenses incurred in connection with the proposed transaction.  Any amounts collected for expenses incurredby Gladstone Management in connection with unconsummated investments will bereimbursed to Gladstone Management. Amounts collected for these expensesincurred by us will be reimbursed to us and will be recognized as “other income”in the period in which such reimbursement is received.  Also, in the event that we have incurredsignificant legal fees in connection with the transaction, we will typicallyseek reimbursement for these expenses from the proposed borrower.  However, there can be no guarantee that wewill be successful in collecting any such reimbursements.

 

The only significant continuing revenue associated with the investmentswe have already closed is interest income and, potentially, capital gains realizedin connection with the liquidation of any associated equity interest (e.g., warrants).

 

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During the three months ended December 31, 2005, we extended,directly or through participations, approximately $26.7 million of new loans toa total of four companies.  Also, duringthe three months ended December 31, 2005, one borrower repaid its loans aheadof contractual maturity at par value and we sold three loan investments at aloss of approximately $1.2 million, for an aggregate return of capital ofapproximately $23.3 million and we received scheduled contractual principalrepayments of approximately $15.4 million, for total principal repayments ofapproximately $38.7 million.  Since ourinitial public offering in August 2001, we have made 81****different loans to, or investments in, 51****companies for a total of approximately $389.6****million, before giving effect to principalrepayments on investments and divestitures.

 

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

 

**External Adviser**

 

Effective October 1, 2004, pursuant to our advisory agreement withGladstone Management, we pay Gladstone Management an annual advisory fee of1.25% of our 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 our total assets (as reduced by cash and cashequivalents pledged to creditors), payable in quarterly computed increments of0.1875%. This fee is then directly reduced by the amount of loan servicing feespaid to Gladstone Management and any other fees received by GladstoneManagement from our borrowers and potential borrowers.  We continue to pay direct expenses including,but not limited to, directors’ fees, legal and accounting fees, stockholderrelated expenses, and directors and officers insurance.

 

Gladstone Management services our loan portfolio pursuant to a loanservicing agreement with Gladstone Business Loan LLC (“Business Loan”) inreturn for a 1.5% annual fee, based on the monthly aggregate outstanding loanbalance of the loans pledged under the facility.  For the three months ended December 31,2005 and December 31, 2004, we incurred approximately $715,415 and$530,952, respectively, in loan servicing fees.

 

For the three months ended December 31, 2005, the gross managementfee, before reductions for loan servicing fees and other fees was approximately$984,000.  After being reduced by loanservicing fees of approximately $715,000 and other fees received by GladstoneManagement of $550,000, our net management fee for the three months ended December 31,2005 was a credit of approximately $281,000. For the three months ended December 31, 2004, the gross managementfee, before reductions for loan servicing fees and other fees was approximately$858,000.  After being reduced by loanservicing fees of approximately $531,000 and other fees received by GladstoneManagement of $286,500, our net management fee for the three months ended December 31,2004 was $40,802.

 

On December 2, 2005, our stockholders approved a proposal to enterinto an amended and restated investment advisory agreement (the “AmendedAdvisory Agreement”) with Gladstone Management and an administration agreement(the “Administration Agreement”) between the Company and GladstoneAdministration, LLC (the “Administrator”), a wholly-owned subsidiary of theAdviser.

 

The Amended Advisory Agreement provides for an annual base managementfee equal to 2% of our assets and an income-based incentive fee which willreward the Adviser if our quarterly net investment income (before giving effectto the incentive fee) exceeds 1.75% of our net assets.  The agreement also provides for a capitalgains-based incentive fee, whereby the Adviser will receive a fee equal to 20%of our realized capital gains (net of realized capital losses and unrealizedcapital depreciation).  Under the AdministrationAgreement, we will pay separately for our allocable portion of theAdministrator’s overhead expenses in performing our obligations, includingrent, and our allocable portion of the salaries and benefits expenses of ourchief financial officer, chief compliance officer and controller and theirrespective staffs.

 

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In connection with the approval of the Amended Advisory Agreement, wewill terminate our Amended and Restated 2001 Equity Incentive Plan (the “Plan”),and seek agreement from all holders of stock options to exercise or terminatetheir options within a limited period of time. The Amended Advisory Agreement and the Administration Agreement willbecome effective upon the later of (i) October 1, 2006, or (ii) thefirst day of the first fiscal quarter following the date that all existingstock options are exercised or terminated. The Amended Advisory Agreement andAdministration Agreement will not become effective as long as the Plan is in effector as long as there are any outstanding stock options.  The current investment advisory agreementwith Gladstone Management will continue in effect until these new agreementsbecome effective.

 

**Off-Balance Sheet Arrangements**

 

We do not have any significant off-balance sheet arrangements asdefined in Item 303(a)(4)(ii) of SEC Regulation S-K as of December 31,2005.

