##### 



Exhibit 13 ALLIED CAPITAL CORPORATION AND SUBSIDIARIES Selected Consolidated Financial Data AS OF AND FOR THE YEARS ENDED DECEMBER 31,($ IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
    
    2004
    
    
    2003
    
    
    2002
    
    
    2001
    
    
    2000Operating DataTotal interest and related portfolio income
    
    $
    367,090
    
    
    $
    329,229
    
    
    $
    309,928
    
    
    $
    289,110
    
    
    $
    211,589Total operating expenses
    
    $
    165,075
    
    
    $
    136,565
    
    
    $
    125,073
    
    
    $
    110,059
    
    
    $
    98,872Income tax expense (benefit)
    
    $
    1,057
    
    
    $
    (2,466
    )
    
    $
    930
    
    
    $
    (412
    )
    
    $
    Net investment income
    
    $
    200,958
    
    
    $
    195,130
    
    
    $
    183,925
    
    
    $
    179,463
    
    
    $
    112,717Net realized gains
    
    $
    117,240
    
    
    $
    75,347
    
    
    $
    44,937
    
    
    $
    661
    
    
    $
    15,523Net change in unrealized appreciation or depreciation
    
    $
    (68,712
    )
    
    $
    (78,466
    )
    
    $
    (571
    )
    
    $
    20,603
    
    
    $
    14,861Net increase in net assets resulting from operations
    
    $
    249,486
    
    
    $
    192,011
    
    
    $
    228,291
    
    
    $
    200,727
    
    
    $
    143,101Diluted earnings per common share
    
    $
    1.88
    
    
    $
    1.62
    
    
    $
    2.20
    
    
    $
    2.16
    
    
    $
    1.94Net investment income and net realized gains per common
share(1)
    
    $
    2.40
    
    
    $
    2.28
    
    
    $
    2.21
    
    
    $
    1.93
    
    
    $
    1.74Dividends per common share(1)
    
    $
    2.30
    
    
    $
    2.28
    
    
    $
    2.23
    
    
    $
    2.01
    
    
    $
    1.82Weighted
average common shares outstandingdiluted(2)
    
    
    132,458
    
    
    
    118,351
    
    
    
    103,574
    
    
    
    93,003
    
    
    
    73,472Balance Sheet DataPortfolio at value
    
    $
    3,013,411
    
    
    $
    2,584,599
    
    
    $
    2,488,167
    
    
    $
    2,329,590
    
    
    $
    1,788,001Total assets
    
    $
    3,260,998
    
    
    $
    3,019,870
    
    
    $
    2,794,319
    
    
    $
    2,460,713
    
    
    $
    1,853,817Total debt outstanding
    
    $
    1,176,568
    
    
    $
    954,200
    
    
    $
    998,450
    
    
    $
    1,020,806
    
    
    $
    786,648Preferred stock issued to Small Business Administration
    
    $
    
    
    
    $
    6,000
    
    
    $
    7,000
    
    
    $
    7,000
    
    
    $
    7,000Shareholders equity
    
    $
    1,979,778
    
    
    $
    1,914,577
    
    
    $
    1,546,071
    
    
    $
    1,352,123
    
    
    $
    1,029,692Shareholders equity per common share (NAV)
    
    $
    14.87
    
    
    $
    14.94
    
    
    $
    14.22
    
    
    $
    13.57
    
    
    $
    12.11Common shares outstanding at end of year(2)
    
    
    133,099
    
    
    
    128,118
    
    
    
    108,698
    
    
    
    99,607
    
    
    
    85,057Other DataInvestments funded
    
    $
    1,524,523
    
    
    $
    931,450
    
    
    $
    506,376
    
    
    $
    680,329
    
    
    $
    901,545Repayments and sales
    
    $
    909,189
    
    
    $
    788,328
    
    
    $
    356,641
    
    
    $
    204,441
    
    
    $
    391,275Realized gains
    
    $
    267,702
    
    
    $
    94,305
    
    
    $
    95,562
    
    
    $
    10,107
    
    
    $
    28,604Realized losses
    
    $
    (150,462
    )
    
    $
    (18,958
    )
    
    $
    (50,625
    )
    
    $
    (9,446
    )
    
    $
    (13,081
    )
   (1)
    
    Dividends are based on taxable income, which differs from income for financial
reporting purposes. Net investment income and net realized gains per common share
(a non-GAAP measure) should not be considered a substitute for earnings per common share. Net investment income and
net realized gains are the most significant components of our annual taxable income from
which dividends are paid.(2)
    
    Excludes 234,977 common shares held in the deferred
compensation trust at and for the year ended December 31, 2000.




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##### 



MANAGEMENTS DISCUSSION AND
ANALYSIS

OF FINANCIAL CONDITION AND RESULTS OF
OPERATIONS


The information contained in this section
should be read in conjunction with our 2004 Consolidated
Financial Statements and the Notes thereto. In addition, this
annual report contains certain forward-looking statements. These
statements include the plans and objectives of management for
future operations and financial objectives and can be identified
by the use of forward-looking terminology such as
may, will, expect,
intend, anticipate,
estimate, or continue or the negative
thereof or other variations thereon or comparable terminology.
These forward-looking statements are subject to the inherent
uncertainties in predicting future results and conditions.
Certain factors that could cause actual results and conditions
to differ materially from those projected in these
forward-looking statements are set forth below in the Risk
Factors section. Other factors that could cause actual results
to differ materially include:



| |   |                                                                                                                        
| | - | -----------------------------------------------------------------------------------------------------------------------
| |  | changes in the economy;                                                                                                
|
| |  | risks associated with possible disruption in
    our operations due to terrorism;                                      
|
| |  | future changes in laws or regulations and
    conditions in our operating areas; and                                   
|
| |  | other risks and uncertainties as may be
    detailed from time to time in our public announcements and SEC
    filings.

Financial or other information presented for
private finance portfolio companies has been obtained from the
portfolio companies, and the financial information presented may
represent unaudited, projected or pro forma financial
information, and therefore may not be indicative of actual
results. In addition, the private equity industry uses financial
measures such as EBITDA or EBITDAM (Earnings Before Interest,
Taxes, Depreciation, Amortization and, in some instances,
Management fees) in order to assess a portfolio companys
financial performance and to value a portfolio company. EBITDA
and EBITDAM are not intended to represent cash flow from
operations as defined by U.S. generally accepted accounting
principles and such information should not be considered as an
alternative to net income, cash flow from operations or any
other measure of performance prescribed by U.S. generally
accepted accounting principles.

OVERVIEW

We are a business development company that
provides long-term debt and equity investment capital to
companies in a variety of industries. Our lending and investment
activity is generally focused on private finance and commercial
real estate finance, primarily the investment in non-investment
grade commercial mortgage-backed securities, which we refer to
as CMBS, and collateralized debt obligation bonds and preferred
shares, which we refer to as CDOs. Our private finance activity
principally involves providing financing through privately
negotiated long-term debt and equity investment capital. Our
private financing is generally used to fund growth,
acquisitions, buyouts, recapitalizations, note purchases, bridge
financings, and other types of financings. We generally invest
in private companies though, from time to time, we may invest in
companies that are public but lack access to additional public
capital or whose securities may not be marginable.



---



##### 



Our portfolio composition at December 31,
2004, 2003, and 2002, was as follows:

|                               |  |                 |    |      |  |      |    |   |  |  |    |  
|------------------------------ |  | --------------- | -- | ---- |  | ---- | -- | - |  |  | -- | -
|                               |  |                
|                               |  | At December 31,
|                               |  |                
|                               |  | 2004            |    | 2003 |  | 2002
|                               |  |                 |    |      |  |     
|Private finance                |  |                 | 76 | %    |  |      | 74 | % |  |  | 70 | %
|Commercial real estate finance |  |                 | 24 | %    |  |      | 26 | % |  |  | 30 | %

Our earnings depend primarily on the level of
interest and dividend income, fee and other income, and net
gains or losses earned on our investment portfolio after
deducting interest expense on borrowed capital and operating
expenses. Interest income results from the stated interest rate
earned on a loan or debt security and the amortization of loan
origination fees and discounts. The level of interest income is
directly related to the balance of the interest-bearing
investment portfolio outstanding during the year multiplied by
the weighted average yield. Our ability to generate interest
income is dependent on economic, regulatory, and competitive
factors that influence new investment activity, the amount of
loans and debt securities for which interest is not accruing and
our ability to secure debt and equity capital for our investment
activities.

Because we are a regulated investment company for
tax purposes, we intend to distribute substantially all of our
annual taxable income as dividends to our shareholders.

PORTFOLIO AND INVESTMENT ACTIVITY

The total portfolio at value, investment
activity, and the yield on interest-bearing investments at and
for the years ended December 31, 2004, 2003, and 2002, were
as follows:

|                                                                    |  |                          |         |      |  |      |         |   |  |   |         |  
|------------------------------------------------------------------- |  | ------------------------ | ------- | ---- |  | ---- | ------- | - |  | - | ------- | -
|                                                                    |  |                         
|                                                                    |  | At and for the          
|                                                                    |  | Years Ended December 31,
|                                                                    |  |                         
|                                                                    |  | 2004                     |         | 2003 |  | 2002
|($ in millions)                                                     |  |                          |         |      |  |     
|Portfolio at value                                                  |  | $                        | 3,013.4 |      |  | $    | 2,584.6 |   |  | $ | 2,488.2 |  
|Investments funded                                                  |  | $                        | 1,524.5 |      |  | $    | 931.5   |   |  | $ | 506.4   |  
|Change in accrued or reinvested interest and
    dividends          |  | $                        | 52.2    |      |  | $    | 45.0    |   |  | $ | 45.8    |  
|Principal collections related to investment
    repayments or sales |  | $                        | 909.2   |      |  | $    | 788.3   |   |  | $ | 356.6   |  
|Yield on interest-bearing
    investments(1)                        |  |                          | 14.0    | %    |  |      | 14.7    | % |  |   | 14.0    | %




|    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
|--- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(1) | The weighted average yield on interest-bearing
    investments is computed as the (a) annual stated interest
    plus the annual amortization of loan origination fees, original
    issue discount, and market discount on accruing interest-bearing
    investments less the annual amortization of loan origination
    costs, divided by (b) total interest-bearing investments at
    value. The weighted average yield is computed as of the balance
    sheet date.



---



##### 



Private Finance

The private finance portfolio at value,
investment activity, and the yield on loans and debt securities
at and for the years ended December 31, 2004, 2003, and
2002, were as follows:

|                                                                    |                           |                          |         |         |         |      |       |         |         |   |       |         |         | 
|------------------------------------------------------------------- | ------------------------- | ------------------------ | ------- | ------- | ------- | ---- | ----- | ------- | ------- | - | ----- | ------- | ------- | 
|                                                                    |                           |                         
|                                                                    |                           | At and for the          
|                                                                    |                           | Years Ended December 31,
|                                                                    |                           |                         
|                                                                    |                           | 2004                     |         | 2003    |         | 2002
|($ in millions)                                                     |                           |                          |         |         |         |     
|Portfolio at value:                                                 |                           |                          |         |         |         |      |       |         |         |   |       |        
|                                                                    | Loans and debt securities |                          | $       | 1,602.9 |         |      | $     | 1,214.9 |         |   | $     | 1,151.2 |        
|                                                                    | Equity interests          |                          |         | 699.2   |         |      |       | 687.8   |         |   |       | 592.0   |        
|                                                                    |                           |                          |         |         |         |      |       |         |         |   |       |        
|                                                                    |                           | Total portfolio          |         | $       | 2,302.1 |      |       | $       | 1,902.7 |   |       | $       | 1,743.2 | 
|                                                                    |                           |                          |         |         |         |      |       |         |         |   |       |        
|Investments funded(1)                                               |                           | $                        | 1,140.8 |         |         | $    | 498.0 |         |         | $ | 297.2 |        
|Change in accrued or reinvested interest and
    dividends          |                           | $                        | 45.6    |         |         | $    | 41.8  |         |         | $ | 43.6  |        
|Principal collections related to investment
    repayments or sales |                           | $                        | 551.9   |         |         | $    | 318.6 |         |         | $ | 129.3 |        
|Yield on interest-bearing
    investments(2)                        |                           |                          | 13.9    | %       |         |      | 15.0  | %       |         |   | 14.4  | %      




|    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                  
|--- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(1) | Investments funded for the year ended
    December 31, 2004, include a $47.5 million
    subordinated debt investment in The Hillman Companies, Inc.
    received in conjunction with the sale of Hillman as discussed
    below.                                                                                                                                                                                                                                
|   
|(2) | The weighted average yield on loans and debt
    securities is computed as the (a) annual stated interest
    plus the annual amortization of loan origination fees, original
    issue discount, and market discount on accruing loans and debt
    securities less the annual amortization of loan origination
    costs, divided by (b) total loans and debt securities at
    value. The weighted average yield is computed as of the balance
    sheet date.

The level of investment activity for investments
funded and principal repayments for private finance investments
can vary substantially from year to year depending on many
factors, including the amount of debt and equity capital
available to middle market companies, the level of merger and
acquisition activity for such companies, the general economic
environment, and the competitive environment for the types of
investments we make. During 2002, we believed that there was a
decline in the availability of senior debt capital from banks
for middle market companies and there were fewer merger and
acquisition transactions for these companies. By mid-2003, we
began to see an increase in merger and acquisition activity for
middle market companies and debt capital became more available.
We believe that merger and acquisition activity in the middle
market was stronger in 2004, which when combined with a lower
interest rate environment resulted in an increase in private
finance investments funded, as well as increased repayments.

Investments funded for the years ended
December 31, 2004, 2003, and 2002, consisted of the
following:

|                                         |                               |            |   |           |       |       |   |       |       |  |   |       |         | 
|---------------------------------------- | ----------------------------- | ---------- | - | --------- | ----- | ----- | - | ----- | ----- |  | - | ----- | ------- | 
|                                         |                               | Loans and  |   |           |       |      
|                                         |                               | Debt       |   | Equity    |       |      
|                                         |                               | Securities |   | Interests |       | Total
|($ in millions)                          |                               |            |   |           |       |      
|For the Year Ended December 31,
    2004 |                               |            |   |           |       |       |   |       |       |  |   |      
|                                         | Companies more than 25% owned |            | $ | 445.4     |       |       | $ | 171.2 |       |  | $ | 616.6 |        
|                                         | Companies 5% to 25% owned     |            |   | 112.0     |       |       |   | 14.4  |       |  |   | 126.4 |        
|                                         | Companies less than 5% owned  |            |   | 351.5     |       |       |   | 46.3  |       |  |   | 397.8 |        
|                                         |                               |            |   |           |       |       |   |       |       |  |   |      
|                                         |                               | Total      |   | $         | 908.9 |       |   | $     | 231.9 |  |   | $     | 1,140.8 | 
|                                         |                               |            |   |           |       |       |   |       |       |  |   |      



---



##### 



|                                         |                               |            |   |           |       |       |   |      |      |  |   |       |       | 
|---------------------------------------- | ----------------------------- | ---------- | - | --------- | ----- | ----- | - | ---- | ---- |  | - | ----- | ----- | 
|                                         |                               | Loans and  |   |           |       |      
|                                         |                               | Debt       |   | Equity    |       |      
|                                         |                               | Securities |   | Interests |       | Total
|($ in millions)                          |                               |            |   |           |       |      
|For the Year Ended December 31,
    2003 |                               |            |   |           |       |       |   |      |      |  |   |      
|                                         | Companies more than 25% owned |            | $ | 53.0      |       |       | $ | 34.0 |      |  | $ | 87.0  |      
|                                         | Companies 5% to 25% owned     |            |   | 23.8      |       |       |   | 1.9  |      |  |   | 25.7  |      
|                                         | Companies less than 5% owned  |            |   | 377.4     |       |       |   | 7.9  |      |  |   | 385.3 |      
|                                         |                               |            |   |           |       |       |   |      |      |  |   |      
|                                         |                               | Total      |   | $         | 454.2 |       |   | $    | 43.8 |  |   | $     | 498.0 | 
|                                         |                               |            |   |           |       |       |   |      |      |  |   |      
|For the Year Ended December 31,
    2002 |                               |            |   |           |       |       |   |      |      |  |   |      
|                                         | Companies more than 25% owned |            | $ | 86.1      |       |       | $ | 18.7 |      |  | $ | 104.8 |      
|                                         | Companies 5% to 25% owned     |            |   | 22.3      |       |       |   | 0.4  |      |  |   | 22.7  |      
|                                         | Companies less than 5% owned  |            |   | 154.6     |       |       |   | 15.1 |      |  |   | 169.7 |      
|                                         |                               |            |   |           |       |       |   |      |      |  |   |      
|                                         |                               | Total      |   | $         | 263.0 |       |   | $    | 34.2 |  |   | $     | 297.2 | 
|                                         |                               |            |   |           |       |       |   |      |      |  |   |      

During 2004, we invested $616.6 million in
companies where we acquired or owned a majority ownership
position as compared to $87.0 million for 2003. Investments in
controlled portfolio companies during 2004 included the
following:



| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  
| | - | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | The purchase of a majority ownership in Advantage
    Sales & Marketing, Inc. (Advantage), a leading sales and
    marketing agency providing outsourced sales, merchandising, and
    marketing services to the consumer packaged goods industry. At
    the closing of the transaction in June 2004, we invested
    $90.2 million in loans and subordinated debt and
    $73.5 million in common stock. In addition, prior to
    completing the purchase, we had invested $93.7 million in
    subordinated debt in certain predecessor companies of Advantage,
    of which $63.5 million was invested in the first and second
    quarters of 2004. This existing debt was exchanged for new
    subordinated debt in Advantage as part of the transaction.
|
| |  | The purchase of a majority ownership in Insight
    Pharmaceuticals Corporation (Insight), a marketer and
    distributor of over-the-counter pharmaceutical products. At the
    closing of the transaction in December 2004, we invested
    $124.0 million in senior and subordinated debt and
    $31.3 million in preferred and common stock. Our debt
    investment in Insight includes a $19.0 million revolving
    line of credit facility, of which Insight had borrowed
    $14.4 million at December 31, 2004.                                                                                                                                                                                                                                      
|
| |  | The purchase of a majority ownership in Financial
    Pacific Company (Financial Pacific), a specialized commercial
    finance company focused on providing leases for
    business-essential equipment to small businesses nationwide. At
    the closing of the transaction in August 2004, we invested
    $68.4 million in debt and $24.7 million in preferred
    and common stock.                                                                                                                                                                                                                                                                                                                                                                        
|
| |  | The purchase of a majority ownership in Mercury
    Air Centers, Inc. (Mercury), an operator of fixed base
    operations, from Mercury Air Group, Inc. At the closing of the
    transaction in April 2004, we invested $53.4 million in
    debt and $29.6 million in common stock. Since closing, we
    have invested an additional $1.6 million in common stock.
    In addition, we have an $8.5 million commitment to fund
    senior subordinated debt for future working capital and
    construction commitments, of which $0.8 million was
    outstanding at December 31, 2004. In connection with the
    transaction, Mercury Air Group, Inc. repaid its $24 million
    subordinated debt obligation to Allied Capital.                           



---



##### 





| |   |                                                                                                                                                                                                                                                                                                      
| | - | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | The purchase of Legacy Partners Group, LLC, a
    financial advisory firm. At the closing of the transaction in
    May 2004, we invested $4.3 million in debt and
    $2.7 million in equity interests. Since closing, we have
    invested additional debt of $5.0 million for working
    capital.

We intend to continue a balanced approach to
private finance investing that emphasizes a complementary mix of
mezzanine investments and buyout investments, subject to
regulatory diversity requirements. The combination of these two
types of investments provides current interest and related
portfolio income and the potential for future capital gains.

We generally fund new investments using cash. In
addition, we may acquire securities in exchange for our common
equity. Also, we may acquire new securities through the
reinvestment of previously accrued interest and dividends in
debt or equity securities, or the current reinvestment of
interest and dividend income through the receipt of a debt or
equity security (payment-in-kind income). From time to time we
may opt to reinvest accrued interest receivable in a new debt or
equity security in lieu of receiving such interest in cash and
then using that cash to make a subsequent investment.

At December 31, 2004, we had outstanding
investment commitments to private finance portfolio companies
totaling $313.1 million including the following:



| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
| | - | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | $96.4 million of financing and purchase
    commitments to Callidus Capital Corporation (Callidus), an asset
    management company that structures and manages collateralized
    debt obligations (CDOs), loan collateralized loan obligations
    (CLOs), and other related investments. We own 80% of the equity
    of the management company. Our commitment consists of
    $50 million of subordinated debt to support Callidus
    warehouse facilities and warehousing activities,
    $44.4 million to purchase below investment grade bonds and
    preferred equity securities in Callidus future CDO or CLO
    transactions, and $2.0 million for working capital needs.
    Callidus has a secured warehouse credit facility with a third
    party for up to $300 million to primarily finance the
    acquisition of loans pending securitization through a CDO or
    CLO. In conjunction with this warehouse credit facility, we have
    agreed to designate up to $45 million of our $50 million
    subordinated debt commitment for Callidus to draw upon to
    provide first loss capital as needed to support the warehouse
    facility.
|
| |  | $107.8 million of availability under our
    outstanding commitment in the form of a $150.0 million
    revolving line of credit facility to support Callidus
    middle market underwriting and syndication activities. At
    December 31, 2004, there was $42.2 million outstanding
    under this facility which had been funded during 2004.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    
|
| |  | $20.0 million in the form of a revolving
    credit facility to Business Loan Express, LLC (BLX) to provide
    working capital to the company. At December 31, 2004, BLX
    had no outstanding borrowings on the facility.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
|
| |  | $17.5 million in the form of debt of
    financing commitments to S.B. Restaurant Company.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            
|
| |  | $18.9 million in the form of equity to eight
    private venture capital funds.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
|
| |  | $9.0 million in the form of equity to
    Pennsylvania Avenue Investors, L.P., a limited partnership
    controlled by us that invests in private buyout equity funds.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                

We may have commitments to fund additional
amounts under earn-out arrangements primarily related to the
purchase of controlled portfolio companies in the future if those



---



##### 



companies meet agreed-upon performance targets.
In addition, we had commitments to private finance portfolio
companies in the form of standby letters of credit and
guarantees totaling $141.6 million.


On March 31, 2004, we sold our control investment
in The Hillman Companies, Inc. (Hillman) for a total transaction
value of $510 million, including the repayment of outstanding
debt and adding the value of Hillmans outstanding trust
preferred shares. We were repaid our existing $44.6 million
in outstanding debt. Total consideration to us from this sale at
closing, including the repayment of debt, was
$244.3 million, which included net cash proceeds of $196.8
million and the receipt of a new subordinated debt instrument of
$47.5 million. During the second quarter of 2004, we sold a
$5.0 million participation in our subordinated debt in
Hillman to a third party, which reduced our investment, and no
gain or loss resulted from the transaction. For the year ended
December 31, 2004, we realized a gain of $150.3 million on
the transaction, including gains of $1.3 million realized
after closing resulting from post-closing adjustments, which
provided additional cash consideration to us in the same amount.
The sale of Hillman is subject to certain other post-closing
adjustments.

The yield on the private finance loans and debt
securities was 13.9% at December 31, 2004, as compared to
15.0% at December 31, 2003. The yield at December 31, 2004,
was lower in part due to lower yielding senior debt investments
in controlled portfolio companies. During 2004, we funded most
or all of the debt and equity capital upon the closing of
certain buyout transactions, which included investments in
lower-yielding senior debt. In addition, we have provided
lower-yielding senior debt to other controlled portfolio
companies during the course of 2004. We currently expect that a
portion of this senior debt outstanding at December 31,
2004, may be refinanced by the portfolio companies during 2005.
While senior debt in the portfolio at December 31, 2004,
may be refinanced, we may continue to fund lower-yielding senior
debt in new or existing portfolio companies in the future, which
may cause the weighted average yield on the private finance debt
portfolio to fluctuate.

Business Loan Express,
LLC.Our
largest investment at December 31, 2004, was in Business
Loan Express, LLC (BLX). Our investment in BLX totaled
$280.4 million at cost and $335.2 million at value, or
10.3% of our total assets, which includes unrealized
appreciation of $54.8 million. BLX was acquired in 2000.

BLX is a national, non-bank lender utilizing the
SBAs 7(a) Guaranteed Loan Program and is licensed by
the SBA as a Small Business Lending Company (SBLC). BLX is a
nationwide preferred lender, as designated by the SBA, and
originates, sells, and services small business loans. In
addition to the SBA 7(a) Guaranteed Loan Program, BLX
originates conventional small business loans, originates loans
under the USDA Business and Industry Guaranteed Loan Program
(B&I) and during the quarter ended March 31, 2004,
began originating small investment real estate loans. BLX has
offices across the United States and is headquartered in New
York, New York.

Changes in the laws or regulations that govern
SBLCs or the SBA 7(a) Guaranteed Loan Program or changes in
government funding for this program could have a material
adverse impact on BLX and, as a result, could negatively affect
our financial results. During 2004, the SBA 7(a) loan
program was faced with funding challenges and operated under
certain restrictions. In December 2004, the appropriations
legislation for fiscal year 2005 was signed into law and the
SBA 7(a) loan program received $16.0 billion in
lending authority. The maximum loan guarantee was increased from
$1.0 million to $1.5 million on a maximum loan amount
of $2.0 million, but piggyback lending (where the
SBA 7(a) loan is in a junior lien position) is not allowed
under the current program.



---



##### 



Summary financial data for BLX at and for the
three months ended December 31, 2004, and its fiscal year
ended September 30, 2004, is presented below. Summary
financial data has been provided by BLX and is unaudited.

|                                    |                                                                 |                    |                         |                   |      |       |   |         |       |       |  
|----------------------------------- | --------------------------------------------------------------- | ------------------ | ----------------------- | ----------------- | ---- | ----- | - | ------- | ----- | ----- | -
|                                    |                                                                 | At and for the     |                         | At and for the   
|                                    |                                                                 | Three Months Ended |                         | Fiscal Year Ended
|                                    |                                                                 | December 31,       |                         | September 30,    
|                                    |                                                                 | 2004               |                         | 2004             
|($ in millions)                     |                                                                 |                    |                         |                  
|Operating Data                      |                                                                 |                    |                         |                   |      |       |   |        
|                                    | Total revenue                                                   |                    | $                       | 28.0              |      |       | $ | 118.3   |      
|                                    | Net income                                                      |                    | $                       | 3.2               |      |       | $ | 14.5    |      
|                                    | Earnings before interest, taxes and management
    fees (EBITM) |                    | $                       | 10.3              |      |       | $ | 44.6    |      
|Balance Sheet Data                  |                                                                 |                    |                         |                   |      |       |   |        
|                                    | Total assets                                                    |                    | $                       | 433.9             |      |       | $ | 446.5   |      
|                                    | Total debt                                                      |                    | $                       | 216.4             |      |       | $ | 229.2   |      
|                                    | Total owners equity                                            |                    | $                       | 155.3             |      |       | $ | 153.2   |      
|Other Data                          |                                                                 |                    |                         |                   |      |       |   |        
|                                    | Loan originations                                               |                    |                         |                   |      |       |   |         |      
|                                    |                                                                 | SBA 7(a)           |                         | $                 | 75.7 |       |   | $       | 358.6 |      
|                                    |                                                                 | Conventional       |                         |                   | 55.7 |       |   |         | 287.0 |      
|                                    |                                                                 | B&I                |                         |                   |     |       |   |         | 11.4  |      
|                                    |                                                                 |                    |                         |                   |      |       |   |        
|                                    |                                                                 |                    | Total loan originations |                   | $    | 131.4 |   |         | $     | 657.0 |  
|                                    |                                                                 |                    |                         |                   |      |       |   |        
|                                   
|                                    | Serviced loan portfolio                                         |                    | $                       | 2,600.6           |      |       | $ | 2,572.9 |      
|                                    | Number of loans                                                 |                    |                         | 3,694             |      |       |   | 3,573   |      
|                                    | Loan delinquencies(1)                                           |                    |                         | 8.4               | %    |       |   | 8.9     | %    
|Serviced Loan Portfolio by Industry |                                                                 |                    |                         |                   |      |       |   |        
|                                    | Hotels                                                          |                    |                         | 24                | %    |       |   | 24      | %    
|                                    | Gas stations/convenience stores                                 |                    |                         | 20                |      |       |   | 20      |      
|                                    | Professional and retail services                                |                    |                         | 12                |      |       |   | 12      |      
|                                    | Restaurants                                                     |                    |                         | 8                 |      |       |   | 8       |      
|                                    | Manufacturing and industrial                                    |                    |                         | 8                 |      |       |   | 8       |      
|                                    | Car wash/auto repair services                                   |                    |                         | 7                 |      |       |   | 7       |      
|                                    | Child care and health care services                             |                    |                         | 6                 |      |       |   | 6       |      
|                                    | Recreation                                                      |                    |                         | 5                 |      |       |   | 5       |      
|                                    | Shrimp/fishing vessels                                          |                    |                         | 4                 |      |       |   | 4       |      
|                                    | Other                                                           |                    |                         | 6                 |      |       |   | 6       |      
|                                    |                                                                 |                    |                         |                   |      |       |   |        
|                                    |                                                                 |                    | Total                   |                   |      | 100   | % |         |       | 100   | %
|                                    |                                                                 |                    |                         |                   |      |       |   |        



---



|    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 | 
|--- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- | 
|(1) | Represents the percentage of loans in the total
    serviced loan portfolio that are greater than 30 days
    delinquent, which includes loans in workout status. Loans
    greater than 30 days delinquent for the SBA 7(a) loan
    portfolio only, which are included in the total serviced loan
    portfolio, were 8.6% at December 31, 2004. SBA 7(a)
    loans greater than one year old at December 31, 2004, had a
    delinquency rate of 10.2%. BLX will from time to time grant a
    deferment to borrowers experiencing short-term cash flow
    shortfalls. Loans that have been granted a deferment that
    perform as required are not considered delinquent consistent
    with SBA practice. The ability of small businesses to repay
    their loans may be adversely affected by numerous factors,
    including a downturn in their industry or negative economic
    conditions. Small businesses are also more vulnerable to
    customer preferences, competition, rising fuel prices and market
    conditions and, as a result, delinquencies in BLXs
    portfolio may increase. For instance, the shrimp and fishing
    industry has been affected by rising fuel costs and competition
    from imported shrimp, which has resulted in an increase in loan
    delinquencies. For these reasons, BLX focuses on collateral
    protection for each loan in addition to the cash flow of the
    small business and generally receives personal guarantees from
    the principal owners of the small business. | 

BLXs business is to originate small
business loans and then sell substantially all of the loans
originated for cash proceeds. BLXs revenues consist of
cash premiums from guaranteed loan sales, gain on sale income
arising from loans sold at par or securitized



---



##### 



where BLX will receive future cash flows
representing the spread between loan interest and the interest
paid on bonds issued including service fee income, interest
income on loans remaining in BLXs portfolio, and other
income. Gain on sale income is a non-cash source of income when
recognized, and as future cash flows are received, the resulting
cash reduces the receivable or residual interest that is
recognized when the loan is sold. The total of cash loan sale
premiums, cash interest income and cash received from residual
interests and other cash income is equal to approximately 93% of
BLXs revenue of $28.0 million for the three months
ended December 31, 2004, and approximately 83% of
BLXs revenue of $118.3 million for the fiscal year
ended September 30, 2004.


During the calendar year ended December 31,
2004, the SBA 7(a) loan program underwent periods of
operational change due to government funding limitations. For
instance, the program implemented caps on loan size and
discontinued the availability of an SBA 7(a) loan in a
second mortgage position, or piggy-back loan. As a
result, BLX had difficulty in building a consistent pipeline of
new loan originations particularly in the March and December
quarters. Loans originated during the three months ended
December 31, 2004, totaled $131.4 million versus
$188.3 million during the three months ended
December 31, 2003. Proceeds from loan sales during the
three months ended December 31, 2004, totaled approximately
$141.2 million. Loans originated during the fiscal year
ended September 30, 2004, totaled $657.0 million.
Proceeds from loan sales during the fiscal year ended
September 30, 2004, totaled approximately
$618.8 million. From time to time, BLX funds the
construction of commercial real estate projects and as a result
is unable to sell a construction loan until the loan is fully
funded and the construction is complete. In addition, BLX
typically does not immediately receive the proceeds from the
sale of its SBA 7(a) guaranteed and unguaranteed loan
strips sold, but receives the cash upon settlement. Therefore,
until BLX sells construction loans or fully funded loans held
for sale, it will finance the origination of the loans through
funding on its revolving line of credit, or through financing
provided by us.

BLX sells the guaranteed piece of SBA 7(a)
guaranteed loans for cash premiums of up to 10% of the
guaranteed loan amount plus a retained annual servicing fee
generally between 1.0% and 2.4% of the guaranteed loan amount.
Cash premiums received from guaranteed loan sales during the
three months ended December 31, 2004, and the fiscal year
ended September 30, 2004, were approximately
$5.7 million and $27.1 million in total, respectively.
Alternatively, BLX may sell the guaranteed pieces of
SBA 7(a) guaranteed loans at par and receive cash only for
the face amount of the loan sold, and instead of receiving a
cash premium, BLX will receive an annual servicing spread on the
loans sold of between 4.0% and 5.0%.

In addition, BLX sells the unguaranteed pieces of
the SBA 7(a) loans and conventional loans it originates
into a conduit facility. The conduit loans are securitized and
BLX retains an interest of up to 5.0% of the loan pool. BLX then
receives the excess of loan interest payments on the loans sold
over the interest cost on the securities issued in the
securitization over the life of the loan pool, which is
generally between 4.3% and 5.0% annually on the loans sold into
the securitization pools.



---



##### 



When BLX sells a guaranteed piece of an
SBA 7(a) loan at par, or when BLX securitizes a loan, it
records a residual interest and servicing asset, together
referred to as the Residual Interest, in order to account for
the retained interest in the loans sold and the net present
value of the future cash flows it expects to receive from the
loans sold or securitized. In computing the Residual Interest,
BLX discounts estimated future cash flows after making
assumptions as to future loan losses and loan prepayments, which
may reduce future cash flows. For the three months ended
December 31, 2004, and the fiscal year ended
September 30, 2004, BLX received cash payments from the
Residual Interest of approximately $17.1 million and
$59.7 million, respectively.

At December 31, 2004, BLXs Residual
Interest totaled $226.5 million, representing BLXs
estimate of the net present value of future cash flows of
scheduled loan payments, after estimated future loan losses and
loan prepayments. If scheduled loan payments were to be received
as stated in the loan agreements with no future losses or
prepayments, BLX would receive future cash flows of
$970.4 million over time, with approximately
$79.7 million, $67.6 million, $66.1 million, and
$64.4 million (or $277.8 million in the aggregate)
scheduled to be received in the next four years ending on
December 31, 2005, 2006, 2007, and 2008, respectively.

As a limited liability company, BLXs
taxable income flows through directly to its members. BLXs
annual taxable income generally differs from its book income for
the fiscal year due to temporary and permanent differences in
the recognition of income and expenses. We hold all of
BLXs Class A and Class B interests, and 94.9% of
the Class C interests. BLXs taxable income is first
allocated to the Class A interests to the extent that
dividends are paid in cash or in kind on such interests, with
the remainder being allocated to the Class B and
Class C interests. BLX declares dividends on its
Class B interests based on an estimate of its annual
taxable income allocable to such interests.

At December 31, 2004, our subordinated debt
investment in BLX was $44.6 million at cost and value. Effective
January 1, 2005, this debt was exchanged for Class B equity
interests, which will be included in private finance equity
interests. Since the subordinated debt will no longer be
outstanding, the amount of taxable income available to flow
through to BLXs equity holders will increase by the amount
of interest that would have otherwise been paid on this debt. As
a result of this exchange, private finance loans and debt
securities would be lower by $44.6 million and the weighted
average yield on the remaining loans and debt securities in the
private finance portfolio, assuming no other changes, at
December 31, 2004, would have been 13.6%.

Total interest and related portfolio income
earned from the Companys investment in BLX for the years
ended December 31, 2004, 2003, and 2002, was
$50.0 million, $46.7 million, and $40.2 million,
respectively, which includes interest income on the subordinated
debt and Class A equity interests of $23.2 million,
$21.9 million, and $20.7 million, respectively,
dividend income on Class B interests of $14.8 million,
$7.8 million, and $0, respectively, loan prepayment
premiums of $0, $0.1 million, and $0, respectively, and
fees and other income of $12.0 million, $16.9 million,
and $19.5 million, respectively. Interest and dividend
income from BLX for the years ended December 31, 2004,
2003, and 2002, included interest and dividend income of
$25.4 million, $17.5 million, and $9.5 million,
respectively, which was paid in kind. The interest and dividends
paid in kind were paid to the Company through the issuance of
additional debt or equity interests. Accrued interest and
dividends receivable at December 31, 2004, included accrued
interest due from BLX totaling $4.0 million, of which
$3.3 million was paid in cash in early January 2005.



---



##### 



We have a commitment to BLX of $20.0 million
in the form of a revolving credit facility to provide working
capital to the company. This facility matures on June 30,
2005. At December 31, 2004, BLX had no outstanding
borrowings under this facility.

At December 31, 2004, BLX had a three-year
$275.0 million revolving credit facility that matures in
January 2007. The facility provides for a sub-facility for the
issuance of letters of credit for up to a total of $50.0
million. As the controlling equity owner in BLX, we have
provided an unconditional guaranty to the revolving credit
facility lenders in an amount equal to 50% of the total
obligations (consisting of principal, letters of credit issued
under the facility, accrued interest, and other fees) of BLX
under the revolving credit facility. At December 31, 2004,
the principal amount outstanding on the revolving credit
facility was $171.8 million and letters of credit issued
under the facility were $17.0 million. The total obligation
guaranteed by us at December 31, 2004, was
$94.6 million. This guaranty can be called by the lenders
only in the event of a default by BLX. BLX was in compliance
with the terms of the revolving credit facility at
December 31, 2004. At December 31, 2004, we had also
provided four standby letters of credit totaling
$35.6 million in connection with four term securitization
transactions completed by BLX.

Commercial Real Estate Finance

The commercial real estate finance portfolio at
value, investment activity, and the yield on interest-bearing
investments at and for the years ended December 31, 2004,
2003, and 2002, were as follows:

|                                                                    |                                |                                         |       |          |       |       |  |          |  |       |       |          |       |  |  |       |  |   |       |       |       |  |  |       |  | 
|------------------------------------------------------------------- | ------------------------------ | --------------------------------------- | ----- | -------- | ----- | ----- |  | -------- |  | ----- | ----- | -------- | ----- |  |  | ----- |  | - | ----- | ----- | ----- |  |  | ----- |  | 
|                                                                    |                                |                                        
|                                                                    |                                | At and for the Years Ended December 31,
|                                                                    |                                |                                        
|                                                                    |                                |                                         |       |          |       |      
|                                                                    |                                | 2004                                    |       | 2003     |       | 2002 
|                                                                    |                                |                                         |       |          |       |      
|                                                                    |                                | Value                                   |       | Yield(1) |       | Value |  | Yield(1) |  | Value |       | Yield(1)
|($ in millions)                                                     |                                |                                         |       |          |       |       |  |          |  |       |       |         
|Portfolio at value:                                                 |                                |                                         |       |          |       |       |  |          |  |       |       |          |       |  |  |       |  |   |       |       |       |  |  |      
|                                                                    | CMBS bonds                     |                                         | $     | 373.8    |       |       |  | 14.6%    |  |       | $     | 394.0    |       |  |  | 14.1% |  |   | $     | 555.5 |       |  |  | 14.2% | 
|                                                                    | CDO bonds and preferred shares |                                         |       | 212.6    |       |       |  | 16.8%    |  |       |       | 186.6    |       |  |  | 16.7% |  |   |       | 52.8  |       |  |  | 17.2% | 
|                                                                    | Commercial mortgage loans      |                                         |       | 95.0     |       |       |  | 6.8%     |  |       |       | 83.6     |       |  |  | 8.6%  |  |   |       | 63.7  |       |  |  | 7.5%  | 
|                                                                    | Residual interest              |                                         |       |         |       |       |  |          |  |       |       |         |       |  |  |       |  |   |       | 69.0  |       |  |  | 9.4%  | 
|                                                                    | Real estate owned              |                                         |       | 16.9     |       |       |  |          |  |       |       | 12.8     |       |  |  |       |  |   |       | 4.0   |       |  |  |       | 
|                                                                    | Equity interests               |                                         |       | 13.0     |       |       |  |          |  |       |       | 4.9      |       |  |  |       |  |   |       |      |       |  |  |       | 
|                                                                    |                                |                                         |       |          |       |       |  |          |  |       |       |          |       |  |  |       |  |   |       |       |       |  |  |      
|                                                                    |                                | Total portfolio                         |       | $        | 711.3 |       |  |          |  |       |       | $        | 681.9 |  |  |       |  |   |       | $     | 745.0 |  |  |       |  | 
|                                                                    |                                |                                         |       |          |       |       |  |          |  |       |       |          |       |  |  |       |  |   |       |       |       |  |  |      
|Investments funded                                                  |                                | $                                       | 383.7 |          |       |       |  |          |  | $     | 433.5 |          |       |  |  |       |  | $ | 209.2 |       |       |  |  |      
|Change in accrued or reinvested interest                            |                                | $                                       | 6.6   |          |       |       |  |          |  | $     | 3.2   |          |       |  |  |       |  | $ | 2.2   |       |       |  |  |      
|Principal collections related to investment
    repayments or sales |                                | $                                       | 357.3 |          |       |       |  |          |  | $     | 469.7 |          |       |  |  |       |  | $ | 227.3 |       |       |  |  |      




|    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
|--- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(1) | The weighted average yield on the
    interest-bearing investments is computed as the (a) annual
    stated interest plus the annual amortization of loan origination
    fees, original issue discount, and market discount on accruing
    interest-bearing investments less the annual amortization of
    origination costs, divided by (b) total interest-bearing
    investments at value. The weighted average yield is computed as
    of the balance sheet date. Interest-bearing investments for the
    commercial real estate finance portfolio include all investments
    except for real estate owned and equity interests.



---



##### 



Our commercial real estate investments funded for
the years ended December 31, 2004, 2003, and 2002, were as
follows:

|                                             |       |        |       |          |  |        |        |        |   |   |       |       | 
|-------------------------------------------- | ----- | ------ | ----- | -------- |  | ------ | ------ | ------ | - | - | ----- | ----- | 
|                                             |       | Face   |       |          |  | Amount
|                                             |       | Amount |       | Discount |  | Funded
|($ in millions)                              |       |        |       |          |  |       
|For the Year Ended December 31,
    2004     |       |        |       |          |  |        |        |        |   |   |       |      
|CMBS bonds (13 new issuances(1))             |       | $      | 419.1 |          |  | $      | (183.7 | )      |   | $ | 235.4 |      
|CDO bonds and preferred shares (3 issuances) |       |        | 40.5  |          |  |        | (0.1   | )      |   |   | 40.4  |      
|Commercial mortgage loans                    |       |        | 112.1 |          |  |        | (8.2   | )      |   |   | 103.9 |      
|Equity interests                             |       |        | 4.0   |          |  |        |       |        |   |   | 4.0   |      
|                                             |       |        |       |          |  |        |        |        |   |   |       |      
|                                             | Total |        | $     | 575.7    |  |        | $      | (192.0 | ) |   | $     | 383.7 | 
|                                             |       |        |       |          |  |        |        |        |   |   |       |      
|For the Year Ended December 31,
    2003     |       |        |       |          |  |        |        |        |   |   |       |      
|CMBS bonds (15 new issuances(1))             |       | $      | 508.5 |          |  | $      | (225.9 | )      |   | $ | 282.6 |      
|CDO bonds and preferred shares (3 issuances) |       |        | 145.8 |          |  |        | (0.4   | )      |   |   | 145.4 |      
|Commercial mortgage loans                    |       |        | 3.0   |          |  |        |       |        |   |   | 3.0   |      
|Equity interests                             |       |        | 2.5   |          |  |        |       |        |   |   | 2.5   |      
|                                             |       |        |       |          |  |        |        |        |   |   |       |      
|                                             | Total |        | $     | 659.8    |  |        | $      | (226.3 | ) |   | $     | 433.5 | 
|                                             |       |        |       |          |  |        |        |        |   |   |       |      
|For the Year Ended December 31,
    2002     |       |        |       |          |  |        |        |        |   |   |       |      
|CMBS bonds (5 new issuances)                 |       | $      | 302.5 |          |  | $      | (140.2 | )      |   | $ | 162.3 |      
|CDO preferred shares (3 issuances)           |       |        | 29.0  |          |  |        |       |        |   |   | 29.0  |      
|Commercial mortgage loans                    |       |        | 11.7  |          |  |        | (1.7   | )      |   |   | 10.0  |      
|Real estate owned                            |       |        | 7.9   |          |  |        |       |        |   |   | 7.9   |      
|                                             |       |        |       |          |  |        |        |        |   |   |       |      
|                                             | Total |        | $     | 351.1    |  |        | $      | (141.9 | ) |   | $     | 209.2 | 
|                                             |       |        |       |          |  |        |        |        |   |   |       |      



---

|    |                                                                                                             
|--- | ------------------------------------------------------------------------------------------------------------
|(1) | CMBS investments also include investments in
    issuances in which we have previously purchased CMBS bonds.

At December 31, 2004, we had outstanding
funding commitments related to commercial mortgage loans and
equity interests of $17.1 million and commitments in the
form of standby letters of credit and guarantees related to
equity interests of $2.7 million.

CMBS Bonds.The underlying pools of mortgage
loans that are collateral for our investments in new CMBS bond
issuances for the years ended December 31, 2004, 2003, and
2002, had respective original underwritten loan to value and
underwritten debt service coverage ratios as follows:

|                               |       |                                  |         |            |  |        |    |            |   |        |         |            |  |  |    |     |   |   |         |         |  |  |    |     |  
|------------------------------ | ----- | -------------------------------- | ------- | ---------- |  | ------ | -- | ---------- | - | ------ | ------- | ---------- |  |  | -- | --- | - | - | ------- | ------- |  |  | -- | --- | -
|                               |       |                                 
|                               |       | For the Years Ended December 31,
|                               |       |                                 
|                               |       |                                  |         |            |  |       
|                               |       | 2004                             |         | 2003       |  | 2002  
|                               |       |                                  |         |            |  |       
|Loan to Value Ranges           |       | Amount                           |         | Percentage |  | Amount |    | Percentage |   | Amount |         | Percentage
|($ in millions)                |       |                                  |         |            |  |        |    |            |   |        |         |           
|Less than 60%                  |       | $                                | 3,581.6 |            |  |        | 22 | %          |   | $      | 4,114.3 |            |  |  | 22 | %   |   | $ | 909.3   |         |  |  | 20 | %  
|60-65%                         |       |                                  | 1,436.1 |            |  |        | 9  |            |   |        | 1,582.8 |            |  |  | 9  |     |   |   | 287.3   |         |  |  | 6  |    
|65-70%                         |       |                                  | 1,288.6 |            |  |        | 8  |            |   |        | 1,768.0 |            |  |  | 10 |     |   |   | 587.9   |         |  |  | 13 |    
|70-75%                         |       |                                  | 3,561.2 |            |  |        | 22 |            |   |        | 4,024.3 |            |  |  | 22 |     |   |   | 1,214.5 |         |  |  | 27 |    
|75-80%                         |       |                                  | 5,655.5 |            |  |        | 35 |            |   |        | 6,560.5 |            |  |  | 36 |     |   |   | 1,477.5 |         |  |  | 33 |    
|Greater than 80%               |       |                                  | 550.0   |            |  |        | 4  |            |   |        | 138.6   |            |  |  | 1  |     |   |   | 47.8    |         |  |  | 1  |    
|                               |       |                                  |         |            |  |        |    |            |   |        |         |            |  |  |    |     |   |   |         |         |  |  |    |    
|                               | Total |                                  | $       | 16,073.0   |  |        |    | 100        | % |        | $       | 18,188.5   |  |  |    | 100 | % |   | $       | 4,524.3 |  |  |    | 100 | %
|                               |       |                                  |         |            |  |        |    |            |   |        |         |            |  |  |    |     |   |   |         |         |  |  |    |    
|Weighted average loan to value |       |                                  | 68.6    | %          |  |        |    |            |   |        | 68.5    | %          |  |  |    |     |   |   | 68.5    | %       |  |  |    |    



---



##### 



|                                             |       |                                  |         |            |  |        |    |            |   |        |         |            |  |  |    |     |   |   |         |         |  |  |    |     |  
|-------------------------------------------- | ----- | -------------------------------- | ------- | ---------- |  | ------ | -- | ---------- | - | ------ | ------- | ---------- |  |  | -- | --- | - | - | ------- | ------- |  |  | -- | --- | -
|                                             |       |                                 
|                                             |       | For the Years Ended December 31,
|                                             |       |                                 
|                                             |       |                                  |         |            |  |       
|                                             |       | 2004                             |         | 2003       |  | 2002  
|Debt Service Coverage                        |       |                                  |         |            |  |       
|Ratio Ranges                                 |       | Amount                           |         | Percentage |  | Amount |    | Percentage |   | Amount |         | Percentage
|($ in millions)                              |       |                                  |         |            |  |        |    |            |   |        |         |           
|Greater than 2.00                            |       | $                                | 2,317.1 |            |  |        | 14 | %          |   | $      | 4,208.7 |            |  |  | 23 | %   |   | $ | 366.9   |         |  |  | 8  | %  
|1.762.00                                    |       |                                  | 1,508.3 |            |  |        | 9  |            |   |        | 2,094.6 |            |  |  | 12 |     |   |   | 229.6   |         |  |  | 5  |    
|1.511.75                                    |       |                                  | 2,071.3 |            |  |        | 13 |            |   |        | 3,132.8 |            |  |  | 17 |     |   |   | 477.4   |         |  |  | 11 |    
|1.261.50                                    |       |                                  | 7,316.1 |            |  |        | 46 |            |   |        | 7,362.9 |            |  |  | 40 |     |   |   | 2,739.6 |         |  |  | 60 |    
|Less than 1.25                               |       |                                  | 2,860.2 |            |  |        | 18 |            |   |        | 1,389.5 |            |  |  | 8  |     |   |   | 710.8   |         |  |  | 16 |    
|                                             |       |                                  |         |            |  |        |    |            |   |        |         |            |  |  |    |     |   |   |         |         |  |  |    |    
|                                             | Total |                                  | $       | 16,073.0   |  |        |    | 100        | % |        | $       | 18,188.5   |  |  |    | 100 | % |   | $       | 4,524.3 |  |  |    | 100 | %
|                                             |       |                                  |         |            |  |        |    |            |   |        |         |            |  |  |    |     |   |   |         |         |  |  |    |    
|Weighted average debt service coverage ratio |       |                                  | 1.59    |            |  |        |    |            |   |        | 1.73    |            |  |  |    |     |   |   | 1.41    |         |  |  |    |    

From time to time, we may sell lower yielding
CMBS bonds rated BBB-through BB-, and to a lesser extent
CMBS bonds rated B+ and B, in order to maximize the return
on our CMBS bond portfolio. The cost basis of and the gross
sales proceeds from CMBS bonds sold, the related net realized
gains from these sales, and the weighted average yield on the
CMBS bonds sold for the years ended December 31, 2004,
2003, and 2002, were as follows:

|                                                              |  |                     |       |      |  |      |       |   |  |   |       |  
|------------------------------------------------------------- |  | ------------------- | ----- | ---- |  | ---- | ----- | - |  | - | ----- | -
|                                                              |  |                    
|                                                              |  | For the Years Ended
|                                                              |  | December 31,       
|                                                              |  |                    
|                                                              |  | 2004                |       | 2003 |  | 2002
|($ in millions)                                               |  |                     |       |      |  |     
|Cost basis                                                    |  | $                   | 273.0 |      |  | $    | 412.3 |   |  | $ | 205.9 |  
|Gross sales proceeds(1)                                       |  | $                   | 295.5 |      |  | $    | 446.8 |   |  | $ | 225.6 |  
|Net realized gains (net of related hedge gains
    or losses) |  | $                   | 17.4  |      |  | $    | 31.6  |   |  | $ | 19.1  |  
|Weighted average yield                                        |  |                     | 8.5   | %    |  |      | 10.1  | % |  |   | 11.5  | %



---

|    |                                                                                                                                                                                                      
|--- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(1) | Gross sales proceeds represent the total cash
    consideration received, including the repayment of the cost
    basis of the bonds and proceeds related to the net realized
    gains on the bonds.

During 2004, we completed a securitization of
$53.7 million of commercial mortgage loans. In connection
with this securitization, we received proceeds, net of costs, of
$54.0 million, including $28.3 million of cash and
$25.7 million of A and AA rated bonds and LLC interests,
which have been included in the CMBS portfolio at
December 31, 2004. The realized gain from this
securitization was $0.3 million.

The CMBS bonds in which we invest are junior in
priority for payment of interest and principal to the more
senior tranches of the related CMBS bond issuance. Cash flow
from the underlying mortgages is generally allocated first to
the senior tranches in order of priority, with the most senior
tranches having a priority right to the cash flow. Then, any
remaining cash flow is allocated, generally, among the other
tranches in order of their relative seniority. To the extent
there are defaults and unrecoverable losses on the underlying
mortgages or properties securing those mortgages resulting in
reduced cash flows, our most subordinate tranche will bear this
loss first. At December 31, 2004, the face value of the
CMBS bonds rated BBB- and below which we held were subordinate
to 84% to 99% of the face value of the bonds issued in these
various CMBS transactions. Given that the non-investment grade
CMBS bonds in which we invest are junior in priority for payment
of interest and principal, we invest in these CMBS bonds at a
discount from the face amount of the bonds. The discount
increases with the decrease in the seniority of the CMBS bonds.
For the years ended December 31, 2004, 2003, and 2002, the
average discount for the CMBS bonds in which we invested was
44%, 44%, and 46%, respectively.



---



##### 



At December 31, 2004, the unamortized
discount related to the CMBS bond portfolio was
$660.4 million, of which $346.5 million has been set
aside to absorb potential future losses. The yield on the CMBS
bonds of 14.6% assumes that this amount that has been set aside
will not be amortized. As the amount of future losses and the
expected timing of recognition of such losses is difficult to
predict and is subject to future events which may alter these
assumptions, no assurance can be given that the anticipated
yield will be achieved. At December 31, 2004, the CMBS bond
portfolio had a fair value of $373.8 million, which
included net unrealized depreciation on the CMBS bonds of
$9.5 million.

The yield on the CMBS bond portfolio at any point
in time will vary depending on the concentration of lower
yielding BB- and above rated CMBS bonds held in the portfolio.
Our CMBS bond portfolio and the related yields at December 31,
2004 and 2003, were as follows:

|                               |       |              |       |       |  |       |      |       |   |   |       |       |  |  |      |      |  
|------------------------------ | ----- | ------------ | ----- | ----- |  | ----- | ---- | ----- | - | - | ----- | ----- |  |  | ---- | ---- | -
|                               |       |             
|                               |       | December 31,
|                               |       |             
|                               |       |              |       |      
|                               |       | 2004         |       | 2003 
|                               |       |              |       |      
|                               |       | Value        |       | Yield |  | Value |      | Yield
|($ in millions)                |       |              |       |       |  |       |      |      
|CMBS bonds rated BB- and above |       | $            | 39.5  |       |  |       | 6.9  | %     |   | $ | 88.4  |       |  |  | 8.2  | %   
|CMBS bonds rated below BB-     |       |              | 334.3 |       |  |       | 15.5 | %     |   |   | 305.6 |       |  |  | 15.8 | %   
|                               |       |              |       |       |  |       |      |       |   |   |       |       |  |  |      |     
|                               | Total |              | $     | 373.8 |  |       |      | 14.6  | % |   | $     | 394.0 |  |  |      | 14.1 | %
|                               |       |              |       |       |  |       |      |       |   |   |       |       |  |  |      |     

At December 31, 2004 and 2003, the age of
our bonds rated below BB- was as follows:

|                         |       |              |       |            |  |       |      |            |   |   |       |       |  |  |      |       |  
|------------------------ | ----- | ------------ | ----- | ---------- |  | ----- | ---- | ---------- | - | - | ----- | ----- |  |  | ---- | ----- | -
|                         |       |             
|                         |       | December 31,
|                         |       |             
|                         |       |              |       |           
|                         |       | 2004         |       | 2003      
|                         |       |              |       |           
|                         |       | Value        |       | Percentage |  | Value |      | Percentage
|($ in millions)          |       |              |       |            |  |       |      |           
|Less than one year old   |       | $            | 82.9  |            |  |       | 24.8 | %          |   | $ | 83.9  |       |  |  | 27.5 | %    
|One to two years old     |       |              | 55.4  |            |  |       | 16.6 |            |   |   | 41.0  |       |  |  | 13.4 |      
|Two to three years old   |       |              | 29.9  |            |  |       | 8.9  |            |   |   | 43.8  |       |  |  | 14.3 |      
|Three years old or older |       |              | 166.1 |            |  |       | 49.7 |            |   |   | 136.9 |       |  |  | 44.8 |      
|                         |       |              |       |            |  |       |      |            |   |   |       |       |  |  |      |      
|                         | Total |              | $     | 334.3      |  |       |      | 100.0      | % |   | $     | 305.6 |  |  |      | 100.0 | %
|                         |       |              |       |            |  |       |      |            |   |   |       |       |  |  |      |      

At December 31, 2004 and 2003, we held CMBS
bonds in 45 and 38 separate CMBS issuances, respectively. The
underlying collateral pool, consisting of commercial mortgage
loans and real estate owned (REO) properties, for these CMBS
bonds consisted of the following at December 31, 2004 and
2003:

|                                                                     |  |              |        |       |  |   |        |      
|-------------------------------------------------------------------- |  | ------------ | ------ | ----- |  | - | ------ | -----
|                                                                     |  |             
|                                                                     |  | December 31,
|                                                                     |  |             
|                                                                     |  | 2004         |        | 2003 
|($ in millions)                                                      |  |              |        |      
|Approximate number of loans and REO
    properties(1)                |  |              | 6,200  |       |  |   | 5,600  |      
|Total outstanding principal balance                                  |  | $            | 42,759 |       |  | $ | 38,437 |      
|Loans over 30 days delinquent or classified
    as REO properties(2) |  |              | 1.6    | % (3) |  |   | 1.5    | % (3)




|    |                                                                                                                                                                                                                                                                                                                                                        
|--- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(1) | Includes approximately 39 and 22 REO properties
    obtained through the foreclosure of commercial mortgage loans at
    December 31, 2004 and 2003, respectively.                                                                                                                                                                                     
|   
|(2) | As a percentage of total outstanding principal
    balance.                                                                                                                                                                                                                                                                                            
|   
|(3) | At December 31, 2004 and 2003, our
    investments included bonds in the first loss, unrated bond class
    in 43 and 34 separate CMBS issuances, respectively. For these
    issuances, loans over 30 days delinquent or classified as
    REO properties were 1.7% of the total outstanding principal
    balance at both December 31, 2004 and 2003.



---



##### 



Collateralized Debt Obligation Bonds and
Preferred Shares.During the year
ended December 31, 2004, we sold CDO bonds with a cost
basis of $19.2 million for a net realized gain of
$0.2 million, net of the related hedge net gain. During the
year ended December 31, 2003, we sold CDO bonds and
preferred shares with a cost basis of $13.9 million,
respectively, for net realized losses of $0.1 million net
of the related hedge gains. The yield on the CDO bonds and
preferred shares sold was 7.7% and 8.0% for the years ended
December 31, 2004 and 2003, respectively.

The bonds and preferred shares of the CDOs in
which we have invested are junior in priority for payment of
interest and principal to the more senior tranches of debt
issued by the CDOs. To the extent there are defaults and
unrecoverable losses on the underlying collateral that result in
reduced cash flows, the preferred shares will bear this loss
first and then the bonds would bear any loss after the preferred
shares. At December 31, 2004, our bonds and preferred
shares in the CDOs were subordinate to 70% to 98% of the more
senior tranches of debt issued in the various CDO transactions.
In addition, included in the CMBS collateral for the CDOs at
December 31, 2004, were certain CMBS bonds that are senior
in priority of repayment to certain lower rated CMBS bonds held
directly by us.

The yield on our CDO bonds and preferred
shares at December 31, 2004, 2003, and 2002, was 16.8%,
16.7%, and 17.2%, respectively. The yield on the
CDO portfolio at any point in time will generally vary
depending on the amount of lower yielding CDO bonds held in
the portfolio.

At December 31, 2004 and 2003, the
underlying collateral for our investments in the outstanding CDO
issuances had balances as follows:

|                                   |                  |              |         |         |  |   |         |         | 
|---------------------------------- | ---------------- | ------------ | ------- | ------- |  | - | ------- | ------- | 
|                                   |                  |             
|                                   |                  | December 31,
|                                   |                  |             
|($ in millions)                    |                  | 2004         |         | 2003   
|                                   |                  |              |         |        
|Investment grade REIT debt(1)      |                  | $            | 1,532.5 |         |  | $ | 1,338.0 |        
|Investment grade CMBS bonds(2)     |                  |              | 918.8   |         |  |   | 662.3   |        
|Non-investment grade CMBS bonds(3) |                  |              | 1,636.4 |         |  |   | 1,133.7 |        
|Other collateral                   |                  |              | 355.8   |         |  |   | 32.4    |        
|                                   |                  |              |         |         |  |   |         |        
|                                   | Total collateral |              | $       | 4,443.5 |  |   | $       | 3,166.4 | 
|                                   |                  |              |         |         |  |   |         |        




|    |                                                                                
|--- | -------------------------------------------------------------------------------
|(1) | Issued by 44 REITs for both periods presented.                                 
|   
|(2) | Issued in 121 and 78 transactions, respectively,
    for the periods presented.
|   
|(3) | Issued in 109 and 68 transactions, respectively,
    for the periods presented.

Since we are limited as to the amount of debt
capital we can use to finance our commercial real estate
investments, we are evaluating various strategic alternatives
for our commercial real estate platform. These alternatives may
include the sale, spin-out or recapitalization of all or part of
our commercial real estate investments.

Hedging Activities

We have invested in CMBS and CDO bonds, which are
purchased at prices that are based in part on comparable
Treasury rates. We have entered into transactions with financial
institutions to hedge against movement in Treasury rates on
certain of the higher rated CMBS and CDO bonds. These
transactions, referred to as short sales, involve receiving the
proceeds from the short sales of borrowed Treasury securities,
with the



---



##### 



obligation to replenish the borrowed Treasury
securities at a later date based on the then current market
price, whatever that price may be. Risks in these contracts
arise from movements in the value of the borrowed Treasury
securities due to changes in interest rates and from the
possible inability of counterparties to meet the terms of their
contracts. If the value of the borrowed Treasury securities
increases, we will incur losses on these transactions. These
losses are limited to the increase in value of the borrowed
Treasury securities; conversely, the value of the hedged CMBS
and CDO bonds would likely increase. If the value of the
borrowed Treasury securities decreases, we will incur gains on
these transactions which are limited to the decline in value of
the borrowed Treasury securities; conversely, the value of the
hedged CMBS and CDO bonds would likely decrease. We do not
anticipate nonperformance by any counterparty in connection with
these transactions.


The total obligations to replenish borrowed
Treasury securities, including accrued interest payable on the
obligations, were $38.2 million and $98.5 million at
December 31, 2004 and 2003, respectively. The net proceeds
related to the sales of the borrowed Treasury securities plus or
minus the cash collateral provided or received under the terms
of the transactions were $38.2 million and
$98.5 million at December 31, 2004 and 2003,
respectively. The amount of the hedge will vary from period to
period depending upon the amount of higher rated CMBS and CDO
bonds that we own and have hedged on the balance sheet date.

Portfolio Asset Quality

Portfolio by Grade.We employ a standard grading
system for our entire portfolio. Grade 1 is used for those
investments from which a capital gain is expected. Grade 2
is used for investments performing in accordance with plan.
Grade 3 is used for investments that require closer
monitoring; however, no loss of investment return or principal
is expected. Grade 4 is used for investments that are in
workout and for which some loss of current investment return is
expected, but no loss of principal is expected. Grade 5 is
used for investments that are in workout and for which some loss
of principal is expected.

At December 31, 2004 and 2003, our portfolio
was graded as follows:

|                |  |              |         |            |  |           |       |            |  |   |         |  |  |  |       |  
|--------------- |  | ------------ | ------- | ---------- |  | --------- | ----- | ---------- |  | - | ------- |  |  |  | ----- | -
|                |  |             
|                |  | December 31,
|                |  |             
|                |  |              |         |           
|                |  | 2004         |         | 2003      
|                |  |              |         |           
|                |  |              |         | Percentage |  |           |       | Percentage
|                |  | Portfolio    |         | of Total   |  | Portfolio |       | of Total  
|Grade           |  | at Value     |         | Portfolio  |  | at Value  |       | Portfolio 
|                |  |              |         |            |  |           |       |           
|                |  |              |         |            |  |          
|($ in millions) |  |              |         |            |  |          
|1               |  | $            | 952.5   |            |  |           | 31.6  | %          |  | $ | 985.1   |  |  |  | 38.1  | %
|2               |  |              | 1,850.5 |            |  |           | 61.4  |            |  |   | 1,271.4 |  |  |  | 49.2  |  
|3               |  |              | 121.2   |            |  |           | 4.0   |            |  |   | 212.4   |  |  |  | 8.2   |  
|4               |  |              | 11.7    |            |  |           | 0.4   |            |  |   | 34.7    |  |  |  | 1.4   |  
|5               |  |              | 77.5    |            |  |           | 2.6   |            |  |   | 81.0    |  |  |  | 3.1   |  
|                |  |              |         |            |  |           |       |            |  |   |         |  |  |  |       |  
|                |  | $            | 3,013.4 |            |  |           | 100.0 | %          |  | $ | 2,584.6 |  |  |  | 100.0 | %
|                |  |              |         |            |  |           |       |            |  |   |         |  |  |  |       |  

Grade 2 investments at December 31, 2004,
increased over Grade 2 investments at December 31,
2003, primarily due to new investments made during 2004.
Investments in new portfolio companies generally enter the
portfolio as Grade 2 investments. We continue to include
our CMBS portfolio in Grade 2 assets, as we are uncertain
as to whether the



---



##### 



unrealized appreciation or depreciation on our
CMBS portfolio at December 31, 2004, will necessarily
result in a realized gain or loss.


Total Grade 3, 4, and 5 portfolio assets as
a percentage of the total portfolio at value at
December 31, 2004 and 2003, were 7.0% and 12.7%,
respectively. Included in Grade 3, 4, and 5 assets at
December 31, 2004 and 2003, were assets totaling
$38.3 million and $31.1 million, respectively, that
are secured by commercial real estate.

Grade 4 and 5 assets include loans, debt
securities, and equity securities. We expect that a number of
portfolio companies will be in the Grades 4 or 5 categories
from time to time. Part of the business of private finance is
working with troubled portfolio companies to improve their
businesses and protect our investment. The number of portfolio
companies and related investment amount included in Grade 4
and 5 may fluctuate from period to period. We continue to follow
our historical practice of working with such companies in order
to recover the maximum amount of our investment.

Loans and Debt Securities on Non-Accrual
Status.At December 31, 2004
and 2003, loans and debt securities at value not accruing
interest for the total investment portfolio were as follows:

|                                                                                |                                |                               |  |      |       |  |  |     |       | 
|------------------------------------------------------------------------------- | ------------------------------ | ----------------------------- |  | ---- | ----- |  |  | --- | ----- | 
|                                                                                |                                |                              
|                                                                                |                                | December 31,                 
|                                                                                |                                |                              
|                                                                                |                                | 2004                          |  | 2003
|($ in millions)                                                                 |                                |                               |  |     
|Loans and debt securities in workout status
    (classified as Grade 4 or 5)(1)
|                                                                                | Private finance                |                               |  |      |       |  |  |     |      
|                                                                                |                                | Companies more than 25% owned |  | $    | 34.4  |  |  | $   | 31.9  | 
|                                                                                |                                | Companies 5% to 25% owned     |  |      |      |  |  |     | 2.7   | 
|                                                                                |                                | Companies less than 5% owned  |  |      | 16.5  |  |  |     | 28.0  | 
|                                                                                | Commercial real estate finance |                               |  | 5.6  |       |  |  | 6.8 |      
|Loans and debt securities not in workout status                                 |                                |                               |  |      |       |  |  |    
|                                                                                | Private finance                |                               |  |      |       |  |  |     |      
|                                                                                |                                | Companies more than 25% owned |  |      | 29.4  |  |  |     | 31.9  | 
|                                                                                |                                | Companies 5% to 25% owned     |  |      | 0.7   |  |  |     |      | 
|                                                                                |                                | Companies less than 5% owned  |  |      | 15.8  |  |  |     | 16.5  | 
|                                                                                | Commercial real estate finance |                               |  | 12.5 |       |  |  | 0.2 |      
|                                                                                |                                |                               |  |      |       |  |  |    
|                                                                                |                                | Total                         |  | $    | 114.9 |  |  | $   | 118.0 | 
|                                                                                |                                |                               |  |      |       |  |  |    
|                                                                                |                                | Percentage of total portfolio |  |      | 3.8%  |  |  |     | 4.6%  | 




|    |                                                                                                                               
|--- | ------------------------------------------------------------------------------------------------------------------------------
|(1) | Workout loans and debt securities exclude equity
    securities that are included in the total Grade 4 and 5
    assets above.