 

**Recent Accounting Pronouncements**

 

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

 

In October 2005, the Financial Accounting Standards Board (“FASB”)released FASB Staff Position No. FAS 123(R)-2 (“FSP FAS 123(R)-2”), “*Practical Accommodation to the Application of GrantDate as Defined in FASB Statement No. 123(R).”* FSP FAS 123(R)-2provides guidance on the application 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 are expected to be communicated to an individual recipient within arelatively short time period for the date of approval. We applied FSP FAS123(R)-2 in conjunction with our adoption of SFAS No. 123(R) on October 1,2005.

 

**Critical Accounting Policies**

 

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

 

**Investment Valuation**

 

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

 

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

 

Debt and equity securities that are not publicly traded, for which alimited market does not exist, or for which a limited market exists but thathave not been rated by a NRSRO (or for which we have various degrees of tradingrestrictions) are valued at fair value as determined in good faith by our Boardof Directors.  In making the good faithdetermination of the value of these securities, we start with the cost basis ofthe security, which includes the amortized original issue discount, and PIKinterest, if any.  We then apply themethods set out below in “Valuation Methods.” Members of our portfolio management team prepare the valuations of ourinvestments in portfolio companies using the most recent portfolio companyfinancial statements and forecasts. These individuals also consult with portfolio company senior managementand ownership to obtain further updates on the portfolio company’s performance,including information such as industry trends, new product development, andother operational issues.  Due to theuncertainty inherent

 

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in the valuation process, such estimates of fair value may differsignificantly from the values that would have been obtained had a ready marketfor the securities existed, and the differences could be material.  Additionally, changes in the marketenvironment and other events that may occur over the life of the investmentsmay cause the gains or losses ultimately realized on these investments to be differentthan the valuations currently assigned. There is no single standard for determining fair value in good faith, asfair value depends upon circumstances of each individual case.  In general, fair value is the amount that wemight reasonably expect to receive upon the current sale of the security.

 

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

 

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

 

With our assessment and S&P value estimates as a backdrop, ourBoard of Directors votes to accept or not accept the analyses and valuesrecommended by management and S&P. At December 31, 2005 and September 30, 2005, the Board ofDirectors elected to accept the valuations recommended by S&P on the loansin our portfolio as denoted on the Schedule of Investments as of December 31,2005 and September 30, 2005 in our consolidated financial statements.Subsequent to September 30, 2005, the fair value of our investment in ARIHoldings, Inc. was reduced from the value proposed by S&P because theinvestment was sold in November 2005 at a value less than that indicatedby S&P on September 30, 2005. Our Board of Directors determined to reduce the value proposed byS&P to the value of the sale price and as such the sale price of theinvestment is reflected in the fair value on our Schedule of Investmentsas of September 30, 2005 in our consolidated financial statements.

 

Because there is a delay between when we close a loan and when the loancan be evaluated by S&P, new loans are not valued immediately by S&P;rather, the Board of Directors makes its own determination about the value ofthese loans in accordance with our valuation policy.  These new loans are usually valued at par.  Because S&P does not provide values formortgage loans or equity securities, our Board of Directors also determines thefair value of these investments using our valuation policy without the input ofS&P.  At December 31, 2005,there were no mortgage loans in our portfolio.

 

*Credit Information:*****We monitor a wide variety of key creditstatistics that provide information regarding our portfolio companies to helpus assess credit quality and portfolio performance.  We require our portfolio companies to provideannual audited and either monthly or quarterly unaudited financialstatements.  Using these statements, wecalculate and evaluate the credit statistics. For purposes of analyzing the financial performance of our portfoliocompanies, we may make certain adjustments to their cash flow statements toreflect the pro forma results of a company consistent with a change of controltransaction, to reflect anticipated cost savings resulting from a merger orrestructuring, costs related to new product development, compensation toprevious owners, and other 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 valuation recommendations.

 

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

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

 

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*(a) the defaultrates set here are for a ten year term debt, if the company’s debt security isless than ten years then the probability of default is adjusted to a lowerpercentage for the shorter period which may move the security higher on ourrisk rating scale.*

 

The above scale gives an indication of the probability of default andthe magnitude of the loss if there is a default. The following table lists therisk ratings for all of the debt securities outstanding at December 31,2005 and September 30, 2005:

 
| **Rating**       | ** ** | **Dec. 31,  2005** | ** ** | **Sept.  30,  2005** | ** ** |
|------------------|------------|-------------------------|------------|----------------------|------------|
| Average          | ** ** | **7.1**                 | ** ** | **7.0**              | ** ** |
| Weighted Average | ** ** | **7.2**                 | ** ** | **7.1**              | ** ** |
| Highest          | ** ** | **9.0**                 | ** ** | **9.0**              | ** ** |
| Lowest           | ** ** | **5.0**                 | ** ** | **5.0**              | ** ** |

 

Our policy is to stop accruing interest on an investment if wedetermine that interest is no longer collectible.  Currently, none of our investments are onnon-accrual.  At December 31, 2005,no payments were past due on any of our debt securities.  At September 30, 2005, ARI Holdings, Inc.was past due on its payments and was placed on non-accrual.  This investment was sold in November 2005at an approximate loss of $1.1 million. We do 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 December 31, 2005, none ofthe debt securities in our portfolio were publicly traded and there was alimited market for 11 debt securities in our portfolio.  At September 30, 2005, none of the debtsecurities in our portfolio were publicly traded and there was a limited marketfor 12 debt securities in our portfolio.

 

For debt securities that either are not publicly traded, for whichthere is no market, or for which there is a market but have not been rated by aNRSRO, we begin with the risk rating designation of the security describedabove.  Using the risk rating designationabove, we seek to determine the value of the security as if we intended to sellthe security in a current sale.  Todetermine the current sale price of the security, we consider some or all ofthe following factors:

 

•                       financialstanding of the issuer of the security;

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

•                       the cost ofthe security;

 

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

•                       contractualrestrictions on the disposition of the security;

•                       pendingpublic offering 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 ofthe issuer to obtain needed financing;

•                       changes inthe economy affecting the issuer;

•                       recentpurchases or sale of a security of the issuer;

•                       pricing byother buyers or sellers of similar securities;

•                       financialstatements of the borrower;

•                       reportsfrom portfolio company senior management and ownership;

•                       the type ofsecurity;

•                       cost atdate of purchase;

•                       size ofholding;

•                       discountfrom market value of unrestricted securities of the same class at the time ofpurchase;

•                       specialreports prepared by analysts;

•                       informationas to any transactions or offers with respect to the security;

•                       existenceof merger proposals or tender offers affecting the securities;

•                       thecollateral;

•                       the issuer’sability to make payments;

•                       the currentand forecasted earnings of the issuer;

•                       sales tothird parties of similar securities;

•                       statisticalratios compared to lending standards;

•                       statisticalratios compared to other similar securities; and

•                       otherpertinent factors.

 

For those debt securities for which S&P prepares valuationrecommendations, we provide the foregoing information to S&P for its use inpreparing its recommendations.

 

For convertible debt, equity, success fees or other equity-likesecurities, we first determine if there is any market for the security.  If there is a market, then we determine thevalue based on the market prices for the security, even if that market is notrobust.  At December 31, 2005 and September 30,2005 there was 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 valuationtechniques consist of: discounted cash flow of the expected sale price in thefuture, valuation of the securities based on recent sales in comparabletransactions, and a review of similar companies that are publicly traded andthe market multiple of their equity securities. At December 31, 2005 and September 30, 2005 we had $37,000invested, at cost, in equity securities compared to our debt portfolio with acost basis of $192,144,728 and $205,338,554, respectively.

 

At December 31, 2005, we had total unrealized appreciation of$1,677,649, which was mainly composed of unrealized appreciation of $657,057 onour warrants of Finn Corporation, $330,963 of unrealized appreciation on oursenior term debt investment in Woven Electronics Corporation, and $229,225 ofunrealized appreciation on our senior term debt investment in BadancoAcquisition Corporation.  This unrealizedappreciation was offset by unrealized depreciation of $1,234,018, most notablycomposed of unrealized depreciation of $519,873 on our senior subordinated termdebt investment in Xspedius Communications, unrealized depreciation of $362,916on our senior term debt investments in Mistras Holdings Corporation, andunrealized depreciation of $151,260 on our senior subordinated term debtinvestment in Consolidated Bedding, Inc. In the aggregate, we recorded net unrealized appreciation of $443,631 onour total investment portfolio.

 

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At September 30, 2005, we had total unrealized depreciation of$6,231,296, which was mainly composed of unrealized depreciation in our seniorsubordinated term debt investment in Finn Corporation (excluding the warrants)of $3,150,000 (which investment repaid in full in December 2005), oursenior subordinated term debt investment in Xspedius Communications of$1,493,182, and our senior term debt in ARI Holdings, Inc. of $1,053,939(which was subsequently sold at the September 30, 2005 reflected fairvalue), partially offset by unrealized appreciation, most notably on, the valueof our warrants of Finn Corporation, which had an unrealized appreciation of$645,114 and our senior term debt investment in Woven Electronics Corporation,which had unrealized appreciation of $431,436. This aforementioned unrealized appreciation plus unrealized appreciationof $625,955 on certain other investments, primarily in our originated loaninvestments and certain syndicate participations, most notably Infor GlobalSolutions, which had unrealized appreciation of $248,750, resulted in overallnet unrealized depreciation of $4,528,791.

 

**Tax Status**

 

*Federal Income Taxes*

 

We intend to continue to qualify for treatment as a RIC under SubtitleA, Chapter 1 of Subchapter M of the Code. As a RIC, we are not subject tofederal income tax on the portion of our taxable income and gains distributedto stockholders. To qualify as a RIC, we are required to distribute tostockholders at least 90% of investment company taxable income, as defined bythe Code.  We have a policy to pay out asa dividend up to 100% of that amount.

 

**Revenue Recognition**

 

*Interest Income Recognition*

 

Interest income is recorded on the accrual basis to the extent thatsuch amounts are expected to be collected. We will stop accruing interest oninvestments and write off any previously accrued and uncollected interest whenit is determined that interest is no longer collectible. Conditional interestor a success fee is recorded when earned upon full repayment of a loaninvestment.