Loans and Debt Securities Over 90 Days
Delinquent.Loans and debt
securities greater than 90 days delinquent at value
December 31, 2004 and 2003, were as follows:

|                               |                           |                               |      |      |       |   |      |      |       | 
|------------------------------ | ------------------------- | ----------------------------- | ---- | ---- | ----- | - | ---- | ---- | ----- | 
|                               |                           |                              
|                               |                           | December 31,                 
|                               |                           |                              
|                               |                           | 2004                          |      | 2003
|                               |                           |                               |      |     
|($ in millions)                |                           |                               |      |     
|Private finance                |                           | $                             | 73.5 |      |       | $ | 85.6 |     
|Commercial real estate finance |                           |                               |      |      |       |   |      |     
|                               | CMBS bonds                |                               |      | 49.0 |       |   |      | 40.3 |      
|                               | Commercial mortgage loans |                               |      | 10.1 |       |   |      | 3.7  |      
|                               |                           |                               |      |      |       |   |      |     
|                               |                           | Total                         |      | $    | 132.6 |   |      | $    | 129.6 | 
|                               |                           |                               |      |      |       |   |      |     
|                               |                           | Percentage of total portfolio |      |      | 4.4%  |   |      |      | 5.0%  | 



---



##### 



Loans and debt securities on non-accrual status
and over 90 days delinquent should not be added together as
they are two separate measures of portfolio asset quality. Loans
and debt securities that are in both categories (i.e., on
non-accrual status and over 90 days delinquent)
totaled $43.9 million and $46.1 million at
December 31, 2004 and 2003, respectively, which included
loans and debt securities that are secured by commercial real
estate of $10.2 million and $3.9 million, respectively.

As a provider of long-term privately negotiated
investment capital, we may defer payment of principal or
interest from time to time. The nature of our private finance
portfolio company relationships frequently provide an
opportunity for portfolio companies to negotiate with us to
amend the terms of payment to us or to restructure their debt
and equity capital. During such restructuring, we may not
receive or accrue interest or dividend payments. As a result,
the amount of the private finance portfolio that is greater than
90 days delinquent or on non-accrual status may vary from
period to period. The investment portfolio is priced to provide
current returns for shareholders assuming that a portion of the
portfolio at any time may not be accruing interest currently. We
also price our private finance investments for a total return
including interest or dividends plus gains from the sale of
equity securities.

For CMBS bonds, interest payments are made to
bondholders from the cash flow on the underlying collateral. To
the extent there are defaults and unrecoverable losses on the
underlying collateral resulting in reduced cash flows, the lower
rated tranches of the CMBS bonds in which we invest may not
receive current interest payments and, therefore, may become
delinquent. However, if the reduced cash flows resulting from
defaults or losses in the underlying collateral pool have been
factored into our yield on the bonds, we may continue to accrue
interest on the bonds to the extent that we expect to collect
such interest over time.

Given these factors, the amount of loans, debt
securities, or CMBS bonds on non-accrual status or greater than
90 days delinquent is not necessarily an indication of
future principal loss or loss of anticipated investment return.
Our portfolio grading system is used as a means to assess loss
of investment return or investment principal.

Accrued Interest and Dividends
Receivable

Accrued interest and dividends receivable as of
December 31, 2004 and 2003, was as follows:

|                               |                                     |              |      |      |      |   |      |      |      | 
|------------------------------ | ----------------------------------- | ------------ | ---- | ---- | ---- | - | ---- | ---- | ---- | 
|                               |                                     |             
|                               |                                     | December 31,
|                               |                                     |             
|                               |                                     | 2004         |      | 2003
|($ in millions)                |                                     |              |      |     
|Private finance                |                                     | $            | 59.8 |      |      | $ | 40.1 |     
|Commercial real estate finance |                                     |              |      |      |      |   |      |     
|                               | CMBS and CDO bonds                  |              |      | 18.9 |      |   |      | 12.1 |     
|                               | Commercial mortgage loans and other |              |      | 0.8  |      |   |      | 0.9  |     
|                               |                                     |              |      |      |      |   |      |     
|                               |                                     | Total        |      | $    | 79.5 |   |      | $    | 53.1 | 
|                               |                                     |              |      |      |      |   |      |     



---



##### 



RESULTS OF OPERATIONS

Comparison of the Years Ended
December 31, 2004, 2003, and 2002

The following table summarizes our operating
results for the years ended December 31, 2004, 2003, and
2002.

|                                                         |                                                           |                                             |         |         |         |        |         |         |         |      |        |        |        |        |    |         |    |   |         |         |         |   |         |         |         |   |        |         |         |   |     |     |     |   
|-------------------------------------------------------- | --------------------------------------------------------- | ------------------------------------------- | ------- | ------- | ------- | ------ | ------- | ------- | ------- | ---- | ------ | ------ | ------ | ------ | -- | ------- | -- | - | ------- | ------- | ------- | - | ------- | ------- | ------- | - | ------ | ------- | ------- | - | --- | --- | --- | --
|                                                         |                                                           |                                             |         |         |         |        |         | Percent |         |      |        |        |        |        |    | Percent
|                                                         |                                                           | 2004                                        |         | 2003    |         | Change |         | Change  |         | 2003 |        | 2002   |        | Change |    | Change 
|(in thousands, except per share amounts)                 |                                                           |                                             |         |         |         |        |         |         |         |      |        |        |        |        |    |        
|Interest and Related Portfolio
    Income                |                                                           |                                             |         |         |         |        |         |         |         |      |        |        |        |        |    |         |    |   |         |         |         |   |         |         |         |   |        |         |         |   |     |    
|                                                         | Interest and dividends                                    |                                             | $       | 319,642 |         |        | $       | 290,719 |         |      | $      | 28,923 |        |        |    | 10      | %  |   | $       | 290,719 |         |   | $       | 264,042 |         |   | $      | 26,677  |         |   |     | 10  | %  
|                                                         | Loan prepayment premiums                                  |                                             |         | 5,502   |         |        |         | 8,172   |         |      |        | (2,670 | )      |        |    | (33     | )% |   |         | 8,172   |         |   |         | 2,776   |         |   |        | 5,396   |         |   |     | 194 | %  
|                                                         | Fees and other income                                     |                                             |         | 41,946  |         |        |         | 30,338  |         |      |        | 11,608 |        |        |    | 38      | %  |   |         | 30,338  |         |   |         | 43,110  |         |   |        | (12,772 | )       |   |     | (30 | )% 
|                                                         |                                                           |                                             |         |         |         |        |         |         |         |      |        |        |        |        |    |         |    |   |         |         |         |   |         |         |         |   |        |         |         |   |     |    
|                                                         |                                                           | Total interest and related portfolio income |         |         | 367,090 |        |         |         | 329,229 |      |        |        | 37,861 |        |    |         | 11 | % |         |         | 329,229 |   |         |         | 309,928 |   |        |         | 19,301  |   |     |     | 6   | % 
|                                                         |                                                           |                                             |         |         |         |        |         |         |         |      |        |        |        |        |    |         |    |   |         |         |         |   |         |         |         |   |        |         |         |   |     |    
|Expenses                                                 |                                                           |                                             |         |         |         |        |         |         |         |      |        |        |        |        |    |         |    |   |         |         |         |   |         |         |         |   |        |         |         |   |     |    
|                                                         | Interest                                                  |                                             |         | 75,650  |         |        |         | 77,233  |         |      |        | (1,583 | )      |        |    | (2      | )% |   |         | 77,233  |         |   |         | 70,443  |         |   |        | 6,790   |         |   |     | 10  | %  
|                                                         | Employee(1)                                               |                                             |         | 40,728  |         |        |         | 36,945  |         |      |        | 3,783  |        |        |    | 10      | %  |   |         | 36,945  |         |   |         | 33,126  |         |   |        | 3,819   |         |   |     | 12  | %  
|                                                         | Individual performance award                              |                                             |         | 13,011  |         |        |         |        |         |      |        | 13,011 |        |        |    | **      |    |   |         |        |         |   |         |        |         |   |        |        |         |   |     |    |    
|                                                         | Administrative(1)                                         |                                             |         | 35,686  |         |        |         | 22,387  |         |      |        | 13,299 |        |        |    | 59      | %  |   |         | 22,387  |         |   |         | 21,504  |         |   |        | 883     |         |   |     | 4   | %  
|                                                         |                                                           |                                             |         |         |         |        |         |         |         |      |        |        |        |        |    |         |    |   |         |         |         |   |         |         |         |   |        |         |         |   |     |    
|                                                         |                                                           | Total operating expenses                    |         |         | 165,075 |        |         |         | 136,565 |      |        |        | 28,510 |        |    |         | 21 | % |         |         | 136,565 |   |         |         | 125,073 |   |        |         | 11,492  |   |     |     | 9   | % 
|                                                         |                                                           |                                             |         |         |         |        |         |         |         |      |        |        |        |        |    |         |    |   |         |         |         |   |         |         |         |   |        |         |         |   |     |    
|                                                         |                                                           | Net investment income before income taxes   |         |         | 202,015 |        |         |         | 192,664 |      |        |        | 9,351  |        |    |         | 5  | % |         |         | 192,664 |   |         |         | 184,855 |   |        |         | 7,809   |   |     |     | 4   | % 
|                                                         |                                                           | Income tax expense (benefit)                |         |         | 1,057   |        |         |         | (2,466  | )    |        |        | 3,523  |        |    |         | ** |   |         |         | (2,466  | ) |         |         | 930     |   |        |         | (3,396  | ) |     |     | **  |   
|                                                         |                                                           |                                             |         |         |         |        |         |         |         |      |        |        |        |        |    |         |    |   |         |         |         |   |         |         |         |   |        |         |         |   |     |    
|                                                         |                                                           | Net investment income                       |         |         | 200,958 |        |         |         | 195,130 |      |        |        | 5,828  |        |    |         | 3  | % |         |         | 195,130 |   |         |         | 183,925 |   |        |         | 11,205  |   |     |     | 6   | % 
|                                                         |                                                           |                                             |         |         |         |        |         |         |         |      |        |        |        |        |    |         |    |   |         |         |         |   |         |         |         |   |        |         |         |   |     |    
|Net Realized and Unrealized Gains
    (Losses)           |                                                           |                                             |         |         |         |        |         |         |         |      |        |        |        |        |    |         |    |   |         |         |         |   |         |         |         |   |        |         |         |   |     |    
|                                                         | Net realized gains                                        |                                             |         | 117,240 |         |        |         | 75,347  |         |      |        | 41,893 |        |        |    | 56      | %  |   |         | 75,347  |         |   |         | 44,937  |         |   |        | 30,410  |         |   |     | 68  | %  
|                                                         | Net change in unrealized appreciation or
    depreciation |                                             |         | (68,712 | )       |        |         | (78,466 | )       |      |        | 9,754  |        |        |    | *       |    |   |         | (78,466 | )       |   |         | (571    | )       |   |        | (77,895 | )       |   |     | *   |    
|                                                         |                                                           |                                             |         |         |         |        |         |         |         |      |        |        |        |        |    |         |    |   |         |         |         |   |         |         |         |   |        |         |         |   |     |    
|                                                         |                                                           | Total net gains (losses)                    |         |         | 48,528  |        |         |         | (3,119  | )    |        |        | 51,647 |        |    |         | *  |   |         |         | (3,119  | ) |         |         | 44,366  |   |        |         | (47,485 | ) |     |     | *   |   
|                                                         |                                                           |                                             |         |         |         |        |         |         |         |      |        |        |        |        |    |         |    |   |         |         |         |   |         |         |         |   |        |         |         |   |     |    
|                                                         |                                                           | Net income                                  |         | $       | 249,486 |        |         | $       | 192,011 |      |        | $      | 57,475 |        |    |         | 30 | % |         | $       | 192,011 |   |         | $       | 228,291 |   |        | $       | (36,280 | ) |     |     | (16 | )%
|                                                         |                                                           |                                             |         |         |         |        |         |         |         |      |        |        |        |        |    |         |    |   |         |         |         |   |         |         |         |   |        |         |         |   |     |    
|Diluted earnings per common share                        |                                                           | $                                           | 1.88    |         |         | $      | 1.62    |         |         | $    | 0.26   |        |        |        | 16 | %       |    | $ | 1.62    |         |         | $ | 2.20    |         |         | $ | (0.58  | )       |         |   | (26 | )% 
|                                                         |                                                           |                                             |         |         |         |        |         |         |         |      |        |        |        |        |    |         |    |   |         |         |         |   |         |         |         |   |        |         |         |   |     |    
|Weighted average common shares
    outstanding  diluted |                                                           |                                             | 132,458 |         |         |        | 118,351 |         |         |      | 14,107 |        |        |        | 12 | %       |    |   | 118,351 |         |         |   | 103,574 |         |         |   | 14,777 |         |         |   | 14  | %  



---

|    |                                                                                                                                                                                                                                                                  
|--- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(1) | Employee and administrative expenses for the year
    ended December 31, 2002, include costs associated with the
    closing of our German office of $0.5 million and
    $2.5 million, respectively, for a total of
    $3.0 million, or $0.03 per common share.



| |   |                                                                                                                                    
| | - | -----------------------------------------------------------------------------------------------------------------------------------
| | * | Net change in unrealized appreciation or
    depreciation and net gains (losses) can fluctuate significantly
    from year to year.



|   |                                     
|-- | ------------------------------------
|** | Percentage change is not meaningful.

Total Interest and Related Portfolio
Income.Total interest and related
portfolio income includes interest and dividend income, loan
prepayment premiums, and fees and other income.



---



##### 



Interest and dividend income for the years ended
December 31, 2004, 2003, and 2002, was composed of the
following:

|                |       |      |       |       |  |      |       |       |  |   |       |       | 
|--------------- | ----- | ---- | ----- | ----- |  | ---- | ----- | ----- |  | - | ----- | ----- | 
|($ in millions) |       | 2004 |       | 2003  |  | 2002
|                |       |      |       |       |  |     
|Interest        |       | $    | 301.0 |       |  | $    | 275.3 |       |  | $ | 259.4 |      
|Dividends       |       |      | 18.6  |       |  |      | 15.4  |       |  |   | 4.6   |      
|                |       |      |       |       |  |      |       |       |  |   |       |      
|                | Total |      | $     | 319.6 |  |      | $     | 290.7 |  |   | $     | 264.0 | 
|                |       |      |       |       |  |      |       |       |  |   |       |      

The level of interest income, which includes
interest paid in cash and in kind, is directly related to the
balance of the interest-bearing investment portfolio outstanding
during the period multiplied by the weighted average yield. The
weighted average yield varies from period to period based on the
current stated interest on interest-bearing investments and the
amount of loans and debt securities for which interest is not
accruing. The interest-bearing investments in the portfolio at
value and the weighted average yield on the interest-bearing
investments in the portfolio at December 31, 2004, 2003,
and 2002, were as follows:

|                           |  |      |         |      |  |      |         |   |  |   |         |  
|-------------------------- |  | ---- | ------- | ---- |  | ---- | ------- | - |  | - | ------- | -
|($ in millions)            |  | 2004 |         | 2003 |  | 2002
|                           |  |      |         |      |  |     
|Interest-bearing portfolio |  | $    | 2,301.2 |      |  | $    | 1,891.9 |   |  | $ | 1,896.2 |  
|Portfolio yield(1)         |  |      | 14.0    | %    |  |      | 14.7    | % |  |   | 14.0    | %

| | 
| | 
| | 



| |     |                                                                                        
| | --- | ---------------------------------------------------------------------------------------
| | (1) | See discussion on portfolio yields above under
    Portfolio and Investment Activity.

Dividend income results from the dividend yield
on preferred equity interests, if any, or the declaration of
dividends by a portfolio company on preferred or common equity
interests. Dividend income will vary from period to period
depending upon the level of yield on our preferred equity
interests and the timing and amount of dividends that are
declared by a portfolio company on preferred or common equity
interests. Dividend income increased in 2004 and 2003 primarily
due to the receipt of dividends from BLX on the Class B
equity interests held by us. The total dividend declared by BLX
was $14.8 million and $7.8 million for the years ended
December 31, 2004 and 2003, respectively, and these
dividends were paid through the issuance of additional
Class B equity interests.

Loan prepayment premiums were $5.5 million,
$8.2 million, and $2.8 million for the years ended
December 31, 2004, 2003, and 2002, respectively. While the
scheduled maturities of private finance and commercial real
estate loans range from five to ten years, it is not unusual for
our borrowers to refinance or pay off their debts to us ahead of
schedule. Therefore, we generally structure our loans to require
a prepayment premium for the first three to five years of the
loan. Accordingly, the amount of prepayment premiums will vary
depending on the level of repayments and the age of the loans at
the time of repayment. Prepayment premiums were higher in 2004
and 2003 as compared to 2002 as a result of an increase in loan
prepayments during the prepayment penalty period. Prepayment
premiums in 2004 were lower than in 2003 because the loans that
prepaid in 2004 generally had lower prepayment penalty
requirements than those that prepaid in 2003.

Fees and other income primarily include fees
related to financial structuring, diligence, transaction
services, management services to portfolio companies,
guarantees, and other advisory services. As a business
development company, we are required to make significant
managerial assistance available to the companies in our
investment portfolio. Managerial assistance includes management
and consulting services including, but not limited to,



---



##### 



corporate finance, information technology,
marketing, human resources, personnel and board member
recruiting, corporate governance, and risk management.


Fees and other income for the years ended
December 31, 2004, 2003, and 2002, included fees relating
to the following:

|                                                                                                   |       |      |      |      |  |      |      |      |  |   |      |      | 
|-------------------------------------------------------------------------------------------------- | ----- | ---- | ---- | ---- |  | ---- | ---- | ---- |  | - | ---- | ---- | 
|($ in millions)                                                                                    |       | 2004 |      | 2003 |  | 2002
|                                                                                                   |       |      |      |      |  |     
|Structuring and diligence                                                                          |       | $    | 18.4 |      |  | $    | 6.1  |      |  | $ | 15.0 |     
|Transaction and other services provided to
    portfolio companies                                 |       |      | 3.2  |      |  |      | 4.5  |      |  |   | 4.4  |     
|Management services provided to portfolio
    companies, other advisory services and guaranty fees |       |      | 17.4 |      |  |      | 18.7 |      |  |   | 23.2 |     
|Other income                                                                                       |       |      | 2.9  |      |  |      | 1.0  |      |  |   | 0.5  |     
|                                                                                                   |       |      |      |      |  |      |      |      |  |   |      |     
|                                                                                                   | Total |      | $    | 41.9 |  |      | $    | 30.3 |  |   | $    | 43.1 | 
|                                                                                                   |       |      |      |      |  |      |      |      |  |   |      |     

Fees and other income are generally related to
specific transactions or services and therefore may vary
substantially from year to year depending on the level and types
of services provided. Loan origination fees that represent yield
enhancement on a loan are capitalized and amortized into
interest income over the life of the loan. Fees and other income
for the year ended December 31, 2004, include structuring
fees related to the purchase of majority ownership in Advantage,
Financial Pacific, Mercury, and Insight totaling
$10.0 million.

BLX and Advantage were our largest investments at
December 31, 2004, and together represented 19.0% of our total
assets. Total interest and related portfolio income earned from
BLX and Advantage for the year ended December 31, 2004, was
$50.0 million and $21.3 million, respectively. Total interest
and related portfolio income for the year ended
December 31, 2004, included $2.5 million of income earned
from Hillman prior to the sale of our control investment on
March 31, 2004, as discussed above.

BLX and Hillman were our largest portfolio
investments at December 31, 2003 and 2002, and together
represented 19.1% and 15.6% of our total assets at
December 31, 2003 and 2002, respectively. Total interest
and related portfolio income earned from BLX for the years ended
December 31, 2003 and 2002, was $46.7 million and $40.2
million, respectively. Total interest and related portfolio
income earned from Hillman for the years ended December 31,
2003 and 2002, was $9.7 million and $9.3 million, respectively.

Operating Expenses.Operating expenses include
interest, employee, and administrative expenses. Our single
largest expense is interest on our indebtedness. The
fluctuations in interest expense during the years ended
December 31, 2004, 2003, and 2002, were primarily
attributable to changes in the level of our borrowings under
various notes payable and debentures and our revolving line of
credit. Our borrowing activity and weighted



---



##### 



average cost of debt, including fees and closing
costs, at and for the years ended December 31, 2004, 2003,
and 2002, were as follows:


|                                  |  |      |         |      |  |      |       |   |  |   |       |  
|--------------------------------- |  | ---- | ------- | ---- |  | ---- | ----- | - |  | - | ----- | -
|($ in millions)                   |  | 2004 |         | 2003 |  | 2002
|                                  |  |      |         |      |  |     
|Total outstanding debt            |  | $    | 1,176.6 |      |  | $    | 954.2 |   |  | $ | 998.5 |  
|Average outstanding debt          |  | $    | 985.6   |      |  | $    | 943.5 |   |  | $ | 938.1 |  
|Weighted average interest cost(1) |  |      | 6.6     | %    |  |      | 7.5   | % |  |   | 6.9   | %



---

| |     |                                                                                                                                                                                                                                                                                                                                                                  
| | --- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | (1) | The weighted average annual interest cost is
    computed as the (a) annual stated interest rate on the debt plus
    the annual amortization of commitment fees and other facility
    fees that are recognized into interest expense over the
    contractual life of the respective borrowings, divided by
    (b) debt outstanding on the balance sheet date.

In addition to interest on indebtedness, interest
expense includes interest on our obligations to replenish
borrowed Treasury securities related to our hedging activities
of $5.2 million, $5.9 million, and $1.7 million
for the years ended December 31, 2004, 2003, and 2002,
respectively.

Employee expenses include salaries and employee
benefits. The change in employee expense reflects the effect of
wage increases, increased staffing, and the change in mix of
employees given their area of responsibility and relevant
experience level. Total employees were 162, 125, and 105 at
December 31, 2004, 2003, and 2002, respectively. During
2003 and 2002, employee expenses included a retention award
program whereby senior officers received cash awards as part of
their compensation. The retention award component for the years
ended December 31, 2003 and 2002, was $8.6 million and
$7.9 million, respectively. Beginning January 1, 2004,
we no longer provided retention awards.

In the first quarter of 2004, we established the
Individual Performance Award (IPA) as a long-term incentive
compensation program for certain officers. In conjunction with
the program, the Board has approved a non-qualified deferred
compensation plan (DCP II), which is administered through a
trust by an independent third-party trustee.

The IPA, which will generally be determined
annually at the beginning of each year, is deposited in the
trust in four equal installments, generally on a quarterly
basis, in the form of cash. The Compensation Committee of the
Board of Directors designed the DCP II to require the
trustee to use the cash to purchase shares of our common stock
in the open market.

Amounts credited to participants under the
DCP II are immediately vested once deposited by us into the
trust. A participants account shall generally become
distributable only after his or her termination of employment,
or in the event of a change of control of the Company. The
Compensation Committee of the Board of Directors may also
determine other distributable events and the timing of such
distributions.

For the year ended December 31, 2004, we
accrued $13.4 million in IPA expense, or $0.10 per
share. We contributed these amounts into the DCP II trust
during the year. Because the IPA is deferred compensation, the
cost of this award is not a current expense for purposes of
computing our taxable income. The expense is deferred for tax
purposes until distributions are made from the trust. The
accounts of the DCP II are consolidated with our accounts.
Further, we are required to mark to market the liability to pay
the employees in our stock and this adjustment is recorded to
the IPA compensation expense. The effect of this adjustment for
the year ended December 31, 2004, was to reduce the
individual performance award expense by $0.4 million. The
Compensation Committee and



---



##### 



the Board of Directors have determined the IPA
for 2005 and it is currently expected to be approximately $7.5
million.


As a result of recent changes in regulation by
the Jobs Creation Act of 2004 associated with deferred
compensation arrangements, as well as an increase in the
competitive market for recruiting top performers in private
equity firms, the Compensation Committee and the Board of
Directors have determined for 2005 that a portion of the IPA
should be replaced with an individual performance bonus (IPB).
The IPB for 2005 has been determined to be approximately
$7.5 million, and will be distributed in cash to award
recipients in equal bi-weekly installments as long as the
recipient remains employed by us. If a recipient terminates
employment during the year, any remaining cash payments under
the IPB would be forfeited.

The total of the IPA and IPB for 2005 is
currently estimated to be $15.0 million. These amounts are
subject to change if there is a change in the composition of the
pool of award recipients during the year.

Administrative expenses include legal and
accounting fees, valuation assistance fees, insurance premiums,
the cost of leases for our headquarters in Washington, DC,
and our regional offices, stock record expenses, directors
fees, and various other expenses. Administrative expenses have
increased to $35.7 million for the year ended
December 31, 2004. This is a $13.3 million increase
over administrative expenses of $22.4 million for the year
ended December 31, 2003.

The largest component of the increase in expenses
resulted from a net increase in legal, accounting, consulting,
and other fees for 2004 as compared to 2003 of
$4.9 million. This increase is primarily attributable to
fees associated with the implementation of the requirements
under the Sarbanes-Oxley Act of 2002 (including Section 404),
the response to requests for information from regulatory and
other government agencies, valuation assistance and other
corporate matters.

Legal fees totaled $4.6 million for 2004 as
compared to $1.4 million for 2003. We expect that legal
expenses will continue to increase substantially in the near
term as the result of ongoing requests for documents and
information from regulatory and other government agencies
related to ongoing investigations. As a result, we expect that
total administrative expenses will also increase in 2005 as
compared to 2004.

We have also incurred increased deal costs in
2004 related to evaluating potential new investments. Costs
related to mezzanine lending are generally paid by the borrower,
however, costs related to buyout investments are generally
funded by us. Accordingly, if a prospective deal does not close,
we incur expenses that are not recoverable. As a result, these
related costs were $1.6 million higher for 2004 than for
the prior year. We have increased our focus on managing
buyout-related costs, however, we expect that there will be some
increased costs from this activity going forward. In addition,
expenses related to portfolio development and workout activities
were $1.5 million higher for 2004 versus the prior year. We
expect the costs related to workouts to decline given the
decline in workout assets in the portfolio.

The remaining increase in administrative expenses
for 2004 over 2003 was primarily due to increased rent of
$1.4 million associated with the opening of an office in
Los Angeles, CA and expanding our office space in Chicago, IL
and New York, NY, increased other corporate expenses, including
stock record expense, insurance premiums and



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##### 



directors fees, of $1.1 million, the
incurrence of $1.0 million in excise tax related to excess
taxable income carried forward into 2005, and increased travel
expenses of $0.8 million.


Administrative expenses were $22.4 million
for 2003, a $0.9 million increase over administrative
expenses of $21.5 million for 2002. Excluding costs
associated with closing the Germany office in 2002 totaling
$2.5 million, administrative expenses for 2003 increased by
$3.4 million over 2002. The net increase in legal,
accounting, consulting and other fees for 2003 as compared to
2002 was $0.8 million. Fees related to market activity in
our stock were substantially lower in 2003 as compared to 2002,
however, the level of professional fees incurred in 2003 still
increased over 2002 as we incurred significant legal,
accounting, consulting and other fees in 2003 related to the
implementation of the requirements under the Sarbanes-Oxley Act
of 2002. The remaining increase in administrative expenses for
2003 over 2002 was primarily due to increased costs associated
with corporate liability insurance of $1.4 million, travel
costs of $0.6 million, and directors fees of
$0.5 million.

Income Tax Expense (Benefit).Our wholly owned subsidiary, AC
Corp, is a corporation subject to federal and state income taxes
and records an expense or benefit for income taxes as
appropriate. For the years ended December 31, 2004 and
2002, we recorded tax expense of $1.1 million and
$0.9 million, respectively, primarily as a result of
AC Corps operating income for the periods. For the
year ended December 31, 2003, we recorded a tax benefit of
$2.5 million as a result of AC Corps operating
loss for the period.

Realized Gains and Losses.Net realized gains primarily
result from the sale of equity securities associated with
certain private finance investments, the sale of CMBS bonds and
CDO bonds and preferred shares, and the realization of
unamortized discount resulting from the sale and early repayment
of private finance loans and commercial mortgage loans, offset
by losses on investments. Net realized gains and losses for the
years ended December 31, 2004, 2003, and 2002, were as
follows:

|                |                    |      |        |       |  |      |       |      |  |   |       |      | 
|--------------- | ------------------ | ---- | ------ | ----- |  | ---- | ----- | ---- |  | - | ----- | ---- | 
|($ in millions) |                    | 2004 |        | 2003  |  | 2002
|                |                    |      |        |       |  |     
|Realized gains  |                    | $    | 267.7  |       |  | $    | 94.3  |      |  | $ | 95.5  |     
|Realized losses |                    |      | (150.5 | )     |  |      | (19.0 | )    |  |   | (50.6 | )   
|                |                    |      |        |       |  |      |       |      |  |   |       |     
|                | Net realized gains |      | $      | 117.2 |  |      | $     | 75.3 |  |   | $     | 44.9 | 
|                |                    |      |        |       |  |      |       |      |  |   |       |     

When we exit an investment and realize a gain or
loss, we make an accounting entry to reverse any unrealized
appreciation or depreciation, respectively, we had previously
recorded to reflect the appreciated or depreciated value of the
investment. For the years ended December 31, 2004, 2003,
and 2002, we reversed previously recorded unrealized
appreciation or depreciation when gains or losses were realized
as follows:

|                                                                                            |                |      |        |       |   |      |       |       |   |   |       |       |  
|------------------------------------------------------------------------------------------- | -------------- | ---- | ------ | ----- | - | ---- | ----- | ----- | - | - | ----- | ----- | -
|($ in millions)                                                                             |                | 2004 |        | 2003  |   | 2002
|                                                                                            |                |      |        |       |   |     
|Reversal of previously recorded unrealized
    appreciation associated with realized gains  |                | $    | (210.5 | )     |   | $    | (78.5 | )     |   | $ | (78.8 | )    
|Reversal of previously recorded unrealized
    depreciation associated with realized losses |                |      | 151.8  |       |   |      | 20.3  |       |   |   | 49.0  |      
|                                                                                            |                |      |        |       |   |      |       |       |   |   |       |      
|                                                                                            | Total reversal |      | $      | (58.7 | ) |      | $     | (58.2 | ) |   | $     | (29.8 | )
|                                                                                            |                |      |        |       |   |      |       |       |   |   |       |      

Realized gains and losses for the years ended
December 31, 2004, 2003, and 2002, resulted from various
private finance and commercial real estate finance transactions.



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Realized gains for the year ended
December 31, 2004, primarily resulted from transactions
involving 13 private finance portfolio companies  The
Hillman Companies, Inc. ($150.3 million), CorrFlex
Graphics, LLC ($25.7 million), Professional Paint, Inc.
($13.7 million), Impact Innovations Group, LLC
($9.4 million), The Hartz Mountain Corporation
($8.3 million), Housecall Medical Resources, Inc.
($7.2 million), International Fiber Corporation
($5.2 million), CBA-Mezzanine Capital Finance, LLC
($4.1 million), United Pet Group, Inc. ($3.8 million),
Oahu Waste Services, Inc. ($2.8 million), Grant
Broadcasting Systems II ($2.7 million), Matrics, Inc.
($2.1 million), and SmartMail, LLC ($2.1 million), and
one transaction involving a commercial mortgage loan
($1.8 million). In addition, gains were also realized on
CMBS bonds ($17.4 million, net of a net realized loss of
$3.8 million from hedges related to the CMBS bonds sold).

Realized gains for the year ended
December 31, 2003, primarily resulted from transactions
involving 11 private finance portfolio companies, including Blue
Rhino Corporation ($12.6 million), CyberRep
($9.6 million), Morton Grove Pharmaceuticals, Inc.
($8.5 million), Warn Industries, Inc. ($8.0 million),
Woodstream Corporation ($6.6 million), Kirklands Inc.
($3.0 million), Julius Koch USA, Inc. ($2.8 million),
GC-Sun Holdings II, LP ($2.5 million), Interline
Brands, Inc. ($1.7 million), WyoTech Acquisition
Corporation ($1.3 million), and Advantage Mayer, Inc.
($1.2 million). In addition, gains were also realized on
CMBS bonds ($31.6 million, net of a net realized loss of
$2.9 million from hedges related to the CMBS bonds sold)
and commercial real estate investments ($1.7 million).

Realized gains for the year ended
December 31, 2002, primarily resulted from transactions
involving eight private finance portfolio companies, including
WyoTech Acquisition Corporation ($60.8 million), Aurora
Communications, LLC ($4.9 million), Oriental Trading
Company, Inc. ($2.5 million), Kirklands, Inc.
($2.2 million), American Home Care Supply, LLC
($1.3 million), Autania AG ($0.8 million), FTI Consulting,
Inc. ($0.7 million), and Cumulus Media, Inc.
($0.5 million). In addition, gains were also realized on
CMBS bonds ($19.1 million, net of a realized loss of
$0.5 million from a hedge related to the CMBS bonds sold),
and one commercial real estate investment ($1.3 million).
The sale of WyoTech in 2002 was subject to post-closing
adjustments, and during 2003, we recognized an additional
realized gain of $1.3 million related to post-closing items.

Realized losses for the year ended
December 31, 2004, primarily resulted from transactions
involving 13 private finance portfolio companies 
American Healthcare Services, Inc. ($32.9 million), The
Color Factory, Inc. ($24.5 million), Executive Greetings,
Inc. ($19.3 million), Sydran Food Services II, L.P.
($18.2 million), Ace Products, Inc. ($17.6 million),
Prosperco Finanz Holding AG ($7.5 million), Logic Bay
Corporation ($5.0 million), Sun States Refrigerated
Services, Inc. ($4.7 million), Chickasaw Sales &
Marketing, Inc. ($3.8 million), Sure-Tel, Inc.
($2.3 million), Liberty-Pittsburgh Systems, Inc.
($2.0 million), EDM Consulting, LLC
($1.9 million), and Startec Global Communications
Corporation ($1.1 million), and two transactions involving
commercial mortgage loans ($2.1 million).

Realized losses for the year ended
December 31, 2003, primarily resulted from transactions
involving three private finance portfolio companies, including
Allied Office Products, Inc. ($7.7 million), Candlewood
Hotel Company ($2.7 million), and North American Archery,
LLC ($2.1 million), and eight transactions involving
commercial mortgage loans ($5.9 million).



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Realized losses for the year ended
December 31, 2002, primarily resulted from transactions
involving 11 private finance portfolio companies, including
Velocita, Inc. ($16.0 million), Schwinn Holdings
Corporation ($7.9 million), Convenience Corporation of
America ($5.8 million), Startec Global Communications
Corporation ($4.5 million), The Loewen Group, Inc. ($2.7
million), Monitoring Solutions, Inc. ($1.7 million), Most
Confiserie ($1.0 million), NetCare AG ($1.0 million),
iSolve Incorporated ($0.9 million), Sure-Tel, Inc.
($0.5 million), and Soff-Cut Holdings, Inc.
($0.5 million), and also from nine commercial real estate
investments ($4.7 million).