 

*Payment in Kind Interest*

 

We also have 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 December 31, 2005 to the three months ended December 31,2004*

 

**Investment Income**

 

Investment income for the three months ended December 31, 2005 wasapproximately $6.0 million as compared to approximately $6.1 million for thethree months ended December 31, 2004.  Although, overall interest income from ourinvestment portfolio increased, the decrease in total investment income was dueprimarily to a decline in prepayment fees as compared to the three months endedDecember 31, 2004.

 

Interest income from our investments in debt securities of privatecompanies was approximately $5.8 million, including approximately $33,000 ofPIK interest, for the three months ended December 31, 2005 as compared toapproximately $5.7 million for the three months ended December 31, 2004,which included approximately $141,000 of PIK interest. This increase****wasprimarily a result of a net increase in investments of approximately $22.8million over December 31, 2004. This increase consisted of $123.5 million of new investments, offset byprincipal repayments and investment sales of approximately $100.7 million.

 

The annualized weighted average yield on our portfolio for the threemonths ended December 31, 2005 was 12.6% (without giving effect to PIKinterest) and 12.6% (after giving effect to PIK interest). The annualized weightedaverage yield on our portfolio for the three months ended December 31,2004 was 14.7% (without giving effect to PIK interest) and 15.0% (after givingeffect to PIK interest). The decline is due to the early repayments ofprincipal balances on certain loans, which had higher interest rates.

 

Interest income from invested cash and cash equivalents for the threemonths ended December 31, 2005 was approximately $9,000, as compared to approximately$16,000 for the three months ended December 31, 2004. This decrease****was primarily a result of a decrease ininvested cash and cash equivalents.

 

For the three months ended December 31, 2005 and December 31,2004, we recorded approximately $107,000 and $115,000, respectively, ininterest income from loans to our employees in connection with the exercise ofemployee stock options.

 

For the three months ended December 31, 2005, we recorded approximately$67,000 of prepayment fees and other income as compared to $240,000 of otherincome for the three months ended December 31, 2004.  The income for both periods consisted ofprepayment penalty fees received upon the full repayment of certain loaninvestments ahead of contractual maturity and prepayment fees received upon theearly unscheduled principal repayments ahead of scheduled payment dates which, inboth instances, were based on a percentage of the outstanding principal amountof the loan at the date of prepayment.

 

**Operating Expenses**

 

Operating expenses for the three months ended December 31, 2005were approximately $1.5 million, as compared to approximately $1.3 million forthe three months ended December 31, 2004. Operating expenses for the threemonths ended December 31, 2005 reflected a significant increase in interestexpense, loan servicing fees, stockholder related costs and stock optioncompensation expense.

 

Loan servicing fees of approximately $715,000 were incurred for thethree months ended December 31, 2005 as compared to approximately $531,000for the three months ended December 31, 2004.  These fees were incurred in connection with aloan servicing agreement between Gladstone Business Loan LLC (“Business Loan”)and Gladstone Management, which is based on the size of the portfolio.  These fees were directly credited against theamount 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 annual administrativefee of 0.75% of total assets (as reduced by cash and cash equivalents pledgedto creditors), payable in quarterly computed increments of 0.1875%, for a totalfee of 2% of total assets (as reduced by cash and cash equivalents pledged tocreditors). 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

 

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

 

Thefollowing table sets forth the computation of the management fee for the threemonths ended December 31, 2005 and December 31, 2004, based on thequarterly increment of 0.50% (0.3125% quarterly advisory fee plus 0.1875%quarterly administrative fee):

 
| ** **                                                 | ** ** | **December 31, 2005** | ** **  | **December 31, 2004** | ** ** |
|------------------------------------------------------------|------------|-----------------------|-------------|-----------------------|------------|
| **Fee:**                                                   | ** ** | ** **            | ** **  | ** **            | ** ** |
| Total assets at                                            |       | $                     | 211,823,244 |                  | $          | 194,085,591 |   |
| Less: Borrowings under line of credit at                   |       | (15,000,000           | )(a)        | (22,435,000           | )(b)       |
| Total assets subject to fee as of                          |       | 196,823,244           |        | 171,650,591           |       |
| Quarterly fee rate                                         |       | 0.50                  | %           | 0.50                  | %          |
| Gross management fee before loan servicing fee  credit     |       | 984,116               |        | 858,254               |       |
| Less: loan servicing fee from Gladstone Business  Loan LLC |       | 715,415               |        | 530,952               |       |
| Management fee before credit:                              |       | 268,701               |        | 327,302               |       |
| **Direct Credit to Management Fee:**                       |       |                  |        |                  |       |
| Fee revenue recorded by Gladstone Management:              |       | 550,000               |        | 286,500               |       |
| Net management fee for the three months ended (c):         |       | $                     | (281,299    | )                     | $          | 40,802 |   |

 

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*(a) **This amount represents borrowings under one of our 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 January 2006.  Solely for the purposes of calculating theamount of the management fee due to Gladstone Management, we treat any suchamounts as “cash and cash equivalents pledged to creditors” under the terms of ouradvisory agreement with Gladstone Management. As a result, such amounts are deducted from our total assets forpurposes of computing the asset base upon which the management fee isdetermined.*

 

*(b) **This amount represents borrowings under one of our lines of credit thatwere held in cash and cash equivalents as of 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 from ourtotal assets for purposes of computing the asset base upon which the managementfee is determined.*

 

*(c)  If the amount presented is in parenthesesit denotes the amount is due back to us from the Adviser; if the amount ispositive, it indicates that we owe the Adviser the stated amount.*

 

Professional fees, consisting primarily of legal and audit fees, forthe three months ended December 31, 2005 were approximately $122,000 ascompared to approximately $239,000 for the three months ended December 31,2004.  The decrease is due primarily to adecrease in non-reimbursable legal fees.

 

Amortization of deferred financing costs, in connection with our linesof credit, were approximately $26,000 for the three months ended December 31,2005 and approximately $92,000 for the three months ended December 31,2004.  The decrease is due to thecompletion of the amortization cycle related to certain deferred financingcosts.

 

Interest expense for the three months ended December 31, 2005 wasapproximately $652,000 as compared to approximately $172,000 for the threemonths ended December 31, 2004.   This increase is primarily a result ofincreased borrowings under our lines of credit during the three months ended December 31,2005, which borrowings were used, in part, to finance our increased investments,borrowings remaining outstanding for longer periods of time and, to a lesserextent, an increase in the interest rates on our borrowings.

 

Stockholder related costs for the three months ended December 31,2005 were approximately $129,000, as compared to approximately $72,000 for thethree months ended December 31, 2004. Stockholder related costs include such recurring items as transfer agentfees, securities fees, and electronic filing fees.  The increase is due mainly to the printingand mailing of the special proxy report to stockholders and the printing of theannual report to stockholders.

 

Directors’ fees for the three months ended December 31, 2005 were$24,000, as compared to approximately $27,000 for the three months ended December 31,2004.

 

Insurance expense for the three months ended December 31, 2005 wasapproximately $51,000, as compared to approximately $46,000 for the threemonths ended December 31, 2004. The increase is primarily the result of anincrease in the amortization of our directors and officers insurance premiums.

 

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Stock option compensation expense for the three months ended December 31,2005 was approximately $43,000.  This isthe result of the adoption of the Statement of Financial Accounting Standards No. 123(revised 2004) (“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 effectivefor awards that are granted, modified, or settled in cash for annual periodsbeginning after June 15, 2005.  The Company adopted SFAS No. 123(R)on October 1, 2005 using the modified prospective approach. Under themodified prospective approach, stock-based compensation expense will berecorded for the unvested portion of previously issued awards that remainoutstanding at October 1, 2005 using the same estimate of the grant datefair value and the same attribution method used to determine the pro formadisclosure under SFAS No. 123. SFAS No. 123(R) also requires that allshare-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 December 31,2004.

 

General and administrative expenses were approximately $56,000 for thethree months ended December 31, 2005, as compared to approximately $43,000for the three months ended December 31, 2004.  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 three months ended December 31, 2005, Gladstone CapitalCorporation recorded approximately $50,000 in connection with penaltiesincurred on misclassified revenue on its fiscal year 2004 corporate tax return.

 

Gladstone Capital Advisers, Inc., a wholly-owned subsidiary ofGladstone Capital Corporation, is subject to federal and state income taxationon the income it has recorded such as managerial assistance and otherfees.  During the three months ended December 31,2004, Gladstone Capital Advisers incurred aggregate federal and state incometaxes of $138,678 resulting from taxable income it received during the 2004fiscal year.  Following theexternalization of our management effective October 1, 2004 substantiallyall revenues previously received by Gladstone Capital Advisers are now receivedby Gladstone Management.  As a result, wedo not anticipate incurring significant tax expense as a result of theactivities of Gladstone Capital Advisers in the future.  No income tax expense was recorded for thethree months ended December 31, 2005.

 

**Realized Gain/(Loss) on Sale of Investments**

 

During the three months ended December 31, 2005, we sold ourinvestments in ARI Holdings, Inc. and Marcal Paper Mills, Inc. for anaggregate loss of approximately $1.2 million. During the three months ended December 31, 2004, we sold our$975,000 syndicated loan participation in Burt’s Bees, Inc. for a gain of$9,750.

 

**Net Unrealized Depreciation on Derivative**

 

During the three months ended December 31, 2005, we recorded netunrealized depreciation of approximately $900 due to a decrease in the fairmarket value of our interest rate cap agreement, as compared to unrealizeddepreciation of approximately $25,000 during the three months ended December 31,2004.

 

**Net Unrealized Appreciation on Investments**

 

For the three months ended December 31, 2005, we recorded netunrealized appreciation on investments of approximately $5.0 million ascompared to net unrealized appreciation of approximately $283,000, for thethree months ended December 31, 2004. The unrealized appreciation is mainly attributable to the earlyrepayment or sale of loans that were underperforming as of September 30,2005, most notably Finn Corporation and ARI Holdings, Inc.