Change in Unrealized Appreciation or
Depreciation.We determine the
value of each investment in our portfolio on a quarterly basis,
and changes in value result in unrealized appreciation or
depreciation being recognized in our statement of operations.
Value, as defined in Section 2(a)(41) of the Investment
Company Act of 1940, is (i) the market price for those
securities for which a market quotation is readily available and
(ii) for all other securities and assets, fair value is as
determined in good faith by the Board of Directors. Since there
is typically no readily available market value for the
investments in our portfolio, we value substantially all of our
portfolio investments at fair value as determined in good faith
by the Board of Directors pursuant to a valuation policy and a
consistently applied valuation process. At December 31,
2004, portfolio investments recorded at fair value were
approximately 92% of our total assets. Because of the inherent
uncertainty of determining the fair value of investments that do
not have a readily available market value, the fair value of our
investments determined in good faith by the Board of Directors
may differ significantly from the values that would have been
used had a ready market existed for the investments, and the
differences could be material.

There is no single standard for determining fair
value in good faith. As a result, determining fair value
requires that judgment be applied to the specific facts and
circumstances of each portfolio investment while employing a
consistently applied valuation process for the types of
investments we make. Unlike banks, we are not permitted to
provide a general reserve for anticipated loan losses. Instead,
we are required to specifically value each individual investment
on a quarterly basis. We will record unrealized depreciation on
investments when we believe that an investment has become
impaired, including where collection of a loan or realization of
an equity security is doubtful, or when the enterprise value of
the portfolio company does not currently support the cost of our
debt or equity investment. Enterprise value means the entire
value of the company to a potential buyer, including the sum of
the values of debt and equity securities used to capitalize the
enterprise at a point in time. We will record unrealized
appreciation if we believe that the underlying portfolio company
has appreciated in value and, therefore, our equity security has
also appreciated in value. Changes in fair value are recorded in
the statement of operations as net change in unrealized
appreciation or depreciation.

As a business development company, we invest in
illiquid securities including debt and equity securities of
companies, non-investment grade CMBS bonds, and CDO bonds and
preferred shares. The structure of each private finance debt and
equity security is specifically negotiated to enable us to
protect our investment and maximize our returns. We include many
terms governing interest rate, repayment terms, prepayment
penalties, financial covenants, operating covenants, ownership
parameters, dilution parameters, liquidation preferences, voting
rights, and put or call rights. Our investments are generally
subject to restrictions on resale and generally have no
established trading market. Because of the type of investments
that we make and the nature of our business, our valuation
process requires an analysis of various factors. Our fair value
methodology includes the



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examination of, among other things, the
underlying investment performance, financial condition, and
market changing events that impact valuation.


Valuation Methodology  Private
Finance.Our process for determining
the fair value of a private finance investment begins with
determining the enterprise value of the portfolio company. The
fair value of our investment is based on the enterprise value at
which the portfolio company could be sold in an orderly
disposition over a reasonable period of time between willing
parties other than in a forced or liquidation sale. The
liquidity event whereby we exit a private finance investment is
generally the sale, the recapitalization or, in some cases, the
initial public offering of the portfolio company.

There is no one methodology to determine
enterprise value and, in fact, for any one portfolio company,
enterprise value is best expressed as a range of fair values,
from which we derive a single estimate of enterprise value. To
determine the enterprise value of a portfolio company, we
analyze its historical and projected financial results. We
generally require portfolio companies to provide annual audited
and quarterly unaudited financial statements, as well as annual
projections for the upcoming fiscal year. Typically in the
private equity business, companies are bought and sold based on
multiples of EBITDA, cash flow, net income, revenues or, in
limited instances, book value. The private equity industry uses
financial measures such as EBITDA or EBITDAM (Earnings Before
Interest, Taxes, Depreciation, Amortization and, in some
instances, Management fees) in order to assess a portfolio
companys financial performance and to value a portfolio
company. EBITDA and EBITDAM are not intended to represent cash
flow from operations as defined by U.S. generally accepted
accounting principles and such information should not be
considered as an alternative to net income, cash flow from
operations, or any other measure of performance prescribed by
U.S. generally accepted accounting principles. When using EBITDA
to determine enterprise value, we may adjust EBITDA for
non-recurring items. Such adjustments are intended to normalize
EBITDA to reflect the portfolio companys earnings power.
Adjustments to EBITDA may include compensation to previous
owners, acquisition, recapitalization, or restructuring related
items or one-time non-recurring income or expense items.

In determining a multiple to use for valuation
purposes, we generally look to private merger and acquisition
statistics, discounted public trading multiples or industry
practices. In estimating a reasonable multiple, we consider not
only the fact that our portfolio company may be a private
company relative to a peer group of public comparables, but we
also consider the size and scope of our portfolio company and
its specific strengths and weaknesses. In some cases, the best
valuation methodology may be a discounted cash flow analysis
based on future projections. If a portfolio company is
distressed, a liquidation analysis may provide the best
indication of enterprise value.

If there is adequate enterprise value to support
the repayment of our debt, the fair value of our loan or debt
security normally corresponds to cost unless the borrowers
condition or other factors lead to a determination of fair value
at a different amount. The fair value of equity interests in
portfolio companies is determined based on various factors,
including the enterprise value remaining for equity holders
after the repayment of the portfolio companys debt and
other preference capital, and other pertinent factors such as
recent offers to purchase a portfolio company, recent
transactions involving the purchase or sale of the portfolio
companys equity securities, or other liquidation events.
The determined equity values are generally discounted when we
have a minority position, restrictions on resale, specific
concerns about the receptivity of the capital markets to a
specific company at a certain time, or other factors.



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In connection with our valuation process to
determine the fair value of a private finance investment, we
work with independent third-party consultants to obtain
assistance and advice as additional support in the preparation
of our internal valuation analysis for a portion of the
portfolio each quarter (for all investments with a cost or value
greater than $250,000). In addition, we may receive independent
assessments of a particular private finance portfolio
companys value in the ordinary course of business, most
often in the context of a prospective sale transaction or in the
context of a bankruptcy process. The valuation analysis prepared
by management using these independent valuation resources is
submitted to our Board of Directors for its determination of
fair value of the portfolio in good faith.

We received quarterly valuation assistance from
S&P Corporate Value Consulting (S&P CVC) during 2004,
including assistance with the valuation of Business Loan Express
(BLX) in the third and fourth quarters of 2004. For the full
year, S&P CVC has assisted us with the valuation of
104 portfolio companies. S&P CVC has assisted us in
valuing all of the portfolio company investments that were in
our portfolio at December 31, 2003, and were still in the
portfolio at December 31, 2004. In addition, S&P CVC
has assisted us in valuing 11 portfolio company investments
that were added to the portfolio during 2004, including
Advantage Sales & Marketing, Inc.

Valuation Methodology  CMBS Bonds
and CDO Bonds and Preferred Shares.CMBS bonds and CDO bonds and preferred
shares are carried at fair value, which is based on a discounted
cash flow model that utilizes prepayment and loss assumptions
based on historical experience and projected performance,
economic factors, the characteristics of the underlying cash
flow and comparable yields for similar CMBS bonds and CDO bonds
and preferred shares. Our assumption with regard to discount
rate may be based on the yield of comparable securities, when
available. We recognize unrealized appreciation or depreciation
on our CMBS bonds and CDO bonds and preferred shares as
comparable yields in the market change and/or based on changes
in estimated cash flows resulting from changes in prepayment or
loss assumptions in the underlying collateral pool. As each CMBS
bond ages, the expected amount of losses and the expected timing
of recognition of such losses in the underlying collateral pool
is updated and the revised cash flows are used in determining
the fair value of the bonds. We have determined the fair value
of our CMBS bonds and CDO bonds and preferred shares on an
individual security-by-security basis. If we were to sell a
group of these investments in a pool in one or more
transactions, the total value received for that pool may be
different than the sum of the fair values of the individual
bonds or preferred shares.

Net Change in Unrealized Appreciation or
Depreciation.For the portfolio, net
change in unrealized appreciation or depreciation for the years
ended December 31, 2004, 2003, and 2002, consisted of the
following:

|                                                                                            |                                                           |      |        |       |   |      |       |       |   |   |       |      |  
|------------------------------------------------------------------------------------------- | --------------------------------------------------------- | ---- | ------ | ----- | - | ---- | ----- | ----- | - | - | ----- | ---- | -
|                                                                                            |                                                           | 2004 |        | 2003  |   | 2002
|($ in millions)                                                                             |                                                           |      |        |       |   |     
|Net unrealized appreciation or depreciation                                                 |                                                           | $    | (10.0  | )     |   | $    | (20.3 | )     |   | $ | 29.2  |     
|Reversal of previously recorded unrealized
    appreciation associated with realized gains  |                                                           |      | (210.5 | )     |   |      | (78.5 | )     |   |   | (78.8 | )   
|Reversal of previously recorded unrealized
    depreciation associated with realized losses |                                                           |      | 151.8  |       |   |      | 20.3  |       |   |   | 49.0  |     
|                                                                                            |                                                           |      |        |       |   |      |       |       |   |   |       |     
|                                                                                            | Net change in unrealized appreciation or
    depreciation |      | $      | (68.7 | ) |      | $     | (78.5 | ) |   | $     | (0.6 | )
|                                                                                            |                                                           |      |        |       |   |      |       |       |   |   |       |     



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For the year ended December 31, 2004, our two
most significant changes in net unrealized appreciation were in
BLX and Advantage. The following is a summary of the methodology
that we used to determine the fair value of these investments.

Business Loan Express, LLC.To determine the value of our
investment in BLX at December 31, 2004, we performed four
separate valuation analyses to determine a range of values:
(1) analysis of comparable public company trading
multiples, (2) analysis of BLXs value assuming an
initial public offering, (3) analysis of merger and
acquisition transactions for financial services companies, and
(4) a discounted dividend analysis. We performed the
analyses with the assistance of JMP Securities. In addition, we
received valuation assistance from S&P CVC for our
investment in BLX at December 31, 2004.

With respect to the analysis of comparable public
company trading multiples and the analysis of BLXs value
assuming an initial public offering, we compute a median
trailing and forward price earnings multiple to apply to
BLXs pro-forma net income adjusted for certain capital
structure changes that we believe would likely occur should the
company be sold. Each quarter we evaluate which public
commercial finance companies should be included in the
comparable group. The comparable group at December 31,
2004, was made up of CapitalSource, Inc., CIT Group, Inc.,
Financial Federal Corporation, GATX Corporation, and Marlin
Business Services Corporation, which is consistent with the
comparable group at December 31, 2003.

Our investment in BLX at December 31, 2004,
was valued at $335.2 million. This fair value was within
the range of values determined by the four valuation analyses.
Unrealized appreciation on our investment was $54.8 million
at December 31, 2004. This is a decrease in unrealized
appreciation of $32.3 million from December 31, 2003.

Advantage Sales & Marketing, Inc.S&P CVC assisted us with the
valuation of our investment in Advantage at December 31,
2004. We determined the enterprise value of Advantage by using
their trailing twelve month normalized EBITDA times a multiple.
The multiple we used was consistent with our entry multiple when
we acquired Advantage in June 2004. Using this enterprise
value, we determined the value of our investments in Advantage
to be $283.0 million, resulting in unrealized appreciation
of $24.3 million.

OTHER MATTERS

Per Share Amounts.All per share amounts included in
the Managements Discussion and Analysis of Financial
Condition and Results of Operations section have been computed
using the weighted average shares used to compute diluted
earnings per share, which were 132.5 million,
118.4 million, and 103.6 million for the years ended
December 31, 2004, 2003, and 2002, respectively.

Regulated Investment Company Status.We have elected to be taxed as a
regulated investment company under Subchapter M of the
Internal Revenue Code of 1986, otherwise referred to as the
Code. As long as we qualify as a regulated investment company,
we are not taxed on our investment company taxable income or
realized net capital gains, to the extent that such taxable
income or gains are distributed, or deemed to be distributed, to
shareholders on a timely basis.

Taxable income generally differs from net income
for financial reporting purposes due to temporary and permanent
differences in the recognition of income and expenses, and
generally excludes net unrealized appreciation or depreciation,
as gains or losses are not included in taxable income until they
are realized. In addition, gains realized for financial



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reporting purposes may differ from gains included
in taxable income as a result of our election to recognize gains
using installment sale treatment, which results in the
deferrment of gains for tax purposes until notes received as
consideration from the sale of investments are collected in cash.


Dividends declared and paid by the Company in a
year generally differ from taxable income for that year as such
dividends may include the distribution of current year taxable
income, the distribution of prior year taxable income carried
forward into and distributed in the current year, or returns of
capital. We are generally required to distribute 98% of our
taxable income during the year the income is earned to avoid
paying an excise tax. If this requirement is not met, the Code
imposes a nondeductible excise tax equal to 4% of the amount by
which 98% of the current years taxable income exceeds the
distribution for the year. The taxable income on which an excise
tax is paid is generally carried forward and distributed to
shareholders in the next tax year. Depending on the level of
taxable income earned in a tax year, we may choose to carry
forward taxable income in excess of current year distributions
into the next tax year and pay a 4% excise tax on such
income, as required.

In order to maintain our status as a regulated
investment company, we must, in general, (1) continue to
qualify as a business development company; (2) derive at
least 90% of our gross income from dividends, interest, gains
from the sale of securities and other specified types of income;
(3) meet asset diversification requirements as defined in
the Code; and (4) timely distribute to shareholders at
least 90% of our annual investment company taxable income as
defined in the Code. We intend to take all steps necessary to
continue to qualify as a regulated investment company. However,
there can be no assurance that we will continue to qualify for
such treatment in future years.

Legal Proceedings.On June 23, 2004, we were notified
by the SEC that they are conducting an informal investigation of
us. On December 22, 2004, we received letters from the
U.S. Attorney for the District of Columbia requesting the
preservation and production of information regarding us and
Business Loan Express, LLC in connection with a criminal
investigation. Based on the information available to us at this
time, the inquiries appear to pertain to matters related to
portfolio valuation and our portfolio company, Business Loan
Express, LLC. We are cooperating with the SECs and the
U.S. Attorneys investigations.

In addition to the above matters, we are party to
certain lawsuits in the normal course of business.

While the outcome of these legal proceedings and
other matters cannot at this time be predicted with certainty,
we do not expect that these matters will have a material effect
upon our financial condition or results of operations.

FINANCIAL CONDITION, LIQUIDITY AND CAPITAL
RESOURCES

Cash Flow From Operating Activities

Our portfolio has historically generated
significant cash flow from which we pay dividends to
shareholders and fund new investment activity. Cash generated
from the portfolio includes cash flow from net investment income
and net realized gains and principal collections related to
investment repayments or sales. Cash flow provided by our



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operating activities before new investment
activity for the years ended December 31, 2004, 2003, and
2002, was as follows:


|                                                        |                                                                        |                     |         |         |  |      |       |         |  |   |       |       | 
|------------------------------------------------------- | ---------------------------------------------------------------------- | ------------------- | ------- | ------- |  | ---- | ----- | ------- |  | - | ----- | ----- | 
|                                                        |                                                                        |                    
|                                                        |                                                                        | For the Years Ended
|                                                        |                                                                        | December 31,       
|                                                        |                                                                        |                    
|($ in millions)                                         |                                                                        | 2004                |         | 2003    |  | 2002
|                                                        |                                                                        |                     |         |         |  |     
|Net cash provided by (used in)
    operating activities |                                                                        | $                   | (179.3  | )       |  | $    | 80.3  |         |  | $ | 65.3  |      
|Add: portfolio investments funded                       |                                                                        |                     | 1,472.4 |         |  |      | 930.6 |         |  |   | 506.4 |      
|                                                        |                                                                        |                     |         |         |  |      |       |         |  |   |       |      
|                                                        | Total cash provided by operating activities
    before new investments |                     | $       | 1,293.1 |  |      | $     | 1,010.9 |  |   | $     | 571.7 | 
|                                                        |                                                                        |                     |         |         |  |      |       |         |  |   |       |      

Because of the significant amount of cash
provided by operating activities before new investments, we
generate sufficient cash flow to fund our operating activities
as well as pay dividends to shareholders.

Dividends to common shareholders for the years
ended December 31, 2004, 2003, and 2002, were
$299.3 million, $267.8 million, and
$229.9 million, respectively. Total regular quarterly
dividends were $2.28, $2.28, and $2.20 per common share for the
years ended December 31, 2004, 2003, and 2002,
respectively. An extra cash dividend of $0.02 and $0.03 per
common share was declared during 2004 and 2002, respectively,
and was paid to shareholders on January 28, 2005, and
January 9, 2003, respectively.

Dividends are generally determined based upon an
estimate of annual taxable income, which includes our taxable
interest, dividend and fee income, as well as taxable net
capital gains. As discussed above, taxable income generally
differs from net income for financial reporting purposes due to
temporary and permanent differences in the recognition of income
and expenses, and generally excludes net unrealized appreciation
or depreciation, as gains or losses are not included in taxable
income until they are realized. Taxable income includes non-cash
income, such as changes in accrued and reinvested interest and
dividends and the amortization of discounts and fees. Cash
collections of income resulting from contractual payment-in-kind
interest or the amortization of discounts and fees generally
occur upon the repayment of the loans or debt securities that
include such items. Non-cash taxable income is reduced by
non-cash expenses, such as realized losses and depreciation and
amortization expense.

Our Board of Directors evaluates whether to
retain or distribute taxable net capital gains on an annual
basis. Our dividend policy allows us to continue to distribute
capital gains, but would also allow us to retain gains to
support future growth. Our Board of Directors reviews the
dividend rate quarterly, and may adjust the quarterly dividend
throughout the year.

At December 31, 2004, we had outstanding
commitments to fund investments totaling $330.2 million. We
intend to fund these commitments and prospective investment
opportunities with existing cash, through cash flow from
operations before new investments, through borrowings under our
line of credit or other long-term debt agreements, or through
the sale or issuance of new equity capital.



---



##### 



Debt and Equity Capital

Because we are a regulated investment company, we
distribute our taxable income and, therefore, require external
capital for asset growth. As a result, from time to time we will
raise growth capital in the form of new debt or equity capital.

At December 31, 2004, 2003, and 2002, our
total assets, total debt outstanding, total shareholders
equity, debt to equity ratio and asset coverage for senior
indebtedness were as follows:

|                           |  |              |         |      |  |      |         |   |  |   |         |  
|-------------------------- |  | ------------ | ------- | ---- |  | ---- | ------- | - |  | - | ------- | -
|                           |  |             
|                           |  | December 31,
|                           |  |             
|($ in millions)            |  | 2004         |         | 2003 |  | 2002
|                           |  |              |         |      |  |     
|Total assets               |  | $            | 3,261.0 |      |  | $    | 3,019.9 |   |  | $ | 2,794.3 |  
|Total debt outstanding     |  | $            | 1,176.6 |      |  | $    | 954.2   |   |  | $ | 998.5   |  
|Total shareholders equity |  | $            | 1,979.8 |      |  | $    | 1,914.6 |   |  | $ | 1,546.1 |  
|Debt to equity ratio       |  |              | 0.59    |      |  |      | 0.50    |   |  |   | 0.65    |  
|Asset coverage ratio(1)    |  |              | 280     | %    |  |      | 322     | % |  |   | 270     | %



---

|    |                                                                                                                                              
|--- | ---------------------------------------------------------------------------------------------------------------------------------------------
|(1) | As a business development company, we are
    generally required to maintain a minimum ratio of 200% of total
    assets to total borrowings.

We currently target a debt to equity ratio
ranging between 0.50:1.00 to 0.65:1.00. During 2003, we
intentionally deleveraged the balance sheet to move the leverage
ratio to the lower end of the target debt to equity ratio range
and have remained within the range during 2004. We recently have
been through a period of economic uncertainty, and we believed
that it was prudent to operate with a larger equity capital base
and less leverage. For the years ended December 31, 2004,
2003, and 2002, we raised equity of $73.5 million,
$422.9 million, and $172.8 million, respectively,
including $86.5 million raised through a non-transferable
rights offering during 2002. In addition, shareholders
equity increased by $51.3 million, $21.2 million, and
$22.1 million through the exercise of employee options, the
collection of notes receivable from the sale of common stock,
and the issuance of shares through our dividend reinvestment
plan for the years ended December 31, 2004, 2003, and 2002,
respectively.

We employ an asset-liability management strategy
that focuses on matching the estimated maturities of our loan
and investment portfolio to the estimated maturities of our
borrowings. We use our revolving line of credit facility as a
means to bridge to long-term financing in the form of debt or
equity capital, which may or may not result in temporary
differences in the matching of estimated maturities.
Availability on the revolving line of credit, net of amounts
committed for standby letters of credit issued under the line of
credit facility, was $396.4 million on December 31,
2004. We evaluate our interest rate exposure on an ongoing
basis. Generally, we seek to fund our primarily fixed-rate
investment portfolio with fixed-rate debt or equity capital. To
the extent deemed necessary, we may hedge variable and
short-term interest rate exposure through interest rate swaps or
other techniques.



---



##### 



At December 31, 2004 and 2003, we had
outstanding debt as follows:

|                              |                         |                                    |       |                   |         |          |       |          |         |             |     |          |     |       |       |       |         |  |   |       |       |  |   |     |     |      
|----------------------------- | ----------------------- | ---------------------------------- | ----- | ----------------- | ------- | -------- | ----- | -------- | ------- | ----------- | --- | -------- | --- | ----- | ----- | ----- | ------- |  | - | ----- | ----- |  | - | --- | --- | -----
|                              |                         |                                    |       |                  
|                              |                         | December 31, 2004                  |       | December 31, 2003
|                              |                         |                                    |       |                  
|                              |                         |                                    |       | Annual            |         |          |       | Annual  
|                              |                         | Facility                           |       | Amount            |         | Interest |       | Facility |         | Amount      |     | Interest
|($ in millions)               |                         | Amount                             |       | Outstanding       |         | Cost(1)  |       | Amount   |         | Outstanding |     | Cost(1) 
|                              |                         |                                    |       |                   |         |          |       |          |         |             |     |         
|Notes payable and debentures: |                         |                                    |       |                   |         |          |       |          |         |             |     |          |     |       |       |       |         |  |   |       |       |  |   |    
|                              | Unsecured notes payable |                                    | $     | 981.4             |         |          | $     | 981.4    |         |             |     | 6.5      | %   |       | $     | 854.0 |         |  | $ | 854.0 |       |  |   | 7.2 | %  
|                              | SBA debentures          |                                    |       | 84.8              |         |          |       | 77.5     |         |             |     | 8.2      | %   |       |       | 101.8 |         |  |   | 94.5  |       |  |   | 8.1 | %  
|                              | OPIC loan               |                                    |       | 5.7               |         |          |       | 5.7      |         |             |     | 6.6      | %   |       |       | 5.7   |         |  |   | 5.7   |       |  |   | 6.6 | %  
|                              |                         |                                    |       |                   |         |          |       |          |         |             |     |          |     |       |       |       |         |  |   |       |       |  |   |    
|                              |                         | Total notes payable and debentures |       |                   | 1,071.9 |          |       |          | 1,064.6 |             |     |          | 6.6 | %     |       |       | 961.5   |  |   |       | 954.2 |  |   |     | 7.3 | %    
|Revolving line of credit      |                         |                                    | 552.5 |                   |         |          | 112.0 |          |         |             | 6.3 | % (2)    |     |       | 532.5 |       |         |  |  |       |       |  |  | (2)
|                              |                         |                                    |       |                   |         |          |       |          |         |             |     |          |     |       |       |       |         |  |   |       |       |  |   |    
|                              |                         | Total debt                         |       | $                 | 1,624.4 |          |       | $        | 1,176.6 |             |     |          | 6.6 | % (2) |       | $     | 1,494.0 |  |   | $     | 954.2 |  |   |     | 7.5 | % (2)
|                              |                         |                                    |       |                   |         |          |       |          |         |             |     |          |     |       |       |       |         |  |   |       |       |  |   |    



---

|    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
|--- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(1) | The weighted average annual interest cost is
    computed as the (a) annual stated interest on the debt plus
    the annual amortization of commitment fees and other facility
    fees that are recognized into interest expense over the
    contractual life of the respective borrowings, divided by
    (b) debt outstanding on the balance sheet date.                                                                                                                                                                                                                                                                                                                          
|   
|(2) | The current interest rate payable on the
    revolving line of credit was 4.7% at December 31, 2004,
    which excluded the annual cost of commitment fees and other
    facility fees of $1.8 million. There were no amounts drawn
    on the revolving line of credit at December 31, 2003. The
    annual cost of commitment fees and other facility fees on the
    revolving line of credit was $2.7 million at
    December 31, 2003. The annual interest cost for total debt
    includes the annual cost of commitment fees and other facility
    fees on the revolving line of credit regardless of the amount
    outstanding on the facility as of the balance sheet date.

Unsecured Notes Payable.We have issued long-term debt to
institutional lenders, primarily insurance companies. The notes
have five- or seven-year maturities, with maturity dates
beginning in 2005 and generally have fixed rates of interest.
The notes generally require payment of interest only
semi-annually, and all principal is due upon maturity.

On March 25, 2004, we issued five-year
unsecured long-term notes denominated in Euros and Sterling for
a total U.S. dollar equivalent of $15.2 million. The notes
have fixed interest rates and have substantially the same terms
as our existing unsecured notes. Simultaneous with issuing the
notes, we entered into a cross-currency swap with a financial
institution which fixed our interest and principal payments in
U.S. dollars for the life of the debt.

On April 30, 2004, we repaid $112.0 million
of unsecured notes payable that matured on May 1, 2004.

On November 15, 2004, we issued
$252.5 million of five-year and $72.5 million of
seven-year unsecured long-term notes, primarily to insurance
companies. The five- and seven-year notes have fixed interest
rates of 5.53% and 5.99%, respectively, and have substantially
the same terms as our existing unsecured long-term notes. We
used a portion of the proceeds from the new long-term note
issuance to repay $102.0 million of our existing unsecured
long-term notes that matured on November 15, 2004, with an
interest cost of 8.5%.

Small Business Administration Debentures.We, through our small business
investment company subsidiary, have debentures payable to the
Small Business Administration with contractual maturities of ten
years. The notes require payment of interest only semi-annually,
and all principal is due upon maturity. During 2004, we repaid
$17.0 million of this outstanding debt. Under the small
business investment company program, we may borrow up to
$119.0 million from the Small Business Administration. At
December 31, 2004, we had a commitment from the Small
Business Administration to borrow up to an



---



##### 



additional $7.3 million above the current
amount outstanding. The commitment expires on September 30,
2005.


Revolving Line of Credit.We have an unsecured revolving
line of credit with a committed amount of $552.5 million.
The line of credit may be expanded through new or additional
commitments up to $600.0 million at our option. The credit
facility generally bears interest at a rate, at our option,
equal to (i) the one-month LIBOR plus 1.50%, (ii) the
Bank of America, N.A. cost of funds plus 1.50% or (iii) the
higher of the Bank of America, N.A. prime rate or the Federal
Funds rate plus 0.50%. The line of credit generally requires
monthly payments of interest, and all principal is due upon
maturity. The revolving line of credit expires in April 2005,
with the right to extend the maturity for one additional year at
our option under substantially similar terms. We plan to
exercise our option to extend the maturity to April 2006, which
will require the payment of an extension fee of 0.3% on existing
commitments. The interest rate on outstanding borrowings will
increase by 0.5% during the extension period.

Outstanding borrowings on the unsecured revolving
line of credit at December 31, 2004, were
$112.0 million. The amount available under the line at
December 31, 2004, was $396.4 million, net of amounts
committed for standby letters of credit of $44.1 million.
Net borrowings under the revolving line of credit for the year
ended December 31, 2004, were $112.0 million.

We have various financial and operating covenants
required by the revolving line of credit and notes payable and
debentures. These covenants require us to maintain certain
financial ratios, including debt to equity and interest
coverage, and a minimum net worth. Our credit facilities limit
our ability to declare dividends if we default under certain
provisions. As of December 31, 2004, we were in compliance
with these covenants.

The following table shows our significant
contractual obligations for the repayment of debt and payment of
other contractual obligations as of December 31, 2004.

|                              |                         |                               |       |                      |         |       |     |       |       |      |       |       |       |      |     |   |     |  |     |       |       |  |     |       |       |  |      |       |       | 
|----------------------------- | ----------------------- | ----------------------------- | ----- | -------------------- | ------- | ----- | --- | ----- | ----- | ---- | ----- | ----- | ----- | ---- | --- | - | --- |  | --- | ----- | ----- |  | --- | ----- | ----- |  | ---- | ----- | ----- | 
|                              |                         |                               |       |                     
|                              |                         |                               |       | Payments Due By Year
|                              |                         |                               |       |                     
|                              |                         |                               |       |                      |         | After
|                              |                         | Total                         |       | 2005                 |         | 2006  |     | 2007  |       | 2008 |       | 2009  |       | 2009
|($ in millions)               |                         |                               |       |                      |         |       |     |       |       |      |       |       |       |     
|Notes payable and debentures: |                         |                               |       |                      |         |       |     |       |       |      |       |       |       |      |     |   |     |  |     |       |       |  |     |       |       |  |      |      
|                              | Unsecured notes payable |                               | $     | 981.4                |         |       | $   | 165.0 |       |      | $     | 175.0 |       |      | $   |  |     |  | $   | 153.0 |       |  | $   | 268.9 |       |  | $    | 219.5 |      
|                              | SBA debentures          |                               |       | 77.5                 |         |       |     | 4.0   |       |      |       |      |       |      |     |  |     |  |     |      |       |  |     |      |       |  |      | 73.5  |      
|                              | OPIC loan               |                               |       | 5.7                  |         |       |     |      |       |      |       | 5.7   |       |      |     |  |     |  |     |      |       |  |     |      |       |  |      |      |      
|Revolving line of credit(1)   |                         |                               | 112.0 |                      |         |       |    |       |       |      | 112.0 |       |       |      |    |   |     |  |    |       |       |  |    |       |       |  |     |      
|Operating leases              |                         |                               | 33.5  |                      |         |       | 4.6 |       |       |      | 4.5   |       |       |      | 4.4 |   |     |  | 4.4 |       |       |  | 4.6 |       |       |  | 11.0 |      
|                              |                         |                               |       |                      |         |       |     |       |       |      |       |       |       |      |     |   |     |  |     |       |       |  |     |       |       |  |      |      
|                              |                         | Total contractual obligations |       | $                    | 1,210.1 |       |     | $     | 173.6 |      |       | $     | 297.2 |      |     | $ | 4.4 |  |     | $     | 157.4 |  |     | $     | 273.5 |  |      | $     | 304.0 | 
|                              |                         |                               |       |                      |         |       |     |       |       |      |       |       |       |      |     |   |     |  |     |       |       |  |     |       |       |  |      |      



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|    |                                                                                                                                                                                                                                                                                                                           
|--- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(1) | As discussed above, we plan to exercise our
    option to extend the maturity of the revolving line of credit to
    April 2006. At December 31, 2004, $396.4 million
    remained unused and available, net of amounts committed for
    standby letters of credit of $44.1 million issued under the
    credit facility.



---



##### 



The following table shows our contractual
commitments that may have the effect of creating, increasing, or
accelerating our liabilities as of December 31, 2004.

|                             |                   |       |       |                                          |  |       |     |      |  |      |      |      |  |      |      |      |  |   |     |     |  |   |     |     |  |   |     |     | 
|---------------------------- | ----------------- | ----- | ----- | ---------------------------------------- |  | ----- | --- | ---- |  | ---- | ---- | ---- |  | ---- | ---- | ---- |  | - | --- | --- |  | - | --- | --- |  | - | --- | --- | 
|                             |                   |       |       |                                         
|                             |                   |       |       | Amount of Commitment Expiration Per Year
|                             |                   |       |       |                                         
|                             |                   |       |       |                                          |  | After
|                             |                   | Total |       | 2005                                     |  | 2006  |     | 2007 |  | 2008 |      | 2009 |  | 2009
|($ in millions)              |                   |       |       |                                          |  |       |     |      |  |      |      |      |  |     
|Guarantees                   |                   | $     | 100.2 |                                          |  | $     | 0.6 |      |  | $    | 1.1  |      |  | $    | 94.8 |      |  | $ | 0.1 |     |  | $ | 2.5 |     |  | $ | 1.1 |    
|Standby letters of credit(1) |                   |       | 44.1  |                                          |  |       |    |      |  |      | 44.1 |      |  |      |     |      |  |   |    |     |  |   |    |     |  |   |    |    
|                             |                   |       |       |                                          |  |       |     |      |  |      |      |      |  |      |      |      |  |   |     |     |  |   |     |     |  |   |     |    
|                             | Total commitments |       | $     | 144.3                                    |  |       | $   | 0.6  |  |      | $    | 45.2 |  |      | $    | 94.8 |  |   | $   | 0.1 |  |   | $   | 2.5 |  |   | $   | 1.1 | 
|                             |                   |       |       |                                          |  |       |     |      |  |      |      |      |  |      |      |      |  |   |     |     |  |   |     |     |  |   |     |    



---

|    |                                                                                                                                                                                                                                                                                                                                                                                                                                                      
|--- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(1) | Standby letters of credit are issued under our
    revolving line of credit. As discussed above, we plan to
    exercise our option to extend the maturity of the revolving line
    of credit to April 2006. Therefore, unless a standby letter
    of credit is set to expire at an earlier date, we have assumed
    that the standby letters of credit will expire contemporaneously
    with the expiration of our line of credit in April 2006.

In addition, we had outstanding commitments to
fund investments totaling $330.2 million at
December 31, 2004, as discussed above.

CRITICAL ACCOUNTING POLICIES

The consolidated financial statements are based
on the selection and application of critical accounting
policies, which require management to make significant estimates
and assumptions. Critical accounting policies are those that are
both important to the presentation of our financial condition
and results of operations and require managements most
difficult, complex, or subjective judgments. Our critical
accounting policies are those applicable to the valuation of
investments and certain revenue recognition matters as discussed
below.

Valuation of Portfolio
Investments.As a business development company, we
invest in illiquid securities including debt and equity
securities of companies, non-investment grade CMBS, and the
bonds and preferred shares of CDOs. Our investments are
generally subject to restrictions on resale and generally have
no established trading market. We value substantially all of our
investments at fair value as determined in good faith by the
Board of Directors in accordance with our valuation policy. We
determine fair value to be the amount for which an investment
could be exchanged in an orderly disposition over a reasonable
period of time between willing parties other than in a forced or
liquidation sale. Our valuation policy considers the fact that
no ready market exists for substantially all of the securities
in which we invest. Our valuation policy is intended to provide
a consistent basis for determining the fair value of the
portfolio. We will record unrealized depreciation on investments
when we believe that an investment has become impaired,
including where collection of a loan or realization of an equity
security is doubtful, or when the enterprise value of the
portfolio company does not currently support the cost of our
debt or equity investments. Enterprise value means the entire
value of the company to a potential buyer, including the sum of
the values of debt and equity securities used to capitalize the
enterprise at a point in time. We will record unrealized
appreciation if we believe that the underlying portfolio company
has appreciated in value and, therefore, our equity security has
also appreciated in value. The value of investments in publicly
traded securities is determined using quoted market prices
discounted for restrictions on resale, if any.