 

**Net Increase in NetAssets from Operations**

 

Overall, we realized a net increasein net assets resulting from operations of approximately $8.2 million for thethree months ended December 31, 2005. Based on a weighted-average of 11,306,510 (basic) and 11,573,620(diluted) shares outstanding, our net increase in net assets from operations perweighted average common share for the three months ended December 31, 2005was $0.73 (basic) and $0.71 (diluted).

 

For thethree months ended December 31, 2004, we realized a net increase in netassets resulting from operations of approximately $5.0 million.  Based on a weighted-average of 11,278,510(basic) and 11,615,796 (diluted) shares outstanding, our net increase in netassets resulting from operations per weighted average common share for the threemonths ended December 31, 2004 was $0.44 (basic) and $0.43 (diluted).

 

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**LIQUIDITYAND CAPITAL RESOURCES**

 

At December 31, 2005, we had investments in debt securities of, orloans to 27 private companies, totaling approximately $192.2 million (costbasis) of total assets. This number includes approximately $33,000 in accruedPIK interest income for the three months ended December 31, 2005, which asdescribed in “Overview,” is added to the carrying value of our investments.

 

During the three months ended December 31, 2005 and December 31,2004, the following investment activity occurred:

 
| **Quarter  Ended** | ** ** | **New Investments** | ** ** | **Principal Repayments** | ** ** | **Net Gain/(Loss)  on Disposal** | ** ** |
|--------------------|------------|---------------------|------------|--------------------------|------------|----------------------------------|------------|
|               |       |                |       |                     |       |                             |       |
| December 31, 2005  |       | $                   | 26,688,457 |                     | $          | 38,702,066                       |       | $ | (1,180,595 | ) |
|               |       |                |       |                     |       |                             |       |
| December 31, 2004  |       | 46,949,500          |       | 25,975,707               |       | 9,750                            |       |
|                    |            |                     |            |                          |            |                                  |            |  |  |  |

 

The following table summarizes thecontractual principal amortization and maturity of our investment portfolio byfiscal year:

 
| **Fiscal  Year Ended September 30,** | ** ** | **Amount** | ** **  |
|--------------------------------------|------------|------------|-------------|
|                                 |       |       |        |
| 2006                                 |       | $          | 6,444,737   |   |
| 2007                                 |       | 14,675,393 |        |
| 2008                                 |       | 21,109,819 |        |
| 2009                                 |       | 31,843,965 |        |
| 2010                                 |       | 47,710,382 |        |
| Thereafter                           |       | 70,397,432 |        |
|                                 |       | $          | 192,181,728 |   |

 

Net cash provided by operatingactivities for the three months ended December 31, 2005, consistingprimarily of the items described in “Results of Operations”, was approximately$4.7 million as compared to net cash provided by operating activities ofapproximately $4.1 million for the three months ended December 31,2004.  Net cash provided by investingactivities was approximately $12.0 million for the three months ended December 31,2005 and mainly consisted of $38.7 million of principal repayments partiallyoffset by new investments of $26.7 million, as compared to net cash used ininvesting activities of approximately $42.2 million for the three months ended December 31,2004, which consisted mainly of new investments of $46.9 million and therepayment of a repurchase agreement of approximately $21.3 million, partiallyoffset by principal repayments of approximately $26.0 million.  Net cash used in financing activities for thethree months ended December 31, 2005 was approximately $1.8 million andmainly consisted of repayments of borrowings on the line of credit ofapproximately $39.2 million and approximately $4.6 million for the payment ofdividends.  These outflows were partiallyoffset by approximately $41.9 million of cash received from borrowings on theline of credit and the exercise of stock options for approximately $86,000.  Net cash used in financing activitieswas approximately $4.5 million for the three months ended December 31,2004 and consisted primarily of the payment of dividends of approximately $4.1million, repayments, net of borrowings, of our line of credit of approximately$0.3 million, and some costs incurred in connection with the shelf offering ofcommon stock completed in September 2004.

 

During the three months ended December 31,2005, cash and cash equivalents increased from approximately $504,000 toapproximately $15.4 million.  Thisincrease was largely the result of $15.0 million of borrowings which were usedto fund a new loan investment subsequent to December 31, 2005.

 

Subsequent to December 31,2005, we funded four new additional loan investments in the aggregate amount of$30.0 million using borrowings from our line of credit.

 

In order to qualify as a regulated investment company and to avoidcorporate level tax on the income we distribute to our stockholders, we are required,under Subchapter M of the Internal Revenue Code, to distribute at least 90% ofour ordinary income and short-term capital gains to our stockholders on anannual basis. In accordance with these requirements, we declared and paid

 

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monthly cash dividends of $0.135 per common share for October,November, and December 2005 and $0.12 per common share for October, November andDecember 2004 and January, February, and March 2005, $0.13 for April,May, and June 2005, and $0.135 for July, August and September 2005.  In January 2006, our Board of Directorsdeclared a monthly dividend of $0.135 per common share for each January,February, and March 2006.

 

We anticipate continuing to borrow funds and, from time to time issuingadditional equity securities to obtain additional capital to make furtherinvestments. To this end, we have an effective registration statement on filewith the Securities and Exchange Commission (“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/ordebt securities.

 

**Revolving Credit Facilities**

 

Through our wholly-owned subsidiary, Business Loan, we have a $100million revolving credit facility (the “DB Facility”) with Deutsche Bank AG, asadministrative agent, which currently matures on May 26, 2006.  Pursuant to the DB Facility, Business Loan haspledged the loans it holds to secure future advances by certain institutionallenders.  Interest rates charged on theadvances under the DB Facility will be based on the London Interbank OfferedRate (“LIBOR”), the Prime Rate or the Federal Funds Rate, depending on marketconditions, and will adjust periodically. As of December 31, 2005, our outstanding principal balance underthis DB Facility was approximately $55.7 million at an interest rate of 4.3%.  Available borrowings are subject to variousconstraints imposed by Deutsche Bank AG, based on the aggregate loan balancepledged by Business Loan, which varies as loans or added and repaid, regardlessof whether such repayments are early prepayment or are made as contractuallyrequired.  At December 31, 2005, theremaining borrowing capacity available under the DB Facility was approximately$16.8 million.  We are in the process ofnegotiating a renewal of this DB Facility, however there can be no guaranteethat we will be able to renew the DB Facility on terms that are favorable tous, if at all.  In the event that we arenot able to renew the DB Facility this could have a material adverse impact onour liquidity and ability to fund new investments.  In October 2005, our Board of Directorsapproved a resolution to seek to increase this credit facility to $150 million.

 

The DB Facility contains covenants that, among other things, requireBusiness Loan to maintain its status as a separate entity; prohibit certainsignificant corporate transactions (such as mergers, consolidations,liquidations or dissolutions); and restrict material changes to our credit andcollection policies.  The DB Facilityalso restricts some of the terms and provisions (including interest rates,terms to maturity and payments schedules) and limits the borrower and industryconcentrations of loans that are eligible to secure advances.  As of December 31, 2005, Business Loanwas in compliance with all of the DB Facility covenants.  We currently intend to securitize all of theloans held by Business Loan and to use the proceeds from the securitization topay down any amounts then outstanding under the revolving credit facility.  However, there can be no assurance that wewill be able to successfully securitize any of these loans on terms acceptableto us, if at all.

 

The administrative agent also requires that any interest or principalpayments on pledged loans be remitted directly by the borrower into a lockboxaccount with the Bank of New York as custodian. Deutsche Bank AG is also the trustee of the account and once a monthremits the collected funds to the Company. For the three months ended December 31,2005, the amount due from custodian decreased by approximately $211,000.

 

Gladstone Management, our affiliated external adviser, services theloans pledged under the DB Facility.  Asa condition to this servicing arrangement, we executed a performance guarantypursuant to which we guaranteed that Gladstone Management would comply fullywith all of its obligations under the facility. The performance guarantyrequires us to maintain a minimum net worth of $100 million and to maintain “assetcoverage” with respect to “senior securities representing indebtedness” of atleast 200%, in accordance with Section 18 of the 1940 Act.  As of December 31, 2005, we were incompliance with our covenants under the performance guaranty.

 

We also have a $15.0 million line of credit agreement with BranchBanking and Trust Company (“BB&T Agreement”) which originally matured on June 1,2005.  The line of credit was subsequentlymodified for quarterly extensions and in December 2005, it was modified toextend the maturity date through December 31, 2006.  Interest on outstanding borrowings is basedon the one month LIBOR plus 2.5% per annum. The unused portion of the line of credit is subject to a fee of 0.2% perannum.  The BB&T Agreement requiresus to meet and maintain certain covenants and ratios with respect to leverageand liquidity. As of December 31, 2005, there were no borrowings outstandingunder the BB&T line of credit with a remaining borrowing capacity availableunder the BB&T Agreement of $15.0 million.  As of December 31, 2005, we were incompliance with all covenants under the BB&T Agreement.

 

Both lines of credit are available for general corporate purposes.

 

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

 

We are subject to financial market risks, including changes in interestrates.  We expect that ultimately approximately 20% of the loans in ourportfolio will be made at fixed rates, with approximately 80% made at variablerates.  Currently our portfolio has approximately 3% of the total of theloan portfolio cost basis at fixed rates, approximately 50% of the total loanportfolio cost basis at variable rates with a floor. Approximately 4% of thetotal loan portfolio cost basis is at a variable rate with a floor and ceiling,and the remaining 43% of the total loan portfolio cost basis is at variablerates without a floor or ceiling.

 

In addition, we have two variable rate borrowing facilities.  We have a $100 million revolving creditfacility with Deutsche Bank AG which matures in May 2006.  We also have a $15 million line of creditagreement with Branch Banking and Trust Company which matured in December 2005and was modified to extend the maturity through December 2006.