Loans and Debt Securities.For loans and debt securities, fair value generally
approximates cost unless the borrowers enterprise value,
overall financial condition or other factors lead to a
determination of fair value at a different amount.

When we receive nominal cost warrants or free
equity securities (nominal cost equity), we allocate
our cost basis in our investment between debt securities and
nominal



---



##### 



cost equity at the time of origination. At that
time, the original issue discount basis of the nominal cost
equity is recorded by increasing the cost basis in the equity
and decreasing the cost basis in the related debt securities.


Interest income is recorded on an accrual basis
to the extent that such amounts are expected to be collected.
For loans and debt securities with contractual payment-in-kind
interest, which represents contractual interest accrued and
added to the loan balance that generally becomes due at
maturity, we will not accrue payment-in-kind interest if the
portfolio company valuation indicates that the payment-in-kind
interest is not collectible. Interest on loans and debt
securities is not accrued if we have doubt about interest
collection. Loans in workout status that are classified as
Grade 4 or 5 assets under our internal grading system
do not accrue interest. In addition, interest may not accrue on
loans or debt securities to portfolio companies that are more
than 50% owned by us depending on such companys capital
requirements. Loan origination fees, original issue discount,
and market discount are capitalized and then amortized into
interest income using the effective interest method. Upon the
prepayment of a loan or debt security, any unamortized loan
origination fees are recorded as interest income and any
unamortized original issue discount or market discount is
recorded as a realized gain. Prepayment premiums are recorded on
loans and debt securities when received.

Equity Securities.Our
equity interests in portfolio companies for which there is no
liquid public market are valued at fair value based on the
enterprise value of the portfolio company, which is determined
using various factors, including cash flow from operations of
the portfolio company and other pertinent factors, such as
recent offers to purchase a portfolio company, recent
transactions involving the purchase or sale of the portfolio
companys equity securities, or other liquidation events.
The determined equity values are generally discounted to account
for restrictions on resale and minority ownership positions.

The value of our equity interests in public
companies for which market quotations are readily available is
based on the closing public market price on the balance sheet
date. Securities that carry certain restrictions on sale are
typically valued at a discount from the public market value of
the security.

Dividend income is recorded on preferred equity
securities on an accrual basis to the extent that such amounts
are expected to be collected, and on common equity securities on
the record date for private companies or on the ex-dividend date
for publicly traded companies.

Commercial Mortgage-Backed Securities
(CMBS) and Collateralized Debt Obligations (CDO).CMBS bonds and CDO bonds and
preferred shares are carried at fair value, which is based on a
discounted cash flow model that utilizes prepayment and loss
assumptions based on historical experience and projected
performance, economic factors, the characteristics of the
underlying cash flow, and comparable yields for similar CMBS
bonds and CDO bonds and preferred shares, when available. We
recognize unrealized appreciation or depreciation on our CMBS
bonds and CDO bonds and preferred shares as comparable yields in
the market change and/or based on changes in estimated cash
flows resulting from changes in prepayment or loss assumptions
in the underlying collateral pool.

We recognize income from the amortization of
original issue discount using the effective interest method,
using the anticipated yield over the projected life of the
investment. Yields are revised when there are changes in actual
and estimated prepayment speeds or actual and estimated credit
losses. Changes in estimated yield are recognized as an
adjustment to the estimated yield over the remaining life of the
CMBS bonds and CDO bonds and preferred shares from the date the
estimated yield is changed.



---



##### 



Net Realized Gains or Losses and Net Change
in Unrealized Appreciation or Depreciation.Realized gains or losses are
measured by the difference between the net proceeds from the
repayment or sale and the cost basis of the investment without
regard to unrealized appreciation or depreciation previously
recognized, and include investments charged off during the year,
net of recoveries. Net change in unrealized appreciation or
depreciation reflects the change in portfolio investment values
during the reporting period, including the reversal of
previously recorded unrealized appreciation or depreciation when
gains or losses are realized.

Fee Income.Fee income includes fees for
guarantees and services rendered by us to portfolio companies
and other third parties such as diligence, structuring,
transaction services, management services, and other advisory
services. Guaranty fees are recognized as income over the
related period of the guaranty. Diligence, structuring, and
transaction services fees are generally recognized as income
when services are rendered or when the related transactions are
completed. Management and other advisory services fees are
generally recognized as income as the services are rendered.



---



##### 



MANAGEMENTS REPORT ON INTERNAL
CONTROL

OVER FINANCIAL REPORTING


The management of Allied Capital Corporation and
subsidiaries (the Company) is responsible for establishing and
maintaining adequate internal control over financial reporting,
as such term is defined in Exchange Act Rules 13a-15(f).
Under the supervision and with the participation of management,
including the Chief Executive Officer and Chief Financial
Officer, the Company conducted an evaluation of the
effectiveness of the Companys internal control over
financial reporting based on the criteria established in
Internal Control  Integrated Frameworkissued
by the Committee of Sponsoring Organizations of the Treadway
Commission (COSO). Based on the Companys evaluation under
the framework in Internal Control  Integrated
Framework, management concluded that the Companys
internal control over financial reporting was effective as of
December 31, 2004. Managements assessment of the
effectiveness of the Companys internal control over
financial reporting as of December 31, 2004, has been
audited by KPMG LLP, an independent registered public accounting
firm, as stated in its report which is included herein.



---



##### 



Report of Independent Registered Public
Accounting Firm

The Board of Directors and Stockholders

Allied Capital Corporation:


We have audited managements assessment,
included in the accompanying managements report on
internal control over financial reporting, that Allied Capital
Corporation and subsidiaries (the Company) maintained effective
internal control over financial reporting as of
December 31, 2004, based on criteria established in
Internal Control  Integrated Frameworkissued
by the Committee of Sponsoring Organizations of the Treadway
Commission (COSO). Allied Capital Corporations management
is responsible for maintaining effective internal control over
financial reporting and for its assessment of the effectiveness
of internal control over financial reporting. Our responsibility
is to express an opinion on managements assessment and an
opinion on the effectiveness of the Companys internal
control over financial reporting based on our audit.

We conducted our audit in accordance with the
standards of the Public Company Accounting Oversight Board
(United States). Those standards require that we plan and
perform the audit to obtain reasonable assurance about whether
effective internal control over financial reporting was
maintained in all material respects. Our audit included
obtaining an understanding of internal control over financial
reporting, evaluating managements assessment, testing and
evaluating the design and operating effectiveness of internal
control, and performing such other procedures as we considered
necessary in the circumstances. We believe that our audit
provides a reasonable basis for our opinion.

A companys internal control over financial
reporting is a process designed to provide reasonable assurance
regarding the reliability of financial reporting and the
preparation of financial statements for external purposes in
accordance with generally accepted accounting principles. A
companys internal control over financial reporting
includes those policies and procedures that (1) pertain to
the maintenance of records that, in reasonable detail,
accurately and fairly reflect the transactions and dispositions
of the assets of the company; (2) provide reasonable
assurance that transactions are recorded as necessary to permit
preparation of financial statements in accordance with generally
accepted accounting principles, and that receipts and
expenditures of the company are being made only in accordance
with authorizations of management and directors of the company;
and (3) provide reasonable assurance regarding prevention
or timely detection of unauthorized acquisition, use, or
disposition of the companys assets that could have a
material effect on the financial statements.

Because of its inherent limitations, internal
control over financial reporting may not prevent or detect
misstatements. Also, projections of any evaluation of
effectiveness to future periods are subject to the risk that
controls may become inadequate because of changes in conditions,
or that the degree of compliance with the policies or procedures
may deteriorate.

In our opinion, managements assessment that
Allied Capital Corporation maintained effective internal control
over financial reporting as of December 31, 2004, is fairly
stated, in all material respects, based on criteria established
in Internal Control  Integrated Framework
issued by the Committee of Sponsoring Organizations of the
Treadway Commission (COSO). Also, in our opinion, Allied Capital
Corporation maintained, in all material respects, effective
internal control over financial reporting as of
December 31, 2004, based on criteria established in
Internal Control  Integrated Framework issued
by the Committee of Sponsoring Organizations of the Treadway
Commission (COSO).

We also have audited, in accordance with the
standards of the Public Company Accounting Oversight Board
(United States), the consolidated balance sheet of Allied
Capital Corporation and subsidiaries as of December 31,
2004 and 2003, including the consolidated statement of
investments as of December 31, 2004, and the related
consolidated statements of operations, changes in net assets and
cash flows, and the financial highlights (included in
Note 15), for each of the years in the three-year period
ended December 31, 2004, and our report dated
March 14, 2005, expressed an unqualified opinion on those
consolidated financial statements.

(KPMG LLP LOGO)

Washington, D.C.

March 14, 2005




---



##### 



Report of Independent Registered Public
Accounting Firm

The Board of Directors and Shareholders 
 Allied Capital Corporation:

We have audited the accompanying consolidated
balance sheet of Allied Capital Corporation and subsidiaries as
of December 31, 2004 and 2003, including the consolidated
statement of investments as of December 31, 2004, and the
related consolidated statements of operations, changes in net
assets and cash flows, and the financial highlights (included in
Note 15), for each of the years in the three-year period
ended December 31, 2004. These consolidated financial
statements and financial highlights are the responsibility of
the Companys management. Our responsibility is to express
an opinion on these consolidated financial statements and
financial highlights based on our audits.

We conducted our audits in accordance with the
standards of the Public Company Accounting Oversight Board
(United States). Those standards require that we plan and
perform the audit to obtain reasonable assurance about whether
the financial statements and financial highlights are free of
material misstatement. An audit includes examining, on a test
basis, evidence supporting the amounts and disclosures in the
financial statements. Our procedures included physical counts of
securities owned as of December 31, 2004 and 2003. An audit
also includes assessing the accounting principles used and
significant estimates made by management, as well as evaluating
the overall financial statement presentation. We believe that
our audits provide a reasonable basis for our opinion.

In our opinion, the consolidated financial
statements and financial highlights referred to above present
fairly, in all material respects, the financial position of
Allied Capital Corporation and subsidiaries as of
December 31, 2004 and 2003, and the results of their
operations, their cash flows, changes in their net assets, and
financial highlights for each of the years in the three-year
period ended December 31, 2004, in conformity with U.S.
generally accepted accounting principles.

Our audits were made for the purpose of forming
an opinion on the consolidated financial statements taken as a
whole. The consolidating balance sheet and related consolidating
statements of operations and cash flows are presented for
purposes of additional analysis of the consolidated financial
statements rather than to present the financial position,
results of operations, and cash flows of the individual
companies. The consolidating information has been subjected to
the auditing procedures applied in the audits of the
consolidated financial statements and, in our opinion, is fairly
stated in all material respects in relation to the consolidated
financial statements taken as a whole.

We also have audited, in accordance with the
standards of the Public Company Accounting Oversight Board
(United States), the effectiveness of Allied Capital
Corporations internal control over financial reporting as
of December 31, 2004, based on criteria established in
Internal Control  Integrated Frameworkissued
by the Committee of Sponsoring Organizations of the Treadway
Commission (COSO), and our report dated March 14, 2005,
expressed an unqualified opinion on managements assessment
of, and the effective operation of, internal control over
financial reporting.

(KPMG LLP LOGO)

Washington, D.C.

March 14, 2005




---



##### 



ALLIED CAPITAL CORPORATION AND
SUBSIDIARIES

CONSOLIDATED BALANCE SHEET

|                                                                    |                                                                                                                                                                               |                                                                          |                                                                       |           |           |           |         |           |         |           | 
|------------------------------------------------------------------- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------- | ------------------------------------------------------------------------ | --------------------------------------------------------------------- | --------- | --------- | --------- | ------- | --------- | ------- | --------- | 
|                                                                    |                                                                                                                                                                               |                                                                         
|                                                                    |                                                                                                                                                                               | December 31,                                                            
|                                                                    |                                                                                                                                                                               |                                                                         
|                                                                    |                                                                                                                                                                               | 2004                                                                     |                                                                       | 2003     
|(in thousands, except share and per share amounts)                  |                                                                                                                                                                               |                                                                          |                                                                       |          
|ASSETS                                                             
|Portfolio at value:                                                 |                                                                                                                                                                               |                                                                          |                                                                       |           |           |           |         |          
|                                                                    | Private finance                                                                                                                                                               |                                                                          |                                                                       |           |           |           |         |           |        
|                                                                    |                                                                                                                                                                               | Companies more than 25% owned (cost:
    2004-$1,389,342; 2003-$755,024) |                                                                       | $         | 1,359,641 |           |         | $         | 900,317 |          
|                                                                    |                                                                                                                                                                               | Companies 5% to 25% owned (cost: 2004-$194,750;
    2003-$195,600)       |                                                                       |           | 188,902   |           |         |           | 218,305 |          
|                                                                    |                                                                                                                                                                               | Companies less than 5% owned (cost:
    2004-$800,828; 2003-$955,507)    |                                                                       |           | 753,543   |           |         |           | 784,050 |          
|                                                                    |                                                                                                                                                                               |                                                                          |                                                                       |           |           |           |         |          
|                                                                    |                                                                                                                                                                               |                                                                          | Total private finance (cost: 2004-$2,384,920;
    2003-$1,906,131)    |           |           | 2,302,086 |         |           |         | 1,902,672 | 
|                                                                    | Commercial real estate finance (cost:
    2004-$722,612; 2003-$694,929)                                                                                                       |                                                                          |                                                                       | 711,325   |           |           |         | 681,927   |        
|                                                                    |                                                                                                                                                                               |                                                                          |                                                                       |           |           |           |         |          
|                                                                    |                                                                                                                                                                               |                                                                          | Total portfolio at value (cost: 2004-$3,107,532;
    2003-$2,601,060) |           |           | 3,013,411 |         |           |         | 2,584,599 | 
|                                                                    |                                                                                                                                                                               |                                                                          |                                                                       |           |           |           |         |          
|Deposits of proceeds from sales of borrowed
    Treasury securities |                                                                                                                                                                               |                                                                          | 38,226                                                                |           |           |           | 98,527  |          
|Accrued interest and dividends receivable                           |                                                                                                                                                                               |                                                                          | 79,489                                                                |           |           |           | 53,079  |          
|Other assets                                                        |                                                                                                                                                                               |                                                                          | 72,712                                                                |           |           |           | 69,498  |          
|Cash and cash equivalents                                           |                                                                                                                                                                               |                                                                          | 57,160                                                                |           |           |           | 214,167 |          
|                                                                    |                                                                                                                                                                               |                                                                          |                                                                       |           |           |           |         |          
|                                                                    |                                                                                                                                                                               |                                                                          | Total assets                                                          |           | $         | 3,260,998 |         |           | $       | 3,019,870 | 
|                                                                    |                                                                                                                                                                               |                                                                          |                                                                       |           |           |           |         |          
|LIABILITIES AND SHAREHOLDERS
    EQUITY                           
|Liabilities:                                                        |                                                                                                                                                                               |                                                                          |                                                                       |           |           |           |         |          
|                                                                    | Notes payable and debentures (maturing within one
    year: 2004-$169,000; 2003-$221,000)                                                                                     |                                                                          | $                                                                     | 1,064,568 |           |           | $       | 954,200   |        
|                                                                    | Revolving line of credit                                                                                                                                                      |                                                                          |                                                                       | 112,000   |           |           |         |          |        
|                                                                    | Obligations to replenish borrowed Treasury
    securities                                                                                                                     |                                                                          |                                                                       | 38,226    |           |           |         | 98,525    |        
|                                                                    | Accounts payable and other liabilities                                                                                                                                        |                                                                          |                                                                       | 66,426    |           |           |         | 46,568    |        
|                                                                    |                                                                                                                                                                               |                                                                          |                                                                       |           |           |           |         |          
|                                                                    |                                                                                                                                                                               |                                                                          | Total liabilities                                                     |           |           | 1,281,220 |         |           |         | 1,099,293 | 
|                                                                    |                                                                                                                                                                               |                                                                          |                                                                       |           |           |           |         |          
|Commitments and contingencies                                       |                                                                                                                                                                               |                                                                          |                                                                       |           |           |           |         |          
|Preferred stock                                                     |                                                                                                                                                                               |                                                                          |                                                                      |           |           |           | 6,000   |          
|Shareholders equity:                                               |                                                                                                                                                                               |                                                                          |                                                                       |           |           |           |         |          
|                                                                    | Common stock, $0.0001 par value, 200,000,000
    shares authorized; 133,098,807 and 128,117,985 shares issued and
    outstanding at December 31, 2004 and 2003, respectively |                                                                          |                                                                       | 13        |           |           |         | 13        |        
|                                                                    | Additional paid-in capital                                                                                                                                                    |                                                                          |                                                                       | 2,094,421 |           |           |         | 1,985,652 |        
|                                                                    | Common stock held in deferred compensation trust                                                                                                                              |                                                                          |                                                                       | (13,503   | )         |           |         |          |        
|                                                                    | Notes receivable from sale of common stock                                                                                                                                    |                                                                          |                                                                       | (5,470    | )         |           |         | (18,632   | )      
|                                                                    | Net unrealized appreciation (depreciation) on
    portfolio                                                                                                                   |                                                                          |                                                                       | (107,767  | )         |           |         | (39,055   | )      
|                                                                    | Undistributed (distributions in excess of)
    earnings                                                                                                                       |                                                                          |                                                                       | 12,084    |           |           |         | (13,401   | )      
|                                                                    |                                                                                                                                                                               |                                                                          |                                                                       |           |           |           |         |          
|                                                                    |                                                                                                                                                                               |                                                                          | Total shareholders equity                                            |           |           | 1,979,778 |         |           |         | 1,914,577 | 
|                                                                    |                                                                                                                                                                               |                                                                          |                                                                       |           |           |           |         |          
|                                                                    |                                                                                                                                                                               |                                                                          | Total liabilities and shareholders equity                            |           | $         | 3,260,998 |         |           | $       | 3,019,870 | 
|                                                                    |                                                                                                                                                                               |                                                                          |                                                                       |           |           |           |         |          
|Net asset value per common share                                    |                                                                                                                                                                               | $                                                                        | 14.87                                                                 |           |           | $         | 14.94   |          
|                                                                    |                                                                                                                                                                               |                                                                          |                                                                       |           |           |           |         |          

The accompanying notes are an integral part of
these consolidated financial statements.



---



##### 



ALLIED CAPITAL CORPORATION AND
SUBSIDIARIES

CONSOLIDATED STATEMENT OF OPERATIONS

|                                                         |                                                           |                               |                                             |         |         |         |         |         |         |         |         |        |         |         | 
|-------------------------------------------------------- | --------------------------------------------------------- | ----------------------------- | ------------------------------------------- | ------- | ------- | ------- | ------- | ------- | ------- | ------- | ------- | ------ | ------- | ------- | 
|                                                         |                                                           |                              
|                                                         |                                                           | For the Years Ended          
|                                                         |                                                           | December 31,                 
|                                                         |                                                           |                              
|                                                         |                                                           | 2004                          |                                             | 2003    |         | 2002   
|(in thousands, except per share amounts)                 |                                                           |                               |                                             |         |         |        
|Interest and Related Portfolio Income:                   |                                                           |                               |                                             |         |         |         |         |         |         |         |         |       
|                                                         | Interest and dividends                                    |                               |                                             |         |         |         |         |         |         |         |         |        |        
|                                                         |                                                           | Companies more than 25% owned |                                             | $       | 91,710  |         |         | $       | 62,563  |         |         | $      | 40,185  |        
|                                                         |                                                           | Companies 5% to 25% owned     |                                             |         | 25,702  |         |         |         | 25,727  |         |         |        | 28,629  |        
|                                                         |                                                           | Companies less than 5% owned  |                                             |         | 202,230 |         |         |         | 202,429 |         |         |        | 195,228 |        
|                                                         |                                                           |                               |                                             |         |         |         |         |         |         |         |         |       
|                                                         |                                                           |                               | Total interest and dividends                |         |         | 319,642 |         |         |         | 290,719 |         |        |         | 264,042 | 
|                                                         | Loan prepayment premiums                                  |                               |                                             |         |         |         |         |         |         |         |         |        |        
|                                                         |                                                           | Companies more than 25% owned |                                             |         |        |         |         |         | 141     |         |         |        |        |        
|                                                         |                                                           | Companies 5% to 25% owned     |                                             |         | 765     |         |         |         | 685     |         |         |        | 200     |        
|                                                         |                                                           | Companies less than 5% owned  |                                             |         | 4,737   |         |         |         | 7,346   |         |         |        | 2,576   |        
|                                                         |                                                           |                               |                                             |         |         |         |         |         |         |         |         |       
|                                                         |                                                           |                               | Total loan prepayment premiums              |         |         | 5,502   |         |         |         | 8,172   |         |        |         | 2,776   | 
|                                                         | Fees and other income                                     |                               |                                             |         |         |         |         |         |         |         |         |        |        
|                                                         |                                                           | Companies more than 25% owned |                                             |         | 29,774  |         |         |         | 18,862  |         |         |        | 25,344  |        
|                                                         |                                                           | Companies 5% to 25% owned     |                                             |         | 1,618   |         |         |         | 629     |         |         |        | 1,123   |        
|                                                         |                                                           | Companies less than 5% owned  |                                             |         | 10,554  |         |         |         | 10,847  |         |         |        | 16,643  |        
|                                                         |                                                           |                               |                                             |         |         |         |         |         |         |         |         |       
|                                                         |                                                           |                               | Total fees and other income                 |         |         | 41,946  |         |         |         | 30,338  |         |        |         | 43,110  | 
|                                                         |                                                           |                               |                                             |         |         |         |         |         |         |         |         |       
|                                                         |                                                           |                               | Total interest and related portfolio income |         |         | 367,090 |         |         |         | 329,229 |         |        |         | 309,928 | 
|                                                         |                                                           |                               |                                             |         |         |         |         |         |         |         |         |       
|Expenses:                                                |                                                           |                               |                                             |         |         |         |         |         |         |         |         |       
|                                                         | Interest                                                  |                               |                                             | 75,650  |         |         |         | 77,233  |         |         |         | 70,443 |        
|                                                         | Employee                                                  |                               |                                             | 40,728  |         |         |         | 36,945  |         |         |         | 33,126 |        
|                                                         | Individual performance award                              |                               |                                             | 13,011  |         |         |         |        |         |         |         |       |        
|                                                         | Administrative                                            |                               |                                             | 35,686  |         |         |         | 22,387  |         |         |         | 21,504 |        
|                                                         |                                                           |                               |                                             |         |         |         |         |         |         |         |         |       
|                                                         |                                                           |                               | Total operating expenses                    |         |         | 165,075 |         |         |         | 136,565 |         |        |         | 125,073 | 
|                                                         |                                                           |                               |                                             |         |         |         |         |         |         |         |         |       
|Net investment income before income taxes                |                                                           |                               | 202,015                                     |         |         |         | 192,664 |         |         |         | 184,855 |       
|Income tax expense (benefit)                             |                                                           |                               | 1,057                                       |         |         |         | (2,466  | )       |         |         | 930     |       
|                                                         |                                                           |                               |                                             |         |         |         |         |         |         |         |         |       
|Net investment income                                    |                                                           |                               | 200,958                                     |         |         |         | 195,130 |         |         |         | 183,925 |       
|                                                         |                                                           |                               |                                             |         |         |         |         |         |         |         |         |       
|Net Realized and Unrealized Gains (Losses)               |                                                           |                               |                                             |         |         |         |         |         |         |         |         |       
|                                                         | Net realized gains (losses)                               |                               |                                             |         |         |         |         |         |         |         |         |        |        
|                                                         |                                                           | Companies more than 25% owned |                                             |         | 86,812  |         |         |         | 1,302   |         |         |        | 58,444  |        
|                                                         |                                                           | Companies 5% to 25% owned     |                                             |         | 43,818  |         |         |         | 19,975  |         |         |        | 866     |        
|                                                         |                                                           | Companies less than 5% owned  |                                             |         | (13,390 | )       |         |         | 54,070  |         |         |        | (14,373 | )      
|                                                         |                                                           |                               |                                             |         |         |         |         |         |         |         |         |       
|                                                         |                                                           |                               | Total net realized gains                    |         |         | 117,240 |         |         |         | 75,347  |         |        |         | 44,937  | 
|                                                         | Net change in unrealized appreciation or
    depreciation |                               |                                             | (68,712 | )       |         |         | (78,466 | )       |         |         | (571   | )      
|                                                         |                                                           |                               |                                             |         |         |         |         |         |         |         |         |       
|                                                         |                                                           |                               | Total net gains (losses)                    |         |         | 48,528  |         |         |         | (3,119  | )       |        |         | 44,366  | 
|                                                         |                                                           |                               |                                             |         |         |         |         |         |         |         |         |       
|Net increase in net assets resulting from
    operations |                                                           | $                             | 249,486                                     |         |         | $       | 192,011 |         |         | $       | 228,291 |       
|                                                         |                                                           |                               |                                             |         |         |         |         |         |         |         |         |       
|Basic earnings per common share                          |                                                           | $                             | 1.92                                        |         |         | $       | 1.64    |         |         | $       | 2.23    |       
|                                                         |                                                           |                               |                                             |         |         |         |         |         |         |         |         |       
|Diluted earnings per common share                        |                                                           | $                             | 1.88                                        |         |         | $       | 1.62    |         |         | $       | 2.20    |       
|                                                         |                                                           |                               |                                             |         |         |         |         |         |         |         |         |       
|Weighted average common shares
    outstanding  basic   |                                                           |                               | 129,828                                     |         |         |         | 116,747 |         |         |         | 102,107 |       
|                                                         |                                                           |                               |                                             |         |         |         |         |         |         |         |         |       
|Weighted average common shares
    outstanding  diluted |                                                           |                               | 132,458                                     |         |         |         | 118,351 |         |         |         | 103,574 |       
|                                                         |                                                           |                               |                                             |         |         |         |         |         |         |         |         |       

The accompanying notes are an integral part of
these consolidated financial statements.



---



##### 



ALLIED CAPITAL CORPORATION AND
SUBSIDIARIES

CONSOLIDATED STATEMENT OF CHANGES IN NET
ASSETS

|                                         |                                                                  |                                                                          |           |          |          |      |           |          |          |   |           |          |          |  
|---------------------------------------- | ---------------------------------------------------------------- | ------------------------------------------------------------------------ | --------- | -------- | -------- | ---- | --------- | -------- | -------- | - | --------- | -------- | -------- | -
|                                         |                                                                  |                                                                         
|                                         |                                                                  | For the Years Ended December 31,                                        
|                                         |                                                                  |                                                                         
|                                         |                                                                  | 2004                                                                     |           | 2003     |          | 2002
|(in thousands, except per share amounts) |                                                                  |                                                                          |           |          |          |     
|Operations                               |                                                                  |                                                                          |           |          |          |      |           |          |          |   |           |         
|                                         | Net investment income                                            |                                                                          | $         | 200,958  |          |      | $         | 195,130  |          |   | $         | 183,925  |         
|                                         | Net realized gains                                               |                                                                          |           | 117,240  |          |      |           | 75,347   |          |   |           | 44,937   |         
|                                         | Net change in unrealized appreciation or
    depreciation        |                                                                          |           | (68,712  | )        |      |           | (78,466  | )        |   |           | (571     | )       
|                                         |                                                                  |                                                                          |           |          |          |      |           |          |          |   |           |         
|                                         |                                                                  | Net increase in net assets resulting from
    operations                 |           |          | 249,486  |      |           |          | 192,011  |   |           |          | 228,291  |  
|                                         |                                                                  |                                                                          |           |          |          |      |           |          |          |   |           |         
|Shareholder distributions                |                                                                  |                                                                          |           |          |          |      |           |          |          |   |           |         
|                                         | Common stock dividends                                           |                                                                          |           | (299,326 | )        |      |           | (267,838 | )        |   |           | (229,935 | )       
|                                         | Preferred stock dividends                                        |                                                                          |           | (62      | )        |      |           | (210     | )        |   |           | (230     | )       
|                                         |                                                                  |                                                                          |           |          |          |      |           |          |          |   |           |         
|                                         |                                                                  | Net decrease in net assets resulting from
    shareholder distributions  |           |          | (299,388 | )    |           |          | (268,048 | ) |           |          | (230,165 | )
|                                         |                                                                  |                                                                          |           |          |          |      |           |          |          |   |           |         
|Capital share transactions               |                                                                  |                                                                          |           |          |          |      |           |          |          |   |           |         
|                                         | Sale of common stock                                             |                                                                          |           | 70,251   |          |      |           | 422,005  |          |   |           | 172,847  |         
|                                         | Issuance of common stock for portfolio investments               |                                                                          |           | 3,227    |          |      |           | 884      |          |   |           |         |         
|                                         | Issuance of common stock upon the exercise of
    stock options  |                                                                          |           | 32,274   |          |      |           | 8,571    |          |   |           | 14,517   |         
|                                         | Issuance of common stock in lieu of cash
    distributions       |                                                                          |           | 5,836    |          |      |           | 6,598    |          |   |           | 6,263    |         
|                                         | Net decrease in notes receivable from sale of
    common stock   |                                                                          |           | 13,162   |          |      |           | 6,072    |          |   |           | 1,324    |         
|                                         | Purchase of common stock held in deferred
    compensation trust |                                                                          |           | (13,503  | )        |      |           |         |          |   |           |         |         
|                                         | Other                                                            |                                                                          |           | 3,856    |          |      |           | 413      |          |   |           | 871      |         
|                                         |                                                                  |                                                                          |           |          |          |      |           |          |          |   |           |         
|                                         |                                                                  | Net increase in net assets resulting from capital
    share transactions |           |          | 115,103  |      |           |          | 444,543  |   |           |          | 195,822  |  
|                                         |                                                                  |                                                                          |           |          |          |      |           |          |          |   |           |         
|                                         |                                                                  | Total increase in net assets                                             |           |          | 65,201   |      |           |          | 368,506  |   |           |          | 193,948  |  
|Net assets at beginning of year          |                                                                  |                                                                          | 1,914,577 |          |          |      | 1,546,071 |          |          |   | 1,352,123 |         
|                                         |                                                                  |                                                                          |           |          |          |      |           |          |          |   |           |         
|Net assets at end of year                |                                                                  | $                                                                        | 1,979,778 |          |          | $    | 1,914,577 |          |          | $ | 1,546,071 |         
|                                         |                                                                  |                                                                          |           |          |          |      |           |          |          |   |           |         
|Net asset value per common share         |                                                                  | $                                                                        | 14.87     |          |          | $    | 14.94     |          |          | $ | 14.22     |         
|                                         |                                                                  |                                                                          |           |          |          |      |           |          |          |   |           |         
|Common shares outstanding at end of year |                                                                  |                                                                          | 133,099   |          |          |      | 128,118   |          |          |   | 108,698   |         
|                                         |                                                                  |                                                                          |           |          |          |      |           |          |          |   |           |         

The accompanying notes are an integral part of
these consolidated financial statements.



---



##### 



ALLIED CAPITAL CORPORATION AND
SUBSIDIARIES

CONSOLIDATED STATEMENT OF CASH FLOWS

|                                                         |                                                                   |                                                                                                             |                                                         |          |            |          |         |          |          |         |        |          |          |         |  
|-------------------------------------------------------- | ----------------------------------------------------------------- | ----------------------------------------------------------------------------------------------------------- | ------------------------------------------------------- | -------- | ---------- | -------- | ------- | -------- | -------- | ------- | ------ | -------- | -------- | ------- | -
|                                                         |                                                                   |                                                                                                            
|                                                         |                                                                   | For the Years Ended December 31,                                                                           
|                                                         |                                                                   |                                                                                                            
|                                                         |                                                                   | 2004                                                                                                        |                                                         | 2003     |            | 2002    
|(in thousands)                                           |                                                                   |                                                                                                             |                                                         |          |            |         
|Cash flows from operating activities                     |                                                                   |                                                                                                             |                                                         |          |            |          |         |          |          |         |        |         
|                                                         | Net increase in net assets resulting from
    operations          |                                                                                                             | $                                                       | 249,486  |            |          | $       | 192,011  |          |         | $      | 228,291  |         
|                                                         | Adjustments                                                       |                                                                                                             |                                                         |          |            |          |         |          |          |         |        |          |         
|                                                         |                                                                   | Portfolio investments                                                                                       |                                                         |          | (1,472,396 | )        |         |          | (930,566 | )       |        |          | (506,376 | )      
|                                                         |                                                                   | Principal collections related to investment
    repayments or sales                                         |                                                         |          | 909,189    |          |         |          | 788,328  |         |        |          | 356,641  |        
|                                                         |                                                                   | Change in accrued or reinvested interest and
    dividends                                                  |                                                         |          | (52,193    | )        |         |          | (44,952  | )       |        |          | (45,809  | )      
|                                                         |                                                                   | Amortization of discounts and fees                                                                          |                                                         |          | (5,235     | )        |         |          | (12,514  | )       |        |          | (12,931  | )      
|                                                         |                                                                   | Changes in other assets and liabilities                                                                     |                                                         |          | 18,716     |          |         |          | (9,352   | )       |        |          | (7,252   | )      
|                                                         |                                                                   | Depreciation and amortization                                                                               |                                                         |          | 1,433      |          |         |          | 1,638    |         |        |          | 1,572    |        
|                                                         |                                                                   | Realized gains from the receipt of notes and
    other securities as consideration from sale of investments |                                                         |          | (47,497    | )        |         |          | (1,668   | )       |        |          |         |        
|                                                         |                                                                   | Realized losses                                                                                             |                                                         |          | 150,462    |          |         |          | 18,958   |         |        |          | 50,625   |        
|                                                         |                                                                   | Net change in unrealized (appreciation) or
    depreciation                                                 |                                                         |          | 68,712     |          |         |          | 78,466   |         |        |          | 571      |        
|                                                         |                                                                   |                                                                                                             |                                                         |          |            |          |         |          |          |         |        |         
|                                                         |                                                                   |                                                                                                             | Net cash provided by (used in) operating
    activities |          |            | (179,323 | )       |          |          | 80,349  |        |          |          | 65,332  |  
|                                                         |                                                                   |                                                                                                             |                                                         |          |            |          |         |          |          |         |        |         
|Cash flows from financing activities                     |                                                                   |                                                                                                             |                                                         |          |            |          |         |          |          |         |        |         
|                                                         | Sale of common stock                                              |                                                                                                             |                                                         | 70,251   |            |          |         | 422,005  |          |         |        | 172,847  |         
|                                                         | Sale of common stock upon the exercise of stock
    options       |                                                                                                             |                                                         | 32,274   |            |          |         | 8,571    |          |         |        | 12,136   |         
|                                                         | Collections of notes receivable from sale of
    common stock     |                                                                                                             |                                                         | 13,162   |            |          |         | 6,072    |          |         |        | 3,706    |         
|                                                         | Borrowings under notes payable and debentures                     |                                                                                                             |                                                         | 340,212  |            |          |         | 300,000  |          |         |        |         |         
|                                                         | Repayments on notes payable and debentures                        |                                                                                                             |                                                         | (231,000 | )          |          |         | (140,000 | )        |         |        | (81,856  | )       
|                                                         | Net borrowings under (repayments on) revolving
    line of credit |                                                                                                             |                                                         | 112,000  |            |          |         | (204,250 | )        |         |        | 59,500   |         
|                                                         | Redemption of preferred stock                                     |                                                                                                             |                                                         | (7,000   | )          |          |         |         |          |         |        |         |         
|                                                         | Purchase of common stock held in deferred
    compensation trust  |                                                                                                             |                                                         | (13,687  | )          |          |         |         |          |         |        |         |         
|                                                         | Other financing activities                                        |                                                                                                             |                                                         | (3,004   | )          |          |         | (5,137   | )        |         |        | (727     | )       
|                                                         | Common stock dividends and distributions paid                     |                                                                                                             |                                                         | (290,830 | )          |          |         | (264,419 | )        |         |        | (220,411 | )       
|                                                         | Preferred stock dividends paid                                    |                                                                                                             |                                                         | (62      | )          |          |         | (210     | )        |         |        | (230     | )       
|                                                         |                                                                   |                                                                                                             |                                                         |          |            |          |         |          |          |         |        |         
|                                                         |                                                                   |                                                                                                             | Net cash provided by (used in) financing
    activities |          |            | 22,316   |         |          |          | 122,632 |        |          |          | (55,035 | )
|                                                         |                                                                   |                                                                                                             |                                                         |          |            |          |         |          |          |         |        |         
|Net increase (decrease) in cash and cash
    equivalents |                                                                   |                                                                                                             | (157,007                                                | )        |            |          | 202,981 |          |          |         | 10,297 |         
|Cash and cash equivalents at beginning of year           |                                                                   |                                                                                                             | 214,167                                                 |          |            |          | 11,186  |          |          |         | 889    |         
|                                                         |                                                                   |                                                                                                             |                                                         |          |            |          |         |          |          |         |        |         
|Cash and cash equivalents at end of year                 |                                                                   | $                                                                                                           | 57,160                                                  |          |            | $        | 214,167 |          |          | $       | 11,186 |         
|                                                         |                                                                   |                                                                                                             |                                                         |          |            |          |         |          |          |         |        |         

The accompanying notes are an integral part of
these consolidated financial statements.



---



##### 



ALLIED CAPITAL CORPORATION AND
SUBSIDIARIES

CONSOLIDATED STATEMENT OF
INVESTMENTS

|                                                                                                                                                                                                                                                                                                                                                                     |                       |                                                       |                                    |                   |        |         |  |       |         |         |  |   |         |         | 
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- | --------------------- | ----------------------------------------------------- | ---------------------------------- | ----------------- | ------ | ------- |  | ----- | ------- | ------- |  | - | ------- | ------- | 
|                                                                                                                                                                                                                                                                                                                                                                     |                       |                                                       |                                    |                  
|                                                                                                                                                                                                                                                                                                                                                                     |                       |                                                       |                                    | December 31, 2004
|Private Finance                                                                                                                                                                                                                                                                                                                                                      |                       |                                                       |                                    |                  
|Portfolio Company                                                                                                                                                                                                                                                                                                                                                    |                       |                                                       |                                    |                  
|(in thousands, except number of shares)                                                                                                                                                                                                                                                                                                                              |                       | Investment(1)(2)                                      |                                    | Principal         |        | Cost    |  | Value
|                                                                                                                                                                                                                                                                                                                                                                     |                       |                                                       |                                    |                   |        |         |  |      
|Companies More Than 25% Owned                                                                                                                                                                                                                                                                                                                                        |                       |                                                       |                                    |                   |        |         |  |       |         |         |  |  
|                                                                                                                                                                                                                                                                                                                                                                    
|Acme Paging, L.P.(4)                                                                                                                                                                                                                                                                                                                                                 |                       | Loan (6.8%, Due 12/07  1/08)(6)                      |                                    | $                 | 4,631  |         |  | $     | 4,631   |         |  | $ |        |        
|                                                                                                                                                                                                                                                                                                                                                                     | (Telecommunications)  |                                                       | Equity Interests                   |                   |        |         |  |       |         | 13,274  |  |   |         | 1,230   | 
|                                                                                                                                                                                                                                                                                                                                                                     |                       | Common Stock (4,656 shares)                           |                                    |                   |        |         |  |       | 27      |         |  |   |        |        
|                                                                                                                                                                                                                                                                                                                                                                    
|Advantage Sales & Marketing, Inc.                                                                                                                                                                                                                                                                                                                                    |                       | Loan (12.0%, Due 9/09)                                |                                    |                   | 60,000 |         |  |       | 59,729  |         |  |   | 59,729  |        
|                                                                                                                                                                                                                                                                                                                                                                     | (Business Services)   |                                                       | Debt Securities (18.5%, Due 12/09) |                   |        | 125,498 |  |       |         | 125,498 |  |   |         | 125,498 | 
|                                                                                                                                                                                                                                                                                                                                                                     |                       | Common Stock (18,957,011 shares)                      |                                    |                   |        |         |  |       | 73,472  |         |  |   | 97,724  |        
|                                                                                                                                                                                                                                                                                                                                                                    
|Alaris Consulting, LLC                                                                                                                                                                                                                                                                                                                                               |                       | Loan (16.3%, Due 12/05  12/07)(6)                    |                                    |                   | 23,665 |         |  |       | 23,724  |         |  |   | 4,663   |        
|                                                                                                                                                                                                                                                                                                                                                                     | (Business Services)   |                                                       | Equity Interests                   |                   |        |         |  |       |         | 5,165   |  |   |         |        | 
|                                                                                                                                                                                                                                                                                                                                                                     |                       | Guaranty ($1,100)                                     |                                    |                   |        |         |  |       |         |         |  |   |         |        
|                                                                                                                                                                                                                                                                                                                                                                    
|American Healthcare Services, Inc.                                                                                                                                                                                                                                                                                                                                   |                       | Loan (1.0%, Due 12/04  12/05)(6)                     |                                    |                   | 5,200  |         |  |       | 4,801   |         |  |   | 4,225   |        
|                                                                                                                                                                                                                                                                                                                                                                     | and Affiliates        |                                                       | Guaranty ($640)                    |                   |        |         |  |       |         |         |  |   |         |         | 
|                                                                                                                                                                                                                                                                                                                                                                     | (Healthcare Services) |                                                       |                                    |                   |        |         |  |       |         |         |  |   |         |         | 
|                                                                                                                                                                                                                                                                                                                                                                    
|Avborne, Inc.(7)                                                                                                                                                                                                                                                                                                                                                     |                       | Loan (25.0%, Due 8/07)                                |                                    |                   | 1,092  |         |  |       | 1,092   |         |  |   | 1,092   |        
|                                                                                                                                                                                                                                                                                                                                                                     | (Business Services)   |                                                       | Preferred Stock (12,500 shares)    |                   |        |         |  |       |         | 14,138  |  |   |         | 7,320   | 
|                                                                                                                                                                                                                                                                                                                                                                     |                       | Common Stock (27,500 shares)                          |                                    |                   |        |         |  |       |        |         |  |   |        |        
|                                                                                                                                                                                                                                                                                                                                                                     |                       | Standby Letter of Credit ($6,978)                     |                                    |                   |        |         |  |       |         |         |  |   |         |        
|                                                                                                                                                                                                                                                                                                                                                                    
|Avborne Heavy Maintenance, Inc.(7)                                                                                                                                                                                                                                                                                                                                   |                       | Preferred Stock (1,568 shares)                        |                                    |                   |        |         |  |       |        |         |  |   |        |        
|                                                                                                                                                                                                                                                                                                                                                                     | (Business Services)   |                                                       | Common Stock (2,750 shares)        |                   |        |         |  |       |         |        |  |   |         |        | 
|                                                                                                                                                                                                                                                                                                                                                                    
|Business Loan Express, LLC                                                                                                                                                                                                                                                                                                                                           |                       | Debt Securities (25.0%, Due 12/08)                    |                                    |                   | 44,628 |         |  |       | 44,615  |         |  |   | 44,615  |        
|                                                                                                                                                                                                                                                                                                                                                                     | (Financial Services)  |                                                       | Class A Equity Interests           |                   |        | 53,862  |  |       |         | 53,862  |  |   |         | 53,862  | 
|                                                                                                                                                                                                                                                                                                                                                                     |                       | Class B Equity Interests                              |                                    |                   |        |         |  |       | 72,661  |         |  |   | 98,741  |        
|                                                                                                                                                                                                                                                                                                                                                                     |                       | Class C Equity Interests                              |                                    |                   |        |         |  |       | 109,301 |         |  |   | 137,988 |        
|                                                                                                                                                                                                                                                                                                                                                                     |                       | Guaranty ($94,633  See Note 3)                       |                                    |                   |        |         |  |       |         |         |  |   |         |        
|                                                                                                                                                                                                                                                                                                                                                                     |                       | Standby Letters of Credit
    ($35,550   See Note 3) |                                    |                   |        |         |  |       |         |         |  |   |         |        
|                                                                                                                                                                                                                                                                                                                                                                    
|Callidus Capital Corporation                                                                                                                                                                                                                                                                                                                                         |                       | Loan (4.9%, Due 12/05)                                |                                    |                   | 42,213 |         |  |       | 42,213  |         |  |   | 42,213  |        
|                                                                                                                                                                                                                                                                                                                                                                     | (Financial Services)  |                                                       | Loan (12.0%, Due 12/06)            |                   |        | 66      |  |       |         | 66      |  |   |         | 66      | 
|                                                                                                                                                                                                                                                                                                                                                                     |                       |                                                       | Debt Securities (18.0%, Due 10/08) |                   |        | 4,051   |  |       |         | 4,051   |  |   |         | 4,051   | 
|                                                                                                                                                                                                                                                                                                                                                                     |                       | Common Stock (10 shares)                              |                                    |                   |        |         |  |       | 1,871   |         |  |   | 3,600   |        
|                                                                                                                                                                                                                                                                                                                                                                    
|Fairchild Industrial Products                                                                                                                                                                                                                                                                                                                                        |                       | Loan (8.5%, Due 7/09)                                 |                                    |                   | 7,038  |         |  |       | 7,038   |         |  |   | 7,038   |        
|                                                                                                                                                                                                                                                                                                                                                                     | Company               |                                                       | Debt Securities (12.0%, Due 7/09)  |                   |        | 3,833   |  |       |         | 3,833   |  |   |         | 3,833   | 
|                                                                                                                                                                                                                                                                                                                                                                     | (Industrial Products) |                                                       | Common Stock (1,000 shares)        |                   |        |         |  |       |         | 2,841   |  |   |         | 2,123   | 
|                                                                                                                                                                                                                                                                                                                                                                    
|(1)Interest
    rates represent the weighted average annual stated interest rate
    on loans and debt securities, which are presented by nature of
    indebtedness for a single issuer. The maturity dates represent
    the earliest and the latest maturity dates.                                                                                               |                       |                                                       |                                    |                  
|(2)Common
    stock, preferred stock, warrants, options, and equity interests
    are generally non-income producing and restricted.                                                                                                                                                                                                                                 |                       |                                                       |                                    |                  
|(3)Public
    company.                                                                                                                                                                                                                                                                                                                                               |                       |                                                       |                                    |                  
|(4)Non-U.S. company
    or principal place of business outside the U.S.                                                                                                                                                                                                                                                                                              |                       |                                                       |                                    |                  
|(5)Non-registered
    investment company.                                                                                                                                                                                                                                                                                                                            |                       |                                                       |                                    |                  
|(6)Loan or
    debt security is on non-accrual status and therefore is
    considered non-income producing.                                                                                                                                                                                                                                                          |                       |                                                       |                                    |                  
|(7)During
    the third quarter of 2004, Avborne, Inc. transferred certain
    equity securities in Avborne Heavy Maintenance, Inc. to its
    lenders, including the Company, in exchange for a reduction in
    contractual interest on the Companys loan to Avborne, Inc.
    Avborne, Inc. and Avborne Heavy Maintenance, Inc. remain
    affiliated companies. |                       |                                                       |                                    |                  



The accompanying notes are an integral part of
these consolidated financial statements.




---



##### 



|                                                                                                                                                                                                                                                                       |                        |                                            |                                              |                   |        |        |  |       |        |        |  |   |        |        | 
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- | ---------------------- | ------------------------------------------ | -------------------------------------------- | ----------------- | ------ | ------ |  | ----- | ------ | ------ |  | - | ------ | ------ | 
|                                                                                                                                                                                                                                                                       |                        |                                            |                                              |                  
|                                                                                                                                                                                                                                                                       |                        |                                            |                                              | December 31, 2004
|Private Finance                                                                                                                                                                                                                                                        |                        |                                            |                                              |                  
|Portfolio Company                                                                                                                                                                                                                                                      |                        |                                            |                                              |                  
|(in thousands, except number of shares)                                                                                                                                                                                                                                |                        | Investment(1)(2)                           |                                              | Principal         |        | Cost   |  | Value
|                                                                                                                                                                                                                                                                       |                        |                                            |                                              |                   |        |        |  |      
|Financial Pacific Company                                                                                                                                                                                                                                              |                        | Loan (17.4%, Due 2/12  8/12)              |                                              | $                 | 68,788 |        |  | $     | 68,473 |        |  | $ | 68,473 |       
|                                                                                                                                                                                                                                                                       | (Financial Services)   |                                            | Preferred Stock (9,950 shares)               |                   |        |        |  |       |        | 9,950  |  |   |        | 10,448 | 
|                                                                                                                                                                                                                                                                       |                        |                                            | Common Stock (14,735 shares)                 |                   |        |        |  |       |        | 14,819 |  |   |        | 14,819 | 
|                                                                                                                                                                                                                                                                      
|ForeSite Towers, LLC                                                                                                                                                                                                                                                   |                        | Equity Interests                           |                                              |                   |        |        |  |       | 18,672 |        |  |   | 21,511 |       
|                                                                                                                                                                                                                                                                       | (Tower Leasing)        |                                            |                                              |                   |        |        |  |       |        |        |  |   |        |        | 
|                                                                                                                                                                                                                                                                      
|GAC Investments, Inc.                                                                                                                                                                                                                                                  |                        | Loan (10.0%, Due 9/10)(6)                  |                                              |                   | 11,000 |        |  |       | 11,000 |        |  |   | 7,517  |       
|                                                                                                                                                                                                                                                                       | (Broadcasting & Cable) |                                            | Common Stock (101 shares)                    |                   |        |        |  |       |        | 43,350 |  |   |        |       | 
|                                                                                                                                                                                                                                                                       |                        |                                            | Guaranty ($800)                              |                   |        |        |  |       |        |        |  |   |        |        | 
|                                                                                                                                                                                                                                                                       |                        | Standby Letter of Credit ($200)            |                                              |                   |        |        |  |       |        |        |  |   |        |       
|                                                                                                                                                                                                                                                                      
|Global Communications, LLC                                                                                                                                                                                                                                             |                        | Loan (14.2%, Due 12/03  12/06)            |                                              |                   | 6,269  |        |  |       | 6,269  |        |  |   | 6,269  |       
|                                                                                                                                                                                                                                                                       | (Business Services)    |                                            | Debt Securities (13.0%, Due
    9/02  9/05) |                   |        | 18,196 |  |       |        | 18,193 |  |   |        | 18,193 | 
|                                                                                                                                                                                                                                                                       |                        | Preferred Equity Interest                  |                                              |                   |        |        |  |       | 14,067 |        |  |   | 14,609 |       
|                                                                                                                                                                                                                                                                       |                        | Options                                    |                                              |                   |        |        |  |       | 1,639  |        |  |   | 2,161  |       
|                                                                                                                                                                                                                                                                      
|Gordian Group, Inc.                                                                                                                                                                                                                                                    |                        | Loan (10.0%, Due 12/08)(6)                 |                                              |                   | 9,392  |        |  |       | 9,439  |        |  |   | 7,381  |       
|                                                                                                                                                                                                                                                                       | (Business Services)    |                                            | Common Stock (1,000 shares)                  |                   |        |        |  |       |        | 5,820  |  |   |        |       | 
|                                                                                                                                                                                                                                                                      
|HealthASPex, Inc.                                                                                                                                                                                                                                                      |                        | Preferred Stock (1,000,000 shares)         |                                              |                   |        |        |  |       | 700    |        |  |   | 700    |       
|                                                                                                                                                                                                                                                                       | (Business Services)    |                                            | Preferred Stock (1,451,380 shares)           |                   |        |        |  |       |        | 4,900  |  |   |        | 1,753  | 
|                                                                                                                                                                                                                                                                       |                        | Common Stock (1,451,380 shares)            |                                              |                   |        |        |  |       | 4      |        |  |   |       |       
|                                                                                                                                                                                                                                                                      
|HMT, Inc.                                                                                                                                                                                                                                                              |                        | Debt Securities (13.3%, Due 12/08)         |                                              |                   | 10,000 |        |  |       | 9,314  |        |  |   | 9,314  |       
|                                                                                                                                                                                                                                                                       | (Energy Services)      |                                            | Preferred Stock (554,052 shares)             |                   |        |        |  |       |        | 2,488  |  |   |        | 2,537  | 
|                                                                                                                                                                                                                                                                       |                        | Common Stock (300,000 shares)              |                                              |                   |        |        |  |       | 3,000  |        |  |   | 3,610  |       
|                                                                                                                                                                                                                                                                       |                        | Warrants                                   |                                              |                   |        |        |  |       | 1,155  |        |  |   | 1,390  |       
|                                                                                                                                                                                                                                                                      
|Housecall Medical Resources, Inc.                                                                                                                                                                                                                                      |                        | Loan (16.8%, Due 11/07  11/09)            |                                              |                   | 15,668 |        |  |       | 15,610 |        |  |   | 15,610 |       
|                                                                                                                                                                                                                                                                       | (Healthcare Services)  |                                            | Common Stock (864,000 shares)                |                   |        |        |  |       |        | 86     |  |   |        | 31,898 | 
|                                                                                                                                                                                                                                                                      
|Impact Innovations Group, LLC
    (Business Services)                                                                                                                                                                                                                  |                        | Equity Interests in Affiliate (See Note 3) |                                              |                   |        |        |  |       |       |        |  |   | 772    |       
|                                                                                                                                                                                                                                                                      
|Insight Pharmaceuticals Corporation                                                                                                                                                                                                                                    |                        | Senior Loan (8.3%, Due 12/07)              |                                              |                   | 66,470 |        |  |       | 66,115 |        |  |   | 66,115 |       
|                                                                                                                                                                                                                                                                       | (Consumer Products)    |                                            | Loan (15.0%, Due 12/09)                      |                   |        | 57,500 |  |       |        | 57,213 |  |   |        | 57,213 | 
|                                                                                                                                                                                                                                                                       |                        |                                            | Preferred Stock (25,000 shares)              |                   |        |        |  |       |        | 25,000 |  |   |        | 25,000 | 
|                                                                                                                                                                                                                                                                       |                        | Common Stock (6,200 shares)                |                                              |                   |        |        |  |       | 6,325  |        |  |   | 6,325  |       
|                                                                                                                                                                                                                                                                      
|Jakel, Inc.                                                                                                                                                                                                                                                            |                        | Loan (15.5%, Due 3/08)(6)                  |                                              |                   | 5,412  |        |  |       | 5,412  |        |  |   | 5,412  |       
|                                                                                                                                                                                                                                                                       | (Industrial Products)  |                                            | Debt Securities (15.5%, Due 3/08)(6)         |                   |        | 8,330  |  |       |        | 8,330  |  |   |        | 8,330  | 
|                                                                                                                                                                                                                                                                       |                        |                                            | Preferred Stock (6,460 shares)               |                   |        |        |  |       |        | 6,460  |  |   |        | 836    | 
|                                                                                                                                                                                                                                                                       |                        |                                            | Common Stock (158,061 shares)                |                   |        |        |  |       |        | 9,347  |  |   |        |       | 
|                                                                                                                                                                                                                                                                      
|Legacy Partners Group, LLC                                                                                                                                                                                                                                             |                        | Loan (14.0%, Due 5/09)(6)                  |                                              |                   | 6,647  |        |  |       | 6,647  |        |  |   | 6,647  |       
|                                                                                                                                                                                                                                                                       | (Financial Services)   |                                            | Debt Securities (18.0%, Due 5/09)(6)         |                   |        | 2,952  |  |       |        | 2,952  |  |   |        | 1,896  | 
|                                                                                                                                                                                                                                                                       |                        | Equity Interests                           |                                              |                   |        |        |  |       | 2,729  |        |  |   |       |       
|                                                                                                                                                                                                                                                                      
|(1)Interest
    rates represent the weighted average annual stated interest rate
    on loans and debt securities, which are presented by nature of
    indebtedness for a single issuer. The maturity dates represent
    the earliest and the latest maturity dates. |                        |                                            |                                              |                  
|(2)Common
    stock, preferred stock, warrants, options, and equity interests
    are generally non-income producing and restricted.                                                                                                                                   |                        |                                            |                                              |                  
|(3)Public
    company.                                                                                                                                                                                                                                                 |                        |                                            |                                              |                  
|(4)Non-U.S. company
    or principal place of business outside the U.S.                                                                                                                                                                                                |                        |                                            |                                              |                  
|(5)Non-registered
    investment company.                                                                                                                                                                                                                              |                        |                                            |                                              |                  
|(6)Loan or
    debt security is on non-accrual status and therefore is
    considered non-income producing.                                                                                                                                                            |                        |                                            |                                              |                  



The accompanying notes are an integral part of
these consolidated financial statements.




---



##### 



|                                        |                       |                                    |                                       |                   |        |        |           |       |        |        |           |   |        |        | 
|--------------------------------------- | --------------------- | ---------------------------------- | ------------------------------------- | ----------------- | ------ | ------ | --------- | ----- | ------ | ------ | --------- | - | ------ | ------ | 
|                                        |                       |                                    |                                       |                  
|                                        |                       |                                    |                                       | December 31, 2004
|Private Finance                         |                       |                                    |                                       |                  
|Portfolio Company                       |                       |                                    |                                       |                  
|(in thousands, except number of shares) |                       | Investment(1)(2)                   |                                       | Principal         |        | Cost   |           | Value
|                                        |                       |                                    |                                       |                   |        |        |           |      
|Litterer Beteiligungs-GmbH(4)           |                       | Debt Securities (8.0%, Due 3/07)   |                                       | $                 | 715    |        |           | $     | 715    |        |           | $ | 715    |       
|                                        | (Business Services)   |                                    | Equity Interest                       |                   |        |        |           |       |        | 1,756  |           |   |        | 2,596  | 
|                                       
|Maui Body Works, Inc.                   |                       | Common Stock (100 shares)          |                                       |                   |        |        |           |       | 2,500  |        |           |   | 1,080  |       
|                                        | (Healthcare Services) |                                    |                                       |                   |        |        |           |       |        |        |           |   |        |        | 
|                                       
|Mercury Air Centers, Inc.               |                       | Senior Loan (10.0%, Due 4/09)      |                                       |                   | 20,000 |        |           |       | 20,000 |        |           |   | 20,000 |       
|                                        | (Business Services)   |                                    | Loan (16.0%, Due 4/09)                |                   |        | 34,791 |           |       |        | 34,613 |           |   |        | 34,613 | 
|                                        |                       |                                    | Common Stock (52,796 shares)          |                   |        |        |           |       |        | 31,214 |           |   |        | 31,214 | 
|                                        |                       |                                    | Standby Letters of Credit ($1,322)    |                   |        |        |           |       |        |        |           |   |        |        | 
|                                       
|MVL Group, Inc.                         |                       | Loan (12.2%, Due 10/07  7/09)     |                                       |                   | 16,124 |        |           |       | 15,656 |        |           |   | 15,656 |       
|                                        | (Business Services)   |                                    | Debt Securities (14.4%, Due 7/09)     |                   |        | 18,039 |           |       |        | 17,526 |           |   |        | 17,526 | 
|                                        |                       | Common Stock (648,661 shares)      |                                       |                   |        |        |           |       | 643    |        |           |   | 9,800  |       
|                                       
|Pennsylvania Avenue Investors, L.P. (5) |                       | Equity Interests                   |                                       |                   |        |        |           |       | 1,027  |        |           |   | 792    |       
|                                        | (Private Equity Fund) |                                    |                                       |                   |        |        |           |       |        |        |           |   |        |        | 
|                                       
|Powell Plant Farms, Inc.                |                       | Loan (15.0%, Due 1/05)             |                                       |                   | 32,040 |        |           |       | 23,192 |        |           |   | 23,192 |       
|                                        | (Consumer Products)   |                                    | Debt Securities (20.0%, Due 6/03)(6)  |                   |        | 19,291 |           |       |        | 19,224 |           |   |        | 10,588 | 
|                                        |                       | Preferred Stock (1,483 shares)     |                                       |                   |        |        |           |       |       |        |           |   |       |       
|                                        |                       | Warrants                           |                                       |                   |        |        |           |       |       |        |           |   |       |       
|                                       
|Redox Brands, Inc.                      |                       | Loan (19.0%, Due 12/07)            |                                       |                   | 3,334  |        |           |       | 3,325  |        |           |   | 3,325  |       
|                                        | (Consumer Products)   |                                    | Debt Securities (16.0%, Due 3/08)     |                   |        | 11,122 |           |       |        | 10,672 |           |   |        | 10,672 | 
|                                        |                       | Preferred Stock (2,726,444 shares) |                                       |                   |        |        |           |       | 7,903  |        |           |   | 11,664 |       
|                                        |                       | Warrants                           |                                       |                   |        |        |           |       | 584    |        |           |   | 584    |       
|                                        |                       | Guaranty ($125)                    |                                       |                   |        |        |           |       |        |        |           |   |        |       
|                                       
|Staffing Partners Holding               |                       | Loan (13.5%, Due 10/06)(6)         |                                       |                   | 1,000  |        |           |       | 1,000  |        |           |   | 1,000  |       
|                                        | Company, Inc.         |                                    | Debt Securities (13.5%, Due 10/06)(6) |                   |        | 6,084  |           |       |        | 6,084  |           |   |        | 6,084  | 
|                                        | (Business Services)   |                                    | Preferred Stock (439,600 shares)      |                   |        |        |           |       |        | 4,968  |           |   |        | 1,961  | 
|                                        |                       | Common Stock (69,773 shares)       |                                       |                   |        |        |           |       | 50     |        |           |   |       |       
|                                        |                       | Warrants                           |                                       |                   |        |        |           |       | 10     |        |           |   |       |       
|                                       
|Startec Global Communications           |                       | Loan (10.0%, Due 5/07  5/09)      |                                       |                   | 16,521 |        |           |       | 16,521 |        |           |   | 16,521 |       
|                                        | Corporation           |                                    | Common Stock (19,180,000 shares)      |                   |        |        |           |       |        | 37,255 |           |   |        | 7,800  | 
|                                        | (Telecommunications)  |                                    |                                       |                   |        |        |           |       |        |        |           |   |        |        | 
|                                       
|STS Operating, Inc.                     |                       | Preferred Stock (6,000,000 shares) |                                       |                   |        |        |           |       | 6,346  |        |           |   | 6,276  |       
|                                        | (Industrial Products) |                                    | Common Stock (3,000,000 shares)       |                   |        |        |           |       |        | 3,177  |           |   |        | 9,632  | 
|                                        |                       |                                    | Options                               |                   |        |        |           |       |        |       |           |   |        |       | 
|                                       
|Total
    companies more than 25% owned |                       |                                    |                                       |                   |        | $      | 1,389,342 |       |        | $      | 1,359,641 |  
|                                       
|Companies 5% to 25% Owned               |                       |                                    |                                       |                  
|                                       
|Air Evac Lifeteam                       |                       | Debt Securities (12.6%, Due 7/10)  |                                       | $                 | 40,144 |        |           | $     | 39,964 |        |           | $ | 39,964 |       
|                                        | (Healthcare Services) |                                    | Equity Interests                      |                   |        |        |           |       |        | 3,000  |           |   |        | 1,092  | 
|                                       

|                                                                                                                                                                                                                                                                       |  |  |  |  |  |  |  |  |  |  |  |  |  | 
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- |  |  |  |  |  |  |  |  |  |  |  |  |  | 
|(1)Interest
    rates represent the weighted average annual stated interest rate
    on loans and debt securities, which are presented by nature of
    indebtedness for a single issuer. The maturity dates represent
    the earliest and the latest maturity dates. |  |  |  | 
|(2)Common
    stock, preferred stock, warrants, options, and equity interests
    are generally non-income producing and restricted.                                                                                                                                   |  |  |  | 
|(3)Public
    company.                                                                                                                                                                                                                                                 |  |  |  | 
|(4)Non-U.S. company
    or principal place of business outside the U.S.                                                                                                                                                                                                |  |  |  | 
|(5)Non-registered
    investment company.                                                                                                                                                                                                                              |  |  |  | 
|(6)Loan or
    debt security is on non-accrual status and therefore is
    considered non-income producing.                                                                                                                                                            |  |  |  | 



The accompanying notes are an integral part of
these consolidated financial statements.




---



##### 



|                                        |                       |                                   |                                                |                   |        |        |         |       |        |       |         |   |        |       | 
|--------------------------------------- | --------------------- | --------------------------------- | ---------------------------------------------- | ----------------- | ------ | ------ | ------- | ----- | ------ | ----- | ------- | - | ------ | ----- | 
|                                        |                       |                                   |                                                |                  
|                                        |                       |                                   |                                                | December 31, 2004
|Private Finance                         |                       |                                   |                                                |                  
|Portfolio Company                       |                       |                                   |                                                |                  
|(in thousands, except number of shares) |                       | Investment(1)(2)                  |                                                | Principal         |        | Cost   |         | Value
|                                        |                       |                                   |                                                |                   |        |        |         |      
|Aspen Pet Products, Inc.                |                       | Loans (19.0%, Due 6/08)           |                                                | $                 | 18,876 |        |         | $     | 18,784 |       |         | $ | 18,784 |      
|                                        | (Consumer Products)   |                                   | Preferred Stock (2,709 shares)                 |                   |        |        |         |       |        | 2,154 |         |   |        | 897   | 
|                                        |                       | Common Stock (1,400 shares)       |                                                |                   |        |        |         |       | 140    |       |         |   |       |      
|                                        |                       | Warrants                          |                                                |                   |        |        |         |       |       |       |         |   |       |      
|                                       
|Becker Underwood, Inc.                  |                       | Loan (14.5%, Due 8/12)            |                                                |                   | 23,049 |        |         |       | 22,939 |       |         |   | 22,939 |      
|                                        | (Industrial Products) |                                   | Common Stock (4,364 shares)                    |                   |        |        |         |       |        | 5,000 |         |   |        | 5,000 | 
|                                       
|Border Foods, Inc.                      |                       | Loan (13.0%, Due 12/10)           |                                                |                   | 3,000  |        |         |       | 3,000  |       |         |   | 3,000  |      
|                                        | (Consumer Products)   |                                   | Debt Securities (13.0%, Due 12/10)             |                   |        | 10,000 |         |       |        | 9,510 |         |   |        | 9,510 | 
|                                        |                       | Preferred Stock (50,919 shares)   |                                                |                   |        |        |         |       | 2,000  |       |         |   | 2,000  |      
|                                        |                       | Common Stock (1,810 shares)       |                                                |                   |        |        |         |       | 45     |       |         |   |       |      
|                                        |                       | Warrants                          |                                                |                   |        |        |         |       | 665    |       |         |   |       |      
|                                       
|The Debt Exchange Inc.                  |                       | Preferred Stock (921,875 shares)  |                                                |                   |        |        |         |       | 1,250  |       |         |   | 1,457  |      
|                                        | (Business Services)   |                                   |                                                |                   |        |        |         |       |        |       |         |   |        |       | 
|                                       
|MasterPlan, Inc.                        |                       | Loan (12.0%, Due on demand)       |                                                |                   | 959    |        |         |       | 959    |       |         |   | 1,204  |      
|                                        | (Business Services)   |                                   | Common Stock (1,350 shares)                    |                   |        |        |         |       |        | 42    |         |   |        | 3,300 | 
|                                       
|MedBridge Healthcare, LLC               |                       | Loan (5.1%, Due 8/09  8/14)      |                                                |                   | 11,311 |        |         |       | 11,311 |       |         |   | 11,311 |      
|                                        | (Healthcare Services) |                                   | Convertible Debenture (2.0%, Due 8/14)
    (6) |                   |        | 3,000  |         |       |        | 1,015 |         |   |        | 678   | 
|                                       
|MortgageRamp, Inc.                      |                       | Common Stock (772,000 shares)     |                                                |                   |        |        |         |       | 3,860  |       |         |   | 903    |      
|                                        | (Business Services)   |                                   |                                                |                   |        |        |         |       |        |       |         |   |        |       | 
|                                       
|Nexcel Synthetics, LLC                  |                       | Loan (14.5%, Due 6/09)            |                                                |                   | 10,248 |        |         |       | 10,211 |       |         |   | 10,211 |      
|                                        | (Consumer Products)   |                                   | Equity Interests                               |                   |        |        |         |       |        | 1,690 |         |   |        | 687   | 
|                                       
|Packaging Advantage Corporation         |                       | Debt Securities (18.5%, Due 4/08) |                                                |                   | 15,439 |        |         |       | 14,731 |       |         |   | 14,731 |      
|                                        | (Business Services)   |                                   | Common Stock (232,168 shares)                  |                   |        |        |         |       |        | 2,386 |         |   |        | 1,479 | 
|                                        |                       | Warrants                          |                                                |                   |        |        |         |       | 963    |       |         |   | 597    |      
|                                       
|Pres Air Trol LLC                       |                       | Debt Securities (12.0%, Due 4/10) |                                                |                   | 6,350  |        |         |       | 6,021  |       |         |   | 6,021  |      
|                                        | (Industrial Products) |                                   | Equity Interests                               |                   |        |        |         |       |        | 1,323 |         |   |        | 900   | 
|                                       
|Progressive International               |                       | Loan (16.0%, Due 12/09)           |                                                |                   | 7,253  |        |         |       | 7,221  |       |         |   | 7,221  |      
|                                        | Corporation           |                                   | Preferred Stock (500 shares)                   |                   |        |        |         |       |        | 500   |         |   |        | 586   | 
|                                        | (Consumer Products)   |                                   | Common Stock (197 shares)                      |                   |        |        |         |       |        | 13    |         |   |        | 13    | 
|                                        |                       | Warrants                          |                                                |                   |        |        |         |       |       |       |         |   |       |      
|                                       
|Soteria Imaging Services, LLC           |                       | Loan (12.5%, Due 11/10)           |                                                |                   | 9,500  |        |         |       | 8,340  |       |         |   | 8,340  |      
|                                        | (Healthcare Services) |                                   | Equity Interests                               |                   |        |        |         |       |        | 2,114 |         |   |        | 2,114 | 
|                                       
|Universal Environmental Services,       |                       | Loan (13.5%, Due 2/09)            |                                                |                   | 12,150 |        |         |       | 12,099 |       |         |   | 12,099 |      
|                                        | LLC                   |                                   | Equity Interests                               |                   |        |        |         |       |        | 1,500 |         |   |        | 1,864 | 
|                                        | (Business Services)   |                                   |                                                |                   |        |        |         |       |        |       |         |   |        |       | 
|                                       
|Total
    companies 5% to 25% owned     |                       |                                   |                                                |                   |        | $      | 194,750 |       |        | $     | 188,902 |  
|                                       
|Companies Less Than 5% Owned            |                       |                                   |                                                |                  
|                                       
|Alderwoods Group, Inc.(3)               |                       | Common Stock (357,568 shares)     |                                                |                   |        |        |         | $     | 5,006  |       |         | $ | 4,062  |      
|                                        | (Consumer Services)   |                                   |                                                |                   |        |        |         |       |        |       |         |   |        |       | 
|                                       

|                                                                                                                                                                                                                                                                       |  |  |  |  |  |  |  |  |  |  |  |  |  | 
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- |  |  |  |  |  |  |  |  |  |  |  |  |  | 
|(1)Interest
    rates represent the weighted average annual stated interest rate
    on loans and debt securities, which are presented by nature of
    indebtedness for a single issuer. The maturity dates represent
    the earliest and the latest maturity dates. |  |  |  | 
|(2)Common
    stock, preferred stock, warrants, options, and equity interests
    are generally non-income producing and restricted.                                                                                                                                   |  |  |  | 
|(3)Public
    company.                                                                                                                                                                                                                                                 |  |  |  | 
|(4)Non-U.S. company
    or principal place of business outside the U.S.                                                                                                                                                                                                |  |  |  | 
|(5)Non-registered
    investment company.                                                                                                                                                                                                                              |  |  |  | 
|(6)Loan or
    debt security is on non-accrual status and therefore is
    considered non-income producing.                                                                                                                                                            |  |  |  | 



The accompanying notes are an integral part of
these consolidated financial statements.