 

In February 2004,we entered into an interest rate cap agreement in order to fulfill anobligation under our line of credit to enter into certain hedging transactionsin connection with our borrowings under the line of credit.  We purchasedthis interest rate cap agreement with a notional amount of $35 million for aone-time, up-front payment of $304,000.  The interest rate cap agreemententitles us to receive payments, if any, equal to the amount by which interestpayments on $35 million at one monthLIBOR exceed the payments on $35 million at 5%.  The cap expires inFebruary 2009.  This interest rate cap agreement effectively caps ourinterest payments on our line of credit borrowing, up to the notional amount ofthe interest rate cap, at five percent.  This mitigates our exposure toincreases in interest rates on our borrowings on our lines of credit, which areat variable rates.  At December 31,2005, the cap agreement had a fair market value of $49,361 and a currentnotional amount of $25.6 million.  At December 31, 2005, theone month LIBOR rate was approximately 4.39%.

 

To illustrate thepotential impact of changes in interest rates on our net increase in net assetsresulting from operations, we have performed the following analysis, whichassumes that our balance sheet remains constant and no further actions beyondthe interest rate cap agreement are taken to alter our existing interest ratesensitivity.  Under this analysis, ahypothetical increase in the one month LIBOR by 1% would increase our netincrease in net assets resulting from operations by approximately $1.6 millionor 8.4%, over the next twelve months, compared to the net increase in netassets resulting from operations for the twelve months ended December 31,2005.  A hypothetical decrease in the onemonth LIBOR by 1% would decrease net increase in net assets resulting fromoperations by approximately $1.6 million, or 8.4%, over the next twelve months,compared to the net increase in net assets resulting from operations for thetwelve months ended December 31, 2005. Although management believes that this analysis is indicative of ourexisting interest rate sensitivity, it does not adjust for potential changes incredit quality, size and composition of our loan portfolio on the balance sheetand other business developments that could affect net increase in net assetsresulting from operations.  Accordingly,no assurances can be given that actual results would not differ materially fromthe results under this hypothetical analysis.

 

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

 

**ITEM 4. CONTROLS ANDPROCEDURES.**

 

As of December 31, 2005, we,including our Chief Executive Officer and Chief Financial Officer, evaluatedthe effectiveness of the design and operation of our disclosure controls andprocedures.  Based on that evaluation,our management, including the Chief Executive Officer and Chief FinancialOfficer, concluded that our disclosure controls and procedures were effectivein timely alerting management, including the Chief Executive Officer and ChiefFinancial Officer, of material information about us required to be included inperiodic Securities and Exchange Commission filings.  However, in evaluating the disclosurecontrols and procedures, management recognized that any controls andprocedures, no matter how well designed and operated can provide onlyreasonable assurance of achieving the desired control objectives, andmanagement necessarily was required to apply its judgment in evaluating thecost-benefit relationship of possible controls and procedures.

 

There have been no changes in ourinternal control over financial reporting that occurred during the quarterended December 31, 2005, that have materially affected, or are reasonablylikely to materially affect, our internal control over financial reporting.

 

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**PART II–OTHERINFORMATION**

 

**ITEM 1. LEGALPROCEEDINGS.**

 

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

 

Not applicable.

 

**ITEM 3. DEFAULTS UPONSENIOR SECURITIES.**

 

Not applicable.

 

**ITEM 4. SUBMISSION OF MATTERSTO A VOTE OF SECURITY HOLDERS.**

 

A special meeting of stockholders was heldon December 2, 2005.  Thestockholders voted to approve an amended Investment Advisory Agreement betweenGladstone Capital Corporation and Gladstone Management Corporation and anAdministration Agreement between Gladstone Capital Corporation and GladstoneAdministration LLC, a wholly owned subsidiary of Gladstone ManagementCorporation.  The voting results are setforth below:

 
| **Shares Voted For** | ** ** | **Shares Voted  Against** | ** ** | **Shares Abstained** | ** ** |
|----------------------|------------|---------------------------|------------|----------------------|------------|
| 5,250,866            |       | 801,946                   |       | 158,756              |       |

 

**ITEM 5. OTHERINFORMATION.**

 

Not applicable

 

**ITEM 6. EXHIBITS**

 

See the exhibit index.

 

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**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 and Treasurer |

 

 

Date: February 7, 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.                              |
|        |       |                                                                                                                                                                                                                                                               |
| 11          |       | Computation of Per Share Earnings (included  in the notes to the unaudited financial statements contained in this report).                                                                                                                                         |
|        |       |                                                                                                                                                                                                                                                               |
| 31.1        |       | Certification of Chief Executive Officer  pursuant to section 302 of The Sarbanes-Oxley Act of 2002.                                                                                                                                                          |
|        |       |                                                                                                                                                                                                                                                               |
| 31.2        |       | Certification of Chief Financial Officer  pursuant to section 302 of The Sarbanes-Oxley Act of 2002.                                                                                                                                                          |
|        |       |                                                                                                                                                                                                                                                               |
| 32.1        |       | Certification of Chief Executive Officer  pursuant to section 906 of The Sarbanes-Oxley Act of 2002.                                                                                                                                                          |
|        |       |                                                                                                                                                                                                                                                               |
| 32.2        |       | Certification of Chief Financial Officer  pursuant to section 906 of The Sarbanes-Oxley Act of 2002.                                                                                                                                                          |

 

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

 

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