---



##### 



|                                               |                        |                                      |                                   |                   |        |       |  |       |        |       |  |   |        |       | 
|---------------------------------------------- | ---------------------- | ------------------------------------ | --------------------------------- | ----------------- | ------ | ----- |  | ----- | ------ | ----- |  | - | ------ | ----- | 
|                                               |                        |                                      |                                   |                  
|                                               |                        |                                      |                                   | December 31, 2004
|Private Finance                                |                        |                                      |                                   |                  
|Portfolio Company                              |                        |                                      |                                   |                  
|(in thousands, except number of shares)        |                        | Investment(1)(2)                     |                                   | Principal         |        | Cost  |  | Value
|                                               |                        |                                      |                                   |                   |        |       |  |      
|American Barbecue & Grill, Inc.                |                        | Warrants                             |                                   |                   |        |       |  | $     | 125    |       |  | $ |       |      
|                                               | (Retail)               |                                      |                                   |                   |        |       |  |       |        |       |  |   |        |       | 
|                                              
|Anthony, Inc.                                  |                        | Loan (12.2%, Due 9/11  9/12)        |                                   | $                 | 14,524 |       |  |       | 14,455 |       |  |   | 14,455 |      
|                                               | (Industrial Products)  |                                      |                                   |                   |        |       |  |       |        |       |  |   |        |       | 
|                                              
|Apogen Technologies, Inc.                      |                        | Debt Securities (13.0%, Due 1/10)    |                                   |                   | 5,000  |       |  |       | 4,982  |       |  |   | 4,982  |      
|                                               | (Business Services)    |                                      | Preferred Stock (270,008 shares)  |                   |        |       |  |       |        | 2,700 |  |   |        | 3,155 | 
|                                               |                        | Common Stock (1,256,452 shares)      |                                   |                   |        |       |  |       | 50     |       |  |   | 2,295  |      
|                                               |                        | Warrants                             |                                   |                   |        |       |  |       |       |       |  |   | 448    |      
|                                              
|Aviation Technologies, Inc.                    |                        | Loan (17.0%, Due 5/11)               |                                   |                   | 21,130 |       |  |       | 21,050 |       |  |   | 21,050 |      
|                                               | (Industrial Products)  |                                      |                                   |                   |        |       |  |       |        |       |  |   |        |       | 
|                                              
|Benchmark Medical, Inc.                        |                        | Debt Securities (14.0%, Due 12/08)   |                                   |                   | 13,718 |       |  |       | 13,656 |       |  |   | 13,656 |      
|                                               | (Healthcare Services)  |                                      | Warrants                          |                   |        |       |  |       |        | 18    |  |   |        | 18    | 
|                                              
|Callidus Debt Partners                         |                        | Preferred Shares (23,600,000 shares) |                                   |                   |        |       |  |       | 23,869 |       |  |   | 23,869 |      
|                                               | CLO Fund III, LTD(4)   |                                      |                                   |                   |        |       |  |       |        |       |  |   |        |       | 
|                                               | (Senior Debt CLO Fund) |                                      |                                   |                   |        |       |  |       |        |       |  |   |        |       | 
|                                              
|Camden Partners Strategic Fund II,
    L.P.(5) |                        | Limited Partnership Interest         |                                   |                   |        |       |  |       | 2,463  |       |  |   | 3,055  |      
|                                               | (Private Equity Fund)  |                                      |                                   |                   |        |       |  |       |        |       |  |   |        |       | 
|                                              
|Catterton Partners V, L.P.(5)                  |                        | Limited Partnership Interest         |                                   |                   |        |       |  |       | 1,589  |       |  |   | 1,415  |      
|                                               | (Private Equity Fund)  |                                      |                                   |                   |        |       |  |       |        |       |  |   |        |       | 
|                                              
|CBS Personnel Holdings, Inc.                   |                        | Loan (15.5%, Due 12/09)              |                                   |                   | 20,000 |       |  |       | 19,905 |       |  |   | 19,905 |      
|                                               | (Business Services)    |                                      |                                   |                   |        |       |  |       |        |       |  |   |        |       | 
|                                              
|Colibri Holding Corporation                    |                        | Debt Securities (12.5%, Due 9/08)    |                                   |                   | 3,750  |       |  |       | 3,511  |       |  |   | 3,511  |      
|                                               | (Consumer Products)    |                                      | Preferred Stock (459 shares)      |                   |        |       |  |       |        | 523   |  |   |        | 780   | 
|                                               |                        | Common Stock (3,362 shares)          |                                   |                   |        |       |  |       | 1,250  |       |  |   | 511    |      
|                                               |                        | Warrants                             |                                   |                   |        |       |  |       | 290    |       |  |   | 119    |      
|                                              
|Community Education
    Centers, Inc.          |                        | Loan (15.0%, Due 12/10)              |                                   |                   | 23,394 |       |  |       | 23,295 |       |  |   | 23,295 |      
|                                               | (Education Services)   |                                      |                                   |                   |        |       |  |       |        |       |  |   |        |       | 
|                                              
|Component Hardware Group, Inc.                 |                        | Preferred Stock (18,000 shares)      |                                   |                   |        |       |  |       | 2,605  |       |  |   | 2,657  |      
|                                               | (Industrial Products)  |                                      | Common Stock (2,000 shares)       |                   |        |       |  |       |        | 200   |  |   |        | 600   | 
|                                              
|Cooper Natural Resources, Inc.                 |                        | Debt Securities (0%, Due 11/07)      |                                   |                   | 1,500  |       |  |       | 1,500  |       |  |   | 1,500  |      
|                                               | (Industrial Products)  |                                      | Preferred Stock (6,316 shares)    |                   |        |       |  |       |        | 1,424 |  |   |        | 20    | 
|                                               |                        | Warrants                             |                                   |                   |        |       |  |       | 830    |       |  |   |       |      
|                                              
|Coverall North America, Inc.                   |                        | Loan (20.0%, Due 7/08)               |                                   |                   | 15,955 |       |  |       | 15,918 |       |  |   | 17,504 |      
|                                               | (Business Services)    |                                      | Debt Securities (20.0%, Due 7/08) |                   |        | 8,249 |  |       |        | 8,229 |  |   |        | 9,049 | 
|                                              
|CTT Holdings                                   |                        | Loan (0%, Due 3/10)(6)               |                                   |                   | 1,125  |       |  |       | 1,125  |       |  |   | 563    |      
|                                               | (Consumer Products)    |                                      |                                   |                   |        |       |  |       |        |       |  |   |        |       | 
|                                              
|DCS Business Services, Inc.                    |                        | Debt (15.8%, Due 7/10)               |                                   |                   | 21,646 |       |  |       | 21,559 |       |  |   | 21,559 |      
|                                               | (Business Services)    |                                      | Preferred Stock (478,816 shares)  |                   |        |       |  |       |        | 1,239 |  |   |        | 3,195 | 
|                                              

|                                                                                                                                                                                                                                                                       |  |  |  |  |  |  |  |  |  |  |  |  |  | 
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- |  |  |  |  |  |  |  |  |  |  |  |  |  | 
|(1)Interest
    rates represent the weighted average annual stated interest rate
    on loans and debt securities, which are presented by nature of
    indebtedness for a single issuer. The maturity dates represent
    the earliest and the latest maturity dates. |  |  |  | 
|(2)Common
    stock, preferred stock, warrants, options, and equity interests
    are generally non-income producing and restricted.                                                                                                                                   |  |  |  | 
|(3)Public
    company.                                                                                                                                                                                                                                                 |  |  |  | 
|(4)Non-U.S. company
    or principal place of business outside the U.S.                                                                                                                                                                                                |  |  |  | 
|(5)Non-registered
    investment company.                                                                                                                                                                                                                              |  |  |  | 
|(6)Loan or
    debt security is on non-accrual status and therefore is
    considered non-income producing.                                                                                                                                                            |  |  |  | 



The accompanying notes are an integral part of
these consolidated financial statements.




---



##### 



|                                        |                        |                                                   |                                          |                   |        |       |  |       |        |       |  |   |        |       | 
|--------------------------------------- | ---------------------- | ------------------------------------------------- | ---------------------------------------- | ----------------- | ------ | ----- |  | ----- | ------ | ----- |  | - | ------ | ----- | 
|                                        |                        |                                                   |                                          |                  
|                                        |                        |                                                   |                                          | December 31, 2004
|Private Finance                         |                        |                                                   |                                          |                  
|Portfolio Company                       |                        |                                                   |                                          |                  
|(in thousands, except number of shares) |                        | Investment(1)(2)                                  |                                          | Principal         |        | Cost  |  | Value
|                                        |                        |                                                   |                                          |                   |        |       |  |      
|Drilltec Patents & Technologies         |                        | Loan (10.0%, Due 8/06)(6)                         |                                          | $                 | 10,994 |       |  | $     | 10,918 |       |  | $ |       |      
|                                        | Company, Inc.          |                                                   | Debt Securities (15.0%, Due 8/06)(6)     |                   |        | 1,500 |  |       |        | 1,500 |  |   |        |      | 
|                                        | (Energy Services)      |                                                   |                                          |                   |        |       |  |       |        |       |  |   |        |       | 
|                                       
|eCentury Capital Partners, L.P.(5)      |                        | Limited Partnership Interest                      |                                          |                   |        |       |  |       | 5,024  |       |  |   | 889    |      
|                                        | (Private Equity Fund)  |                                                   |                                          |                   |        |       |  |       |        |       |  |   |        |       | 
|                                       
|EDM Consulting, LLC                     |                        | Loan (5.3%, Due 12/06)                            |                                          |                   | 100    |       |  |       | 100    |       |  |   | 100    |      
|                                        | (Business Services)    |                                                   |                                          |                   |        |       |  |       |        |       |  |   |        |       | 
|                                       
|Elexis Beta GmbH(4)                     |                        | Options                                           |                                          |                   |        |       |  |       | 426    |       |  |   | 50     |      
|                                        | (Industrial Products)  |                                                   |                                          |                   |        |       |  |       |        |       |  |   |        |       | 
|                                       
|E-Talk Corporation                      |                        | Preferred Stock (133 shares)                      |                                          |                   |        |       |  |       | 10,009 |       |  |   |       |      
|                                        | (Business Services)    |                                                   | Common Stock (8,656 shares)              |                   |        |       |  |       |        |      |  |   |        |      | 
|                                       
|Frozen Specialties, Inc.                |                        | Debt Securities (16.0%, Due 5/08)                 |                                          |                   | 11,000 |       |  |       | 10,637 |       |  |   | 10,637 |      
|                                        | (Consumer Products)    |                                                   | Warrants                                 |                   |        |       |  |       |        | 435   |  |   |        | 435   | 
|                                       
|Garden Ridge Corporation
    (Retail)   |                        | Debt Securities (12.9%, Due 12/05 
    12/07)(6) |                                          |                   | 27,271 |       |  |       | 27,271 |       |  |   | 12,722 |      
|                                        |                        |                                                   | Preferred Stock (1,130 shares)           |                   |        |       |  |       |        | 1,130 |  |   |        |      | 
|                                        |                        | Common Stock (847,800 shares)                     |                                          |                   |        |       |  |       | 613    |       |  |   |       |      
|                                       
|Geotrace Technologies, Inc.             |                        | Debt Securities (12.0%, Due 6/09)                 |                                          |                   | 18,400 |       |  |       | 16,296 |       |  |   | 16,296 |      
|(Energy Services)                       |                        | Warrants                                          |                                          |                   |        |       |  |       | 2,350  |       |  |   | 2,350  |      
|                                       
|Ginsey Industries, Inc.                 |                        | Loans (12.5%, Due 3/06)                           |                                          |                   | 4,505  |       |  |       | 4,505  |       |  |   | 4,505  |      
|                                        | (Consumer Products)    |                                                   | Convertible Debentures (12.5%, Due 3/06) |                   |        | 500   |  |       |        | 500   |  |   |        | 663   | 
|                                        |                        | Warrants                                          |                                          |                   |        |       |  |       |       |       |  |   | 1,737  |      
|                                       
|Grant Broadcasting Systems II           |                        | Loan (5.0%, Due 6/09)                             |                                          |                   | 2,750  |       |  |       | 2,750  |       |  |   | 2,750  |      
|                                        | (Broadcasting & Cable) |                                                   |                                          |                   |        |       |  |       |        |       |  |   |        |       | 
|                                       
|Grotech Partners, VI, L.P.(5)           |                        | Limited Partnership Interest                      |                                          |                   |        |       |  |       | 5,574  |       |  |   | 3,444  |      
|                                        | (Private Equity Fund)  |                                                   |                                          |                   |        |       |  |       |        |       |  |   |        |       | 
|                                       
|Haven Eldercare of New England, LLC     |                        | Loans (9.3%, Due 10/05)                           |                                          |                   | 46,671 |       |  |       | 46,668 |       |  |   | 46,668 |      
|                                        | (Healthcare Services)  |                                                   |                                          |                   |        |       |  |       |        |       |  |   |        |       | 
|                                       
|The Hillman Companies, Inc.(3)          |                        | Loan (13.5%, Due 9/11)                            |                                          |                   | 43,024 |       |  |       | 42,807 |       |  |   | 42,807 |      
|                                        | (Consumer Products)    |                                                   |                                          |                   |        |       |  |       |        |       |  |   |        |       | 
|                                       
|Homax Holdings, Inc.                    |                        | Debt (12.0%, Due 8/11)                            |                                          |                   | 14,000 |       |  |       | 12,920 |       |  |   | 12,920 |      
|                                        | (Consumer Products)    |                                                   | Preferred Stock (89 shares)              |                   |        |       |  |       |        | 89    |  |   |        | 84    | 
|                                        |                        |                                                   | Common Stock (28 shares)                 |                   |        |       |  |       |        | 6     |  |   |        | 6     | 
|                                        |                        |                                                   | Warrants                                 |                   |        |       |  |       |        | 1,106 |  |   |        | 1,371 | 
|                                       
|Icon International, Inc.                |                        | Common Stock (25,707 shares)                      |                                          |                   |        |       |  |       | 76     |       |  |   |       |      
|                                        | (Business Services)    |                                                   |                                          |                   |        |       |  |       |        |       |  |   |        |       | 
|                                       
|Interline Brands, Inc.(3)               |                        | Common Stock (152,371 shares)                     |                                          |                   |        |       |  |       | 2,286  |       |  |   | 2,600  |      
|                                        | (Business Services)    |                                                   |                                          |                   |        |       |  |       |        |       |  |   |        |       | 
|                                       

|                                                                                                                                                                                                                                                                       |  |  |  |  |  |  |  |  |  |  |  |  |  | 
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- |  |  |  |  |  |  |  |  |  |  |  |  |  | 
|(1)Interest
    rates represent the weighted average annual stated interest rate
    on loans and debt securities, which are presented by nature of
    indebtedness for a single issuer. The maturity dates represent
    the earliest and the latest maturity dates. |  |  |  | 
|(2)Common
    stock, preferred stock, warrants, options, and equity interests
    are generally non-income producing and restricted.                                                                                                                                   |  |  |  | 
|(3)Public
    company.                                                                                                                                                                                                                                                 |  |  |  | 
|(4)Non-U.S. company
    or principal place of business outside the U.S.                                                                                                                                                                                                |  |  |  | 
|(5)Non-registered
    investment company.                                                                                                                                                                                                                              |  |  |  | 
|(6)Loan or
    debt security is on non-accrual status and therefore is
    considered non-income producing.                                                                                                                                                            |  |  |  | 



The accompanying notes are an integral part of
these consolidated financial statements.




---



##### 



|                                               |                        |                                         |                                                  |                   |        |        |  |       |        |        |  |   |        |       | 
|---------------------------------------------- | ---------------------- | --------------------------------------- | ------------------------------------------------ | ----------------- | ------ | ------ |  | ----- | ------ | ------ |  | - | ------ | ----- | 
|                                               |                        |                                         |                                                  |                  
|                                               |                        |                                         |                                                  | December 31, 2004
|Private Finance                                |                        |                                         |                                                  |                  
|Portfolio Company                              |                        |                                         |                                                  |                  
|(in thousands, except number of shares)        |                        | Investment(1)(2)                        |                                                  | Principal         |        | Cost   |  | Value
|                                               |                        |                                         |                                                  |                   |        |        |  |      
|International Fiber Corporation                |                        | Debt Securities (14.0%, Due 6/12)       |                                                  | $                 | 21,114 |        |  | $     | 21,016 |        |  | $ | 21,016 |      
|                                               | (Industrial Products)  |                                         | Preferred Stock (25,000 shares)                  |                   |        |        |  |       |        | 2,500  |  |   |        | 2,500 | 
|                                              
|MedAssets, Inc.                                |                        | Preferred Stock (227,865 shares)        |                                                  |                   |        |        |  |       | 2,049  |        |  |   | 2,726  |      
|                                               | (Business Services)    |                                         | Warrants                                         |                   |        |        |  |       |        | 136    |  |   |        | 25    | 
|                                              
|Mid-Atlantic Venture Fund IV,
    L.P.(5)      |                        | Limited Partnership Interest            |                                                  |                   |        |        |  |       | 6,600  |        |  |   | 3,171  |      
|                                               | (Private Equity Fund)  |                                         |                                                  |                   |        |        |  |       |        |        |  |   |        |       | 
|                                              
|Mogas Energy, LLC
    (Energy Services)        |                        | Debt Securities (9.5%, Due 3/12  4/12) |                                                  |                   | 17,479 |        |  |       | 15,956 |        |  |   | 15,956 |      
|                                               |                        |                                         | Warrants                                         |                   |        |        |  |       |        | 1,774  |  |   |        | 2,800 | 
|                                              
|Nobel Learning Communities,                    |                        | Preferred Stock (1,214,356 shares)      |                                                  |                   |        |        |  |       | 2,764  |        |  |   | 2,764  |      
|                                               | Inc.(3)                |                                         | Warrants                                         |                   |        |        |  |       |        | 575    |  |   |        | 308   | 
|                                               | (Education)            |                                         |                                                  |                   |        |        |  |       |        |        |  |   |        |       | 
|                                              
|Norstan Apparel Shops, Inc.                    |                        | Loan (16.0%, Due 12/07)(6)              |                                                  |                   | 500    |        |  |       | 500    |        |  |   | 500    |      
|                                               | (Retail)               |                                         | Debt Securities (17.8%, Due 12/07 
    9/08)(6) |                   |        | 13,588 |  |       |        | 12,960 |  |   |        | 2,585 | 
|                                               |                        |                                         | Common Stock (29,663 shares)                     |                   |        |        |  |       |        | 4,750  |  |   |        |      | 
|                                               |                        | Warrants                                |                                                  |                   |        |        |  |       | 655    |        |  |   |       |      
|                                               |                        | Guaranty ($)                           |                                                  |                   |        |        |  |       |        |        |  |   |        |      
|                                              
|Norwesco, Inc.                                 |                        | Loan (14.0%, Due 12/11)                 |                                                  |                   | 15,000 |        |  |       | 14,925 |        |  |   | 14,925 |      
|                                               | (Industrial Products)  |                                         |                                                  |                   |        |        |  |       |        |        |  |   |        |       | 
|                                              
|Novak Biddle Venture Partners III,
    L.P.(5) |                        | Limited Partnership Interest            |                                                  |                   |        |        |  |       | 979    |        |  |   | 1,142  |      
|                                               | (Private Equity Fund)  |                                         |                                                  |                   |        |        |  |       |        |        |  |   |        |       | 
|                                              
|Oahu Waste Services, Inc.                      |                        | Stock Appreciation Rights               |                                                  |                   |        |        |  |       | 239    |        |  |   | 300    |      
|                                               | (Business Services)    |                                         |                                                  |                   |        |        |  |       |        |        |  |   |        |       | 
|                                              
|Onyx Television GmbH(4)                        |                        | Preferred Units                         |                                                  |                   |        |        |  |       | 201    |        |  |   |       |      
|                                               | (Broadcasting & Cable) |                                         |                                                  |                   |        |        |  |       |        |        |  |   |        |       | 
|                                              
|Opinion Research Corporation(3)                |                        | Loan (13.2%, Due 11/07  5/09)          |                                                  |                   | 20,625 |        |  |       | 20,533 |        |  |   | 20,533 |      
|                                               | (Business Services)    |                                         | Warrants                                         |                   |        |        |  |       |        | 996    |  |   |        | 480   | 
|                                              
|Oriental Trading Company, Inc.                 |                        | Common Stock (13,820 shares)            |                                                  |                   |        |        |  |       | 10     |        |  |   | 5,400  |      
|                                               | (Consumer Products)    |                                         |                                                  |                   |        |        |  |       |        |        |  |   |        |       | 
|                                              
|Polaris Pool Systems, Inc.                     |                        | Debt Securities (12.0%, Due 9/07)       |                                                  |                   | 12,500 |        |  |       | 11,334 |        |  |   | 12,477 |      
|                                               | (Consumer Products)    |                                         | Warrants                                         |                   |        |        |  |       |        | 1,145  |  |   |        | 7,396 | 
|                                              
|Pro Mach, Inc.                                 |                        | Loan (13.8%, Due 6/12)                  |                                                  |                   | 19,000 |        |  |       | 18,906 |        |  |   | 18,906 |      
|                                               | (Industrial Products)  |                                         | Equity Interests                                 |                   |        |        |  |       |        | 1,500  |  |   |        | 1,500 | 
|                                              
|RadioVisa Corporation                          |                        | Loan (15.5%, Due 12/08)                 |                                                  |                   | 25,892 |        |  |       | 25,779 |        |  |   | 25,779 |      
|                                               | (Broadcasting & Cable) |                                         |                                                  |                   |        |        |  |       |        |        |  |   |        |       | 
|                                              
|Resun Leasing, Inc.                            |                        | Loan (15.5%, Due 11/07)                 |                                                  |                   | 30,000 |        |  |       | 30,000 |        |  |   | 30,000 |      
|                                               | (Business Services)    |                                         |                                                  |                   |        |        |  |       |        |        |  |   |        |       | 
|                                              

|                                                                                                                                                                                                                                                                       |  |  |  |  |  |  |  |  |  |  |  |  |  | 
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- |  |  |  |  |  |  |  |  |  |  |  |  |  | 
|(1)Interest
    rates represent the weighted average annual stated interest rate
    on loans and debt securities, which are presented by nature of
    indebtedness for a single issuer. The maturity dates represent
    the earliest and the latest maturity dates. |  |  |  | 
|(2)Common
    stock, preferred stock, warrants, options, and equity interests
    are generally non-income producing and restricted.                                                                                                                                   |  |  |  | 
|(3)Public
    company.                                                                                                                                                                                                                                                 |  |  |  | 
|(4)Non-U.S. company
    or principal place of business outside the U.S.                                                                                                                                                                                                |  |  |  | 
|(5)Non-registered
    investment company.                                                                                                                                                                                                                              |  |  |  | 
|(6)Loan or
    debt security is on non-accrual status and therefore is
    considered non-income producing.                                                                                                                                                            |  |  |  | 



The accompanying notes are an integral part of
these consolidated financial statements.




---



##### 



|                                        |                        |                                      |                                    |                   |        |        |  |       |        |        |  |   |        |        | 
|--------------------------------------- | ---------------------- | ------------------------------------ | ---------------------------------- | ----------------- | ------ | ------ |  | ----- | ------ | ------ |  | - | ------ | ------ | 
|                                        |                        |                                      |                                    |                  
|                                        |                        |                                      |                                    | December 31, 2004
|Private Finance                         |                        |                                      |                                    |                  
|Portfolio Company                       |                        |                                      |                                    |                  
|(in thousands, except number of shares) |                        | Investment(1)(2)                     |                                    | Principal         |        | Cost   |  | Value
|                                        |                        |                                      |                                    |                   |        |        |  |      
|S.B. Restaurant Company                 |                        | Debt Securities (15.0%, Due 11/08)   |                                    | $                 | 15,215 |        |  | $     | 14,667 |        |  | $ | 14,667 |       
|                                        | (Retail)               |                                      | Preferred Stock (54,125 shares)    |                   |        |        |  |       |        | 135    |  |   |        | 135    | 
|                                        |                        | Warrants                             |                                    |                   |        |        |  |       | 619    |        |  |   | 619    |       
|                                       
|SBBUT, LLC                              |                        | Equity Interests                     |                                    |                   |        |        |  |       | 85     |        |  |   | 85     |       
|                                        | (Consumer Products)    |                                      |                                    |                   |        |        |  |       |        |        |  |   |        |        | 
|                                       
|Soff-Cut Holdings, Inc.                 |                        | Preferred Stock (300 shares)         |                                    |                   |        |        |  |       | 300    |        |  |   |       |       
|                                        | (Industrial Products)  |                                      | Common Stock (2,000 shares)        |                   |        |        |  |       |        | 200    |  |   |        |       | 
|                                       
|SPP Mezzanine Fund, L.P.(5)             |                        | Limited Partnership Interest         |                                    |                   |        |        |  |       | 1,663  |        |  |   | 1,543  |       
|                                        | (Private Equity Fund)  |                                      |                                    |                   |        |        |  |       |        |        |  |   |        |        | 
|                                       
|SunStates Refrigerated Services,        |                        | Loan (7.8%, Due 1/05)(6)             |                                    |                   | 450    |        |  |       | 450    |        |  |   | 180    |       
|                                        | Inc.                   |                                      |                                    |                   |        |        |  |       |        |        |  |   |        |        | 
|                                        | (Warehouse Facilities) |                                      |                                    |                   |        |        |  |       |        |        |  |   |        |        | 
|                                       
|United Site Services, Inc.              |                        | Loan (12.2%, Due 6/10  12/10)       |                                    |                   | 53,731 |        |  |       | 53,446 |        |  |   | 53,446 |       
|                                        | (Business Services)    |                                      | Common Stock (160,588 shares)      |                   |        |        |  |       |        | 1,000  |  |   |        | 1,000  | 
|                                       
|Universal Tax Systems, Inc.             |                        | Loan (14.5%, Due 7/11)               |                                    |                   | 18,592 |        |  |       | 18,506 |        |  |   | 18,506 |       
|                                        | (Business Services)    |                                      |                                    |                   |        |        |  |       |        |        |  |   |        |        | 
|                                       
|Updata Venture Partners II,
    L.P.(5) |                        | Limited Partnership Interest         |                                    |                   |        |        |  |       | 4,375  |        |  |   | 4,322  |       
|                                        | (Private Equity Fund)  |                                      |                                    |                   |        |        |  |       |        |        |  |   |        |        | 
|                                       
|U.S. Security Holdings, Inc.            |                        | Warrants                             |                                    |                   |        |        |  |       | 826    |        |  |   | 2,400  |       
|                                        | (Business Services)    |                                      |                                    |                   |        |        |  |       |        |        |  |   |        |        | 
|                                       
|Venturehouse-Cibernet Investors, LLC    |                        | Equity Interest                      |                                    |                   |        |        |  |       | 34     |        |  |   | 34     |       
|                                        | (Business Services)    |                                      |                                    |                   |        |        |  |       |        |        |  |   |        |        | 
|                                       
|Venturehouse Group, LLC(5)              |                        | Equity Interest                      |                                    |                   |        |        |  |       | 598    |        |  |   | 415    |       
|                                        | (Private Equity Fund)  |                                      |                                    |                   |        |        |  |       |        |        |  |   |        |        | 
|                                       
|VICORP Restaurants, Inc.(3)             |                        | Warrants                             |                                    |                   |        |        |  |       | 33     |        |  |   | 504    |       
|                                        | (Retail)               |                                      |                                    |                   |        |        |  |       |        |        |  |   |        |        | 
|                                       
|Walker Investment Fund II, LLLP(5)      |                        | Limited Partnership Interest         |                                    |                   |        |        |  |       | 1,330  |        |  |   | 378    |       
|                                        | (Private Equity Fund)  |                                      |                                    |                   |        |        |  |       |        |        |  |   |        |        | 
|                                       
|Wear Me Apparel Corporation             |                        | Debt Securities (15.0%, Due 12/10)   |                                    |                   | 50,000 |        |  |       | 48,777 |        |  |   | 48,777 |       
|                                        | (Consumer Products)    |                                      | Warrants                           |                   |        |        |  |       |        | 1,219  |  |   |        | 1,219  | 
|                                       
|Weston Solutions, Inc.                  |                        | Loan (17.3%, Due 6/10)               |                                    |                   | 7,350  |        |  |       | 7,322  |        |  |   | 7,322  |       
|                                        | (Business Services)    |                                      |                                    |                   |        |        |  |       |        |        |  |   |        |        | 
|                                       
|Wilshire Restaurant Group, Inc.         |                        | Debt Securities (20.0%, Due 6/07)(6) |                                    |                   | 19,107 |        |  |       | 18,566 |        |  |   | 15,636 |       
|                                        | (Retail)               |                                      | Warrants                           |                   |        |        |  |       |        | 735    |  |   |        |       | 
|                                       
|Wilton Industries, Inc.                 |                        | Loan (19.3%, Due 6/08)               |                                    |                   | 7,200  |        |  |       | 7,200  |        |  |   | 7,200  |       
|                                        | (Consumer Products)    |                                      |                                    |                   |        |        |  |       |        |        |  |   |        |        | 
|                                       
|Woodstream Corporation                  |                        | Loan (14.0%, Due 11/10)              |                                    |                   | 257    |        |  |       | 256    |        |  |   | 256    |       
|                                        | (Consumer Products)    |                                      | Debt Securities (14.0%, Due 11/10) |                   |        | 17,520 |  |       |        | 16,929 |  |   |        | 16,929 | 
|                                        |                        | Common Stock (180 shares)            |                                    |                   |        |        |  |       | 1,800  |        |  |   | 2,639  |       
|                                        |                        | Warrants                             |                                    |                   |        |        |  |       | 587    |        |  |   | 861    |       
|                                       

|                                                                                                                                                                                                                                                                       |  |  |  |  |  |  |  |  |  |  |  |  |  | 
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- |  |  |  |  |  |  |  |  |  |  |  |  |  | 
|(1)Interest
    rates represent the weighted average annual stated interest rate
    on loans and debt securities, which are presented by nature of
    indebtedness for a single issuer. The maturity dates represent
    the earliest and the latest maturity dates. |  |  |  | 
|(2)Common
    stock, preferred stock, warrants, options, and equity interests
    are generally non-income producing and restricted.                                                                                                                                   |  |  |  | 
|(3)Public
    company.                                                                                                                                                                                                                                                 |  |  |  | 
|(4)Non-U.S. company
    or principal place of business outside the U.S.                                                                                                                                                                                                |  |  |  | 
|(5)Non-registered
    investment company.                                                                                                                                                                                                                              |  |  |  | 
|(6)Loan or
    debt security is on non-accrual status and therefore is
    considered non-income producing.                                                                                                                                                            |  |  |  | 



The accompanying notes are an integral part of
these consolidated financial statements.




---



##### 



|                                                    |  |                      |  |                   |     |      |           |       |     |   |           |   |     | 
|--------------------------------------------------- |  | -------------------- |  | ----------------- | --- | ---- | --------- | ----- | --- | - | --------- | - | --- | 
|Private Finance                                     |  |                      |  |                  
|Portfolio Company                                   |  |                      |  | December 31, 2004
|(in thousands, except number of shares              |  |                      |  |                  
|and number of portfolio companies)                  |  | Investment(1)(2)     |  | Principal         |     | Cost |           | Value
|                                                    |  |                      |  |                   |     |      |           |      
|Other companies                                     |  | Other investments(6) |  | $                 | 228 |      |           | $     | 228 |   |           | $ | 228 | 
|                                                    |  | Other investments    |  |                   | 791 |      |           |       | 798 |   |           |   | 791 | 
|                                                    |  | Guaranty ($226)      |  |                   |     |      |           |       |     |   |           |   |     | 
|                                                   
|Total
    companies less than 5% owned              |  |                      |  |                   |     | $    | 800,828   |       |     | $ | 753,543   |  
|                                                   
|Total
    private finance (116 portfolio companies) |  |                      |  |                   |     | $    | 2,384,920 |       |     | $ | 2,302,086 |  
|                                                   

|                                                                                                                                                                                                                                                                       |  |  |  |  |  |  |  |  |  |  |  |  |  | 
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- |  |  |  |  |  |  |  |  |  |  |  |  |  | 
|(1)Interest
    rates represent the weighted average annual stated interest rate
    on loans and debt securities, which are presented by nature of
    indebtedness for a single issuer. The maturity dates represent
    the earliest and the latest maturity dates. |  |  |  | 
|(2)Common
    stock, preferred stock, warrants, options, and equity interests
    are generally non-income producing and restricted.                                                                                                                                   |  |  |  | 
|(3)Public
    company.                                                                                                                                                                                                                                                 |  |  |  | 
|(4)Non-U.S. company
    or principal place of business outside the U.S.                                                                                                                                                                                                |  |  |  | 
|(5)Non-registered
    investment company.                                                                                                                                                                                                                              |  |  |  | 
|(6)Loan or
    debt security is on non-accrual status and therefore is
    considered non-income producing.                                                                                                                                                            |  |  |  | 



The accompanying notes are an integral part of
these consolidated financial statements.




---



##### 



|                                               |                                                                                |                                                                |  |                   |   |      |   |        |           |  |   |        |         |  |   |        |         | 
|---------------------------------------------- | ------------------------------------------------------------------------------ | -------------------------------------------------------------- |  | ----------------- | - | ---- | - | ------ | --------- |  | - | ------ | ------- |  | - | ------ | ------- | 
|                                               |                                                                                |                                                                |  |                  
|                                               |                                                                                |                                                                |  | December 31, 2004
|                                               |                                                                                | Stated                                                         |  |                  
|                                               |                                                                                | Interest                                                       |  | Face              |   | Cost |   | Value 
|                                               |                                                                                |                                                                |  |                   |   |      |   |       
|Commercial Real Estate Finance                 |                                                                                |                                                                |  |                   |   |      |   |        |           |  |   |        |         |  |   |       
|(in thousands, except number of
    issuances) |                                                                                |                                                                |  |                   |   |      |   |        |           |  |   |        |         |  |   |       
|Commercial Mortgage-Backed
    Securities      |                                                                                |                                                                |  |                   |   |      |   |        |           |  |   |        |         |  |   |       
|                                               | Mortgage Capital Funding, Series 1998-MC3                                      |                                                                |  | 5.5               | % |      | $ | 51,105 |           |  | $ | 35,635 |         |  | $ | 31,332 |        
|                                               | Morgan Stanley Capital I, Series 1999-RM1                                      |                                                                |  | 6.4               | % |      |   | 27,936 |           |  |   | 9,169  |         |  |   | 9,169  |        
|                                               | COMM 1999-1                                                                    |                                                                |  | 5.7               | % |      |   | 50,032 |           |  |   | 28,192 |         |  |   | 27,399 |        
|                                               | Morgan Stanley Capital I, Series 1999-FNV1                                     |                                                                |  | 6.1               | % |      |   | 20,168 |           |  |   | 10,603 |         |  |   | 7,575  |        
|                                               | DLJ Commercial Mortgage Trust 1999-CG2                                         |                                                                |  | 6.1               | % |      |   | 39,165 |           |  |   | 13,344 |         |  |   | 13,789 |        
|                                               | Commercial Mortgage Acceptance Corp.,
    Series 1999-C1                       |                                                                |  | 6.8               | % |      |   | 18,173 |           |  |   | 4,685  |         |  |   | 4,685  |        
|                                               | LB Commercial Mortgage Trust, Series 1999-C2                                   |                                                                |  | 6.7               | % |      |   | 11,151 |           |  |   | 1,581  |         |  |   | 1,748  |        
|                                               | Chase Commercial Mortgage Securities Corp.,
    Series 1999-2                  |                                                                |  | 6.5               | % |      |   | 20,576 |           |  |   | 5,137  |         |  |   | 9,191  |        
|                                               | FUNB CMT, Series 1999-C4                                                       |                                                                |  | 6.5               | % |      |   | 18,587 |           |  |   | 7,700  |         |  |   | 6,866  |        
|                                               | Heller Financial, HFCMC Series 2000 PH-1                                       |                                                                |  | 6.6               | % |      |   | 23,536 |           |  |   | 8,433  |         |  |   | 8,528  |        
|                                               | SBMS VII, Inc., Series 2000-NL1                                                |                                                                |  | 7.2               | % |      |   | 8,122  |           |  |   | 4,388  |         |  |   | 3,474  |        
|                                               | DLJ Commercial Mortgage Trust,
    Series 2000-CF1                             |                                                                |  | 7.0               | % |      |   | 24,793 |           |  |   | 11,271 |         |  |   | 10,128 |        
|                                               | Deutsche Bank Alex. Brown, Series Comm
    2000-C1                             |                                                                |  | 6.9               | % |      |   | 12,290 |           |  |   | 3,693  |         |  |   | 2,511  |        
|                                               | LB-UBS Commercial Mortgage Trust,
    Series 2000-C4                           |                                                                |  | 6.9               | % |      |   | 13,841 |           |  |   | 3,421  |         |  |   | 1,704  |        
|                                               | Credit Suisse First Boston Mortgage Securities
    Corp., Series 2001-CK1      |                                                                |  | 5.9               | % |      |   | 16,861 |           |  |   | 4,147  |         |  |   | 5,010  |        
|                                               | JP Morgan-CIBC-Deutsche 2001                                                   |                                                                |  | 5.8               | % |      |   | 20,528 |           |  |   | 6,884  |         |  |   | 5,920  |        
|                                               | Lehman Brothers-UBS Warburg 2001-C2                                            |                                                                |  | 6.4               | % |      |   | 22,203 |           |  |   | 6,433  |         |  |   | 8,935  |        
|                                               | SBMS VII, Inc., Series 2001-C1                                                 |                                                                |  | 6.1               | % |      |   | 10,637 |           |  |   | 2,564  |         |  |   | 1,651  |        
|                                               | GE Capital Commercial Mortgage Securities Corp.,
    Series 2001-2             |                                                                |  | 6.1               | % |      |   | 18,446 |           |  |   | 6,766  |         |  |   | 6,766  |        
|                                               | Credit Suisse First Boston Mortgage Securities
    Corp.,
    Series 2001-CKN5 |                                                                |  | 5.2               | % |      |   | 16,881 |           |  |   | 5,416  |         |  |   | 3,468  |        
|                                               | JP Morgan Chase Commercial Mortgage Securities
    Corp.,
    Series 2001-C1   |                                                                |  | 5.6               | % |      |   | 21,141 |           |  |   | 5,786  |         |  |   | 5,786  |        
|                                               | SBMS VII, Inc., Series 2001-C2                                                 |                                                                |  | 6.2               | % |      |   | 21,735 |           |  |   | 5,743  |         |  |   | 5,743  |        
|                                               | FUNB CMT, Series 2002-C1                                                       |                                                                |  | 6.0               | % |      |   | 18,087 |           |  |   | 7,288  |         |  |   | 6,625  |        
|                                               | GE Capital Commercial Mortgage Corp.,
    Series 2002-1                        |                                                                |  | 6.2               | % |      |   | 25,965 |           |  |   | 7,163  |         |  |   | 7,163  |        
|                                               | GMAC Commercial Mortgage Securities, Inc.,
    Series 2002-C2                  |                                                                |  | 5.8               | % |      |   | 23,053 |           |  |   | 7,601  |         |  |   | 7,601  |        
|                                               | GE Capital Commercial Mortgage Corp.,
    Series 2002-3                        |                                                                |  | 5.1               | % |      |   | 27,796 |           |  |   | 6,326  |         |  |   | 6,326  |        
|                                               | Morgan Stanley Dean Witter Capital I Trust
    2002-IQ3                        |                                                                |  | 6.0               | % |      |   | 12,508 |           |  |   | 1,819  |         |  |   | 1,819  |        
|                                               | LB-UBS Commercial Mortgage Trust 2003-C1                                       |                                                                |  | 4.6               | % |      |   | 23,999 |           |  |   | 3,953  |         |  |   | 3,953  |        
|                                               | GS Mortgage Securities Corporation II
    Series 2003-C1                       |                                                                |  | 4.7               | % |      |   | 20,147 |           |  |   | 5,553  |         |  |   | 5,553  |        
|                                               | Credit Suisse First Boston Mortgage Securities
    Corp., Series 2003-CK2      |                                                                |  | 4.9               | % |      |   | 32,170 |           |  |   | 12,399 |         |  |   | 12,837 |        
|                                               | COMM 2003-LNB1                                                                 |                                                                |  | 4.4               | % |      |   | 20,094 |           |  |   | 3,281  |         |  |   | 3,281  |        
|                                               | Wachovia Bank Commercial Mortgage Trust,
    Series 2003-C5                    |                                                                |  | 4.3               | % |      |   | 34,527 |           |  |   | 8,086  |         |  |   | 8,086  |        
|                                               | GMAC Commercial Mortgage Securities, Inc.,
    Series 2003-C2                  |                                                                |  | 5.5               | % |      |   | 30,654 |           |  |   | 6,662  |         |  |   | 6,662  |        
|                                               | Wachovia Bank Commercial Mortgage Trust, Series
    2003-C9                    |                                                                |  | 5.3               | % |      |   | 28,737 |           |  |   | 8,933  |         |  |   | 8,933  |        
|                                               | GE Commercial Mortgage Corporation, Series 2004-C1                             |                                                                |  | 5.0               | % |      |   | 27,083 |           |  |   | 7,179  |         |  |   | 7,179  |        
|                                               | LB-UBS Commercial Mortgage Trust 2004-C1                                       |                                                                |  | 4.9               | % |      |   | 21,365 |           |  |   | 5,836  |         |  |   | 5,836  |        
|                                               | MezzCapp Commercial Mortgage Trust,
    Series 2004-C1                         |                                                                |  | 10.0              | % |      |   | 1,990  |           |  |   | 816    |         |  |   | 816    |        
|                                               | COMM 2004-LNB3                                                                 |                                                                |  | 5.3               | % |      |   | 26,708 |           |  |   | 9,658  |         |  |   | 9,658  |        
|                                               | GMAC Commercial Mortgage Securities, Inc.
    Series 2004-C1                   |                                                                |  | 5.3               | % |      |   | 23,035 |           |  |   | 10,616 |         |  |   | 10,646 |        
|                                               | GS Mortgage Securities Corporation II,
    Series 2004-C1                      |                                                                |  | 4.6               | % |      |   | 20,076 |           |  |   | 8,224  |         |  |   | 8,224  |        
|                                               | J.P. Morgan Chase Commercial Mortgage Securities
    Corp., Series 2004-LN2    |                                                                |  | 5.3               | % |      |   | 29,590 |           |  |   | 9,372  |         |  |   | 9,372  |        
|                                               | Wachovia Bank Commercial Mortgage Trust,
    Series 2004-C14                   |                                                                |  | 5.3               | % |      |   | 21,947 |           |  |   | 5,305  |         |  |   | 5,305  |        
|                                               | COMM 2004-LNB4                                                                 |                                                                |  | 4.7               | % |      |   | 43,033 |           |  |   | 20,888 |         |  |   | 21,191 |        
|                                               | Credit Suisse First Boston Mortgage Security
    Corp., Series 2004-C5         |                                                                |  | 4.7               | % |      |   | 12,125 |           |  |   | 9,445  |         |  |   | 9,466  |        
|                                               | ACGS, 2004-1                                                                   |                                                                |  | 5.4               | % |      |   | 9,292  |           |  |   | 9,218  |         |  |   | 9,197  |        
|                                               | ACGS, 2004-1, LLC Interests (See Note 3)                                       |                                                                |  |                   |   |      |   | 21,800 |           |  |   | 16,698 |         |  |   | 16,698 |        
|                                              
|                                               |                                                                                | Total commercial mortgage-backed securities
    (45 issuances) |  |                   |   |      |   | $      | 1,043,688 |  |   | $      | 383,310 |  |   | $      | 373,805 | 
|                                              



The accompanying notes are an integral part of
these consolidated financial statements.




---



##### 



|                                           |                                               |                                                          |   |        |         |  |   |        |         | 
|------------------------------------------ | --------------------------------------------- | -------------------------------------------------------- | - | ------ | ------- |  | - | ------ | ------- | 
|                                           |                                               |                                                         
|                                           |                                               | December 31, 2004                                       
|                                           |                                               |                                                         
|                                           |                                               | Cost                                                     |   | Value 
|                                           |                                               |                                                          |   |       
|Commercial Real Estate Finance             |                                               |                                                          |   |        |         |  |   |       
|(in thousands, except number of
    loans) |                                               |                                                          |   |        |         |  |   |       
|Collateralized Debt Obligations            |                                               |                                                          |   |        |         |  |   |       
|                                           | Crest 2001-1,
    Ltd.(4)                     |                                                          | $ | 22,032 |         |  | $ | 22,032 |        
|                                           | Crest 2002-1,
    Ltd.(4)                     |                                                          |   | 24,487 |         |  |   | 24,487 |        
|                                           | Crest 2002-IG,
    Ltd.(4)                    |                                                          |   | 4,119  |         |  |   | 4,119  |        
|                                           | Crest Clarendon Street
    2002-1, Ltd.(4)    |                                                          |   | 974    |         |  |   | 974    |        
|                                           | Crest 2003-1,
    Ltd.(4)                     |                                                          |   | 93,754 |         |  |   | 93,754 |        
|                                           | Crest 2003-2,
    Ltd.(4)                     |                                                          |   | 27,164 |         |  |   | 27,164 |        
|                                           | TIAA Real Estate CDO
    2003-1, Ltd.(4)      |                                                          |   | 986    |         |  |   | 986    |        
|                                           | Crest Exeter Street Solar
    2004-1, Ltd.(4) |                                                          |   | 1,818  |         |  |   | 1,818  |        
|                                           | Fairfield Street Solar
    2004-1, Ltd.(4)    |                                                          |   | 5,956  |         |  |   | 5,939  |        
|                                           | Crest 2004-1,
    Ltd.(4)                     |                                                          |   | 31,300 |         |  |   | 31,300 |        
|                                          
|                                           |                                               | Total
    collateralized debt obligations (10 issuances) |   | $      | 212,590 |  |   | $      | 212,573 | 
|                                          

|                                                        |                              |                                      |               |           |   |   |        |  |       |   |           |   |         |   |           |       |         | 
|------------------------------------------------------- | ---------------------------- | ------------------------------------ | ------------- | --------- | - | - | ------ |  | ----- | - | --------- | - | ------- | - | --------- | ----- | ------- | 
|                                                        |                              | Interest                             |               | Number of |   |   |        | 
|                                                        |                              | Rate Ranges                          |               | Loans     |   |   |        | 
|                                                        |                              |                                      |               |           |   |   |        | 
|Commercial Mortgage Loans                               |                              |                                      |               |           |   |   |        |  |       |   |           |   |         |   |           |      
|                                                        |                              |                                      | Up to 6.99%   |           |   |   | 13     |  |       | $ | 31,167    |   |         | $ | 29,567    |      
|                                                        |                              |                                      | 7.00%8.99%   |           |   |   | 14     |  |       |   | 30,169    |   |         |   | 30,169    |      
|                                                        |                              |                                      | 9.00%10.99%  |           |   |   | 4      |  |       |   | 19,129    |   |         |   | 19,129    |      
|                                                        |                              |                                      | 11.00%12.99% |           |   |   | 3      |  |       |   | 4,484     |   |         |   | 1,753     |      
|                                                        |                              |                                      | 13.00%14.99% |           |   |   | 3      |  |       |   | 10,454    |   |         |   | 10,468    |      
|                                                        |                              | 15.00% and above                     |               |           | 2 |   |        |  | 3,970 |   |           |   | 3,970   |  
|                                                       
|                                                        |                              | Total commercial mortgage loans(6)   |               |           |   |   |        |  | 39    |   |           | $ | 99,373  |   |           | $     | 95,056  | 
|                                                       
|Real Estate Owned                                       |                              |                                      |               |           |   |   |        |  |       | $ | 16,170    |   |         | $ | 16,871    |      
|                                                       
|Equity Interests(2)                                     |                              |                                      |               |           |   |   |        |  |       |   |           |   |         |   |           |      
|Companies more than 25% owned (Guarantees 
    $2,681) |                              |                                      |               |           |   | $ | 11,169 |  |       | $ | 10,474    |  
|                                                        | Companies less than 5% owned |                                      |               |           |   |   |        |  |       |   |           |  |         |   |           | 2,546 |        
|                                                       
|                                                        |                              | Total equity interests               |               |           |   |   |        |  |       |   |           | $ | 11,169  |   |           | $     | 13,020  | 
|                                                       
|                                                        |                              | Total commercial real estate finance |               |           |   |   |        |  |       |   |           | $ | 722,612 |   |           | $     | 711,325 | 
|                                                       
|Total portfolio                                         |                              |                                      |               |           |   |   |        |  |       | $ | 3,107,532 |   |         | $ | 3,013,411 |      
|                                                       

|                                                                                                                                                                                                                                                                       |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  | 
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  | 
|(1)Interest
    rates represent the weighted average annual stated interest rate
    on loans and debt securities, which are presented by nature of
    indebtedness for a single issuer. The maturity dates represent
    the earliest and the latest maturity dates.
|(2)Common
    stock, preferred stock, warrants, options, and equity interests
    are generally non-income producing and restricted.                                                                                                                                  
|(3)Public
    company.                                                                                                                                                                                                                                                
|(4)Non-U.S. company
    or principal place of business outside the U.S.                                                                                                                                                                                               
|(5)Non-registered
    investment company.                                                                                                                                                                                                                             
|(6)Commercial
    mortgage loans totaling $18.0 million were on non-accrual
    status and therefore were considered non-income producing.                                                                                                                            



The accompanying notes are an integral part of
these consolidated financial statements.




---



##### 



ALLIED CAPITAL CORPORATION AND
SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS

Note 1. Organization

Allied Capital Corporation, a Maryland
corporation, is a closed-end management investment company that
has elected to be regulated as a business development company
(BDC) under the Investment Company Act of 1940
(1940 Act). Allied Capital Corporation
(ACC) has a subsidiary that has also elected to be
regulated as a BDC, Allied Investment Corporation (Allied
Investment), which is licensed under the Small Business
Investment Act of 1958 as a Small Business Investment Company
(SBIC). In addition, ACC has a real estate
investment trust subsidiary, Allied Capital REIT, Inc.
(Allied REIT), and several subsidiaries which are
single member limited liability companies established primarily
to hold real estate properties. ACC also has a subsidiary, A.C.
Corporation (AC Corp), that provides diligence and
structuring services on private finance and commercial real
estate finance transactions, as well as structuring,
transaction, management and advisory services to the Company,
its portfolio companies and other third parties.

Allied Capital Corporation and its subsidiaries,
collectively, are referred to as the Company.

In accordance with specific rules prescribed for
investment companies, subsidiaries hold investments on behalf of
the Company or provide substantial services to the Company.
Portfolio investments are held for purposes of deriving
investment income and future capital gains. The Company
consolidates the results of its subsidiaries for financial
reporting purposes. The financial results of the Companys
portfolio investments are not consolidated in the Companys
financial statements.

The investment objective of the Company is to
achieve current income and capital gains. In order to achieve
this objective, the Company has invested in companies in a
variety of industries, non-investment grade commercial
mortgage-backed securities (CMBS) and collateralized
debt obligation bonds and preferred shares (CDOs).

Note 2. Summary of Significant Accounting
Policies



| |                      
| | ---------------------
| | Basis of Presentation

The consolidated financial statements include the
accounts of ACC and its subsidiaries. All intercompany accounts
and transactions have been eliminated in consolidation. Certain
reclassifications have been made to the 2003 and 2002 balances
to conform with the 2004 financial statement presentation.

The private finance portfolio and the interest
and related portfolio income and net realized gains (losses) on
the private finance portfolio are presented in three categories:
companies more than 25% owned, which represent portfolio
companies where the Company directly or indirectly owns more
than 25% of the outstanding voting securities of such portfolio
company and, therefore, are deemed controlled by the Company
under the 1940 Act; companies owned 5% to 25%, which represent
portfolio companies where the Company directly or indirectly
owns 5% to 25% of the outstanding voting securities of such
portfolio company or where the Company holds one or more seats
on the portfolio companys board of directors and,
therefore, are deemed to be an affiliated person under the 1940
Act; and companies less than 5% owned which represent portfolio
companies where the Company directly or indirectly owns less
than 5% of the outstanding voting



---



##### 



ALLIED CAPITAL CORPORATION AND
SUBSIDIARIES


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

Note 2. Summary of Significant Accounting
Policies, continued

securities of such portfolio company and where
the Company has no other affiliations with such portfolio
company. The interest and related portfolio income and net
realized gains (losses) from the commercial real estate finance
portfolio and other sources are included in the companies less
than 5% owned category on the consolidated statement of
operations.

In the ordinary course of business, the Company
enters into transactions with portfolio companies in the more
than 25% owned and the 5% to 25% owned categories that may be
considered related party transactions.



| |                                       
| | --------------------------------------
| | Valuation of Portfolio
    Investments

The Company, as a BDC, invests in illiquid
securities including debt and equity securities of companies,
non-investment grade CMBS, and the bonds and preferred shares of
CDOs. The Companys investments are generally subject to
restrictions on resale and generally have no established trading
market. The Company values substantially all of its investments
at fair value as determined in good faith by the Board of
Directors in accordance with the Companys valuation
policy. The Company determines fair value to be the amount for
which an investment could be exchanged in an orderly disposition
over a reasonable period of time between willing parties other
than in a forced or liquidation sale. The Companys
valuation policy considers the fact that no ready market exists
for substantially all of the securities in which it invests. The
Companys valuation policy is intended to provide a
consistent basis for determining the fair value of the
portfolio. The Company will record unrealized depreciation on
investments when it believes that an investment has become
impaired, including where collection of a loan or realization of
an equity security is doubtful, or when the enterprise value of
the portfolio company does not currently support the cost of the
Companys debt or equity investments. Enterprise value
means the entire value of the company to a potential buyer,
including the sum of the values of debt and equity securities
used to capitalize the enterprise at a point in time. The
Company will record unrealized appreciation if it believes that
the underlying portfolio company has appreciated in value and,
therefore, the Companys equity security has also
appreciated in value. The value of investments in publicly
traded securities is determined using quoted market prices
discounted for restrictions on resale, if any.



| |                          
| | -------------------------
| | Loans and Debt Securities

For loans and debt securities, fair value
generally approximates cost unless the borrowers
enterprise value, overall financial condition or other factors
lead to a determination of fair value at a different amount.

When the Company receives nominal cost warrants
or free equity securities (nominal cost equity), the
Company allocates its cost basis in its investment between its
debt securities and its nominal cost equity at the time of
origination. At that time, the original issue discount basis of
the nominal cost equity is recorded by increasing the cost basis
in the equity and decreasing the cost basis in the related debt
securities.

Interest income is recorded on an accrual basis
to the extent that such amounts are expected to be collected.
For loans and debt securities with contractual payment-in-kind
interest, which represents contractual interest accrued and
added to the loan balance that



---



##### 



ALLIED CAPITAL CORPORATION AND
SUBSIDIARIES


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)



Note 2. Summary of Significant Accounting
Policies, continued


generally becomes due at maturity, the Company
will not accrue payment-in-kind interest if the portfolio
company valuation indicates that the payment-in-kind interest is
not collectible. Interest on loans and debt securities is not
accrued if the Company has doubt about interest collection.
Loans in workout status that are classified as Grade 4 or 5
assets under the Companys internal grading system do not
accrue interest. In addition, interest may not accrue on loans
or debt securities to portfolio companies that are more than 50%
owned by the Company depending on such companys working
capital needs. Loan origination fees, original issue discount,
and market discount are capitalized and then amortized into
interest income using the effective interest method. Upon the
prepayment of a loan or debt security, any unamortized loan
origination fees are recorded as interest income and any
unamortized original issue discount or market discount is
recorded as a realized gain. Prepayment premiums are recorded on
loans and debt securities when received.

The weighted average yield on loans and debt
securities is computed as the (a) annual stated interest
plus the annual amortization of loan origination fees, original
issue discount, and market discount on accruing loans and debt
securities less the annual amortization of loan origination
costs, divided by (b) total loans and debt securities at
value. The weighted average yield is computed as of the balance
sheet date.



| |                  
| | -----------------
| | Equity Securities

The Companys equity interests in portfolio
companies for which there is no liquid public market are valued
at fair value based on the enterprise value of the portfolio
company, which is determined using various factors, including
cash flow from operations of the portfolio company and other
pertinent factors, such as recent offers to purchase a portfolio
company, recent transactions involving the purchase or sale of
the portfolio companys equity securities, or other
liquidation events. The determined equity values are generally
discounted to account for restrictions on resale and minority
ownership positions.

The value of the Companys equity interests
in public companies for which market quotations are readily
available is based on the closing public market price on the
balance sheet date. Securities that carry certain restrictions
on sale are typically valued at a discount from the public
market value of the security.

Dividend income is recorded on preferred equity
securities on an accrual basis to the extent that such amounts
are expected to be collected, and on common equity securities on
the record date for private companies or on the ex-dividend date
for publicly traded companies.



| |                                                                                                   
| | --------------------------------------------------------------------------------------------------
| | Commercial Mortgage-Backed Securities
    (CMBS) and Collateralized Debt Obligations
    (CDO)

CMBS bonds and CDO bonds and preferred shares are
carried at fair value, which is based on a discounted cash flow
model that utilizes prepayment and loss assumptions based on
historical experience and projected performance, economic
factors, the characteristics of the underlying cash flow, and
comparable yields for similar CMBS bonds and CDO bonds and
preferred shares, when available. The Company recognizes
unrealized



---



##### 



ALLIED CAPITAL CORPORATION AND
SUBSIDIARIES


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)



Note 2. Summary of Significant Accounting
Policies, continued


appreciation or depreciation on its CMBS bonds
and CDO bonds and preferred shares as comparable yields in the
market change and/or based on changes in estimated cash flows
resulting from changes in prepayment or loss assumptions in the
underlying collateral pool.

The Company recognizes income from the
amortization of original issue discount using the effective
interest method, using the anticipated yield over the projected
life of the investment. Yields are revised when there are
changes in actual and estimated prepayment speeds or actual and
estimated credit losses. Changes in estimated yield are
recognized as an adjustment to the estimated yield over the
remaining life of the CMBS bonds and CDO bonds and preferred
shares from the date the estimated yield is changed.



| |                                                                                           
| | ------------------------------------------------------------------------------------------
| | Net Realized Gains or Losses and Net Change
    in Unrealized Appreciation or Depreciation

Realized gains or losses are measured by the
difference between the net proceeds from the repayment or sale
and the cost basis of the investment without regard to
unrealized appreciation or depreciation previously recognized,
and include investments charged off during the year, net of
recoveries. Net change in unrealized appreciation or
depreciation reflects the change in portfolio investment values
during the reporting period, including the reversal of
previously recorded unrealized appreciation or depreciation when
gains or losses are realized.



| |           
| | ----------
| | Fee Income

Fee income includes fees for guarantees and
services rendered by the Company to portfolio companies and
other third parties such as diligence, structuring, transaction
services, management services, and other advisory services.
Guaranty fees are recognized as income over the related period
of the guaranty. Diligence, structuring, and transaction
services fees are generally recognized as income when services
are rendered or when the related transactions are completed.
Management and other advisory services fees are generally
recognized as income as the services are rendered.



| |           
| | ----------
| | Guarantees

The Company accounts for guarantees under FASB
Interpretation No. 45, Guarantors Accounting and
Disclosure Requirements for Guarantees, Including Indirect
Guarantees of Indebtedness of Others (the
Interpretation). In accordance with the
Interpretation, guarantees meeting the characteristics described
in the Interpretation, and issued or modified after
December 31, 2002, are recognized at fair value at
inception. However, certain guarantees are excluded from the
initial recognition provisions of the Interpretation. See
Note 5 for disclosures related to the Companys
guarantees.



| |                
| | ---------------
| | Financing Costs

Debt financing costs are based on actual costs
incurred in obtaining debt financing and are deferred and
amortized as part of interest expense over the term of the
related debt instrument. Costs associated with the issuance of
common stock, such as underwriting,



---



##### 



ALLIED CAPITAL CORPORATION AND
SUBSIDIARIES


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)



Note 2. Summary of Significant Accounting
Policies, continued


accounting and legal fees, and printing costs are
recorded as a reduction to the proceeds from the sale of common
stock.



| |                          
| | -------------------------
| | Cash and Cash Equivalents

Cash and cash equivalents include cash in banks
and all highly liquid investments with original maturities of
three months or less.



| |                          
| | -------------------------
| | Dividends to Shareholders

Dividends to shareholders are recorded on the
record date.



| |                         
| | ------------------------
| | Stock Compensation Plans

The Company has a stock-based employee
compensation plan, which is described more fully in
Note 10. The Company accounts for this plan under the
recognition and measurement principles of APB Opinion
No. 25, Accounting for Stock Issued to Employees,
and related interpretations. No stock-based employee
compensation cost is reflected in net increase in net assets
resulting from operations, as all options granted under this
plan had an exercise price equal to the market value of the
underlying common stock on the date of grant. The following
table illustrates the effect on net increase in net assets
resulting from operations and earnings per share if the Company
had applied the fair value recognition provisions of FASB
Statement No. 123, Accounting for Stock-Based
Compensation, to stock-based employee compensation for the
years ended December 31, 2004, 2003, and 2002.

|                                                                                                                                                 |             |      |         |      |  |      |         |      |  |   |         |      | 
|------------------------------------------------------------------------------------------------------------------------------------------------ | ----------- | ---- | ------- | ---- |  | ---- | ------- | ---- |  | - | ------- | ---- | 
|                                                                                                                                                 |             | 2004 |         | 2003 |  | 2002
|(in thousands, except per share amounts)                                                                                                         |             |      |         |      |  |     
|Net increase in net assets resulting from
    operations as reported                                                                             |             | $    | 249,486 |      |  | $    | 192,011 |      |  | $ | 228,291 |     
|Less total stock-based employee compensation
    expense determined under fair value based method for all awards,
    net of related tax effects |             |      | (16,908 | )    |  |      | (12,294 | )    |  |   | (6,863  | )   
|                                                                                                                                                 |             |      |         |      |  |      |         |      |  |   |         |     
|Pro forma net increase in net assets resulting
    from operations                                                                               |             |      | 232,578 |      |  |      | 179,717 |      |  |   | 221,428 |     
|Less preferred stock dividends                                                                                                                   |             |      | (62     | )    |  |      | (210    | )    |  |   | (230    | )   
|                                                                                                                                                 |             |      |         |      |  |      |         |      |  |   |         |     
|Pro forma net income available to common
    shareholders                                                                                        |             | $    | 232,516 |      |  | $    | 179,507 |      |  | $ | 221,198 |     
|                                                                                                                                                 |             |      |         |      |  |      |         |      |  |   |         |     
|Basic earnings per common share:                                                                                                                 |             |      |         |      |  |      |         |      |  |   |         |     
|                                                                                                                                                 | As reported |      | $       | 1.92 |  |      | $       | 1.64 |  |   | $       | 2.23 | 
|                                                                                                                                                 | Pro forma   |      | $       | 1.79 |  |      | $       | 1.54 |  |   | $       | 2.17 | 
|Diluted earnings per common share:                                                                                                               |             |      |         |      |  |      |         |      |  |   |         |     
|                                                                                                                                                 | As reported |      | $       | 1.88 |  |      | $       | 1.62 |  |   | $       | 2.20 | 
|                                                                                                                                                 | Pro forma   |      | $       | 1.76 |  |      | $       | 1.52 |  |   | $       | 2.14 | 

Pro forma expenses are based on the underlying
value of the options granted by the Company. The fair value of
each option grant is estimated on the date of grant using the
Black-Scholes option pricing model and expensed over the vesting
period. The following



---



##### 



ALLIED CAPITAL CORPORATION AND
SUBSIDIARIES


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)



Note 2. Summary of Significant Accounting
Policies, continued


weighted average assumptions were used to
calculate the fair value of options granted during the years
ended December 31, 2004, 2003, and 2002:

|                                       |  |      |      |      |  |      |      |   |  |   |      |  
|-------------------------------------- |  | ---- | ---- | ---- |  | ---- | ---- | - |  | - | ---- | -
|                                       |  | 2004 |      | 2003 |  | 2002
|                                       |  |      |      |      |  |     
|Risk-free interest rate                |  |      | 2.9  | %    |  |      | 2.8  | % |  |   | 3.2  | %
|Expected life                          |  |      | 5.0  |      |  |      | 5.0  |   |  |   | 5.0  |  
|Expected volatility                    |  |      | 37.0 | %    |  |      | 38.4 | % |  |   | 39.7 | %
|Dividend yield                         |  |      | 8.8  | %    |  |      | 8.9  | % |  |   | 8.5  | %
|Weighted average fair value per option |  | $    | 4.17 |      |  | $    | 3.47 |   |  | $ | 3.78 |  



| |                                   
| | ----------------------------------
| | Federal and State Income
    Taxes

The Company intends to comply with the
requirements of the Internal Revenue Code (Code)
that are applicable to regulated investment companies
(RIC) and real estate investment trusts
(REIT). The Company and its subsidiaries that
qualify as a RIC or a REIT intend to distribute or retain
through a deemed distribution all of their annual taxable income
to shareholders; therefore, the Company has made no provision
for federal income taxes for these entities. AC Corp is a
corporation subject to federal and state income taxes and
records a benefit or expense for income taxes as appropriate.



| |                      
| | ---------------------
| | Per Share Information

Basic earnings per common share is calculated
using the weighted average number of common shares outstanding
for the period presented. Diluted earnings per common share
reflects the potential dilution that could occur if options to
issue common stock were exercised into common stock. Earnings
per share is computed after subtracting dividends on preferred
shares.



| |                                                                
| | ---------------------------------------------------------------
| | Use of Estimates in the Preparation of
    Financial Statements

The preparation of financial statements in
conformity with U.S. generally accepted accounting principles
requires management to make estimates and assumptions that
affect the reported amounts of assets and liabilities and
disclosure of contingent assets and liabilities at the date of
the financial statements and the reported amounts of revenue and
expenses during the reporting period. Actual results could
differ from these estimates.

The consolidated financial statements include
portfolio investments at value of $3.0 billion and
$2.6 billion at December 31, 2004 and 2003,
respectively. At December 31, 2004 and 2003, 92% and 85%,
respectively, of the Companys total assets represented
portfolio investments whose fair values have been determined by
the Board of Directors in good faith in the absence of readily
available market values. Because of the inherent uncertainty of
valuation, the Board of Directors determined values may
differ significantly from the values that would have been used
had a ready market existed for the investments, and the
differences could be material.



---



##### 



ALLIED CAPITAL CORPORATION AND
SUBSIDIARIES


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)



Note 2. Summary of Significant Accounting
Policies, continued




| |                                     
| | ------------------------------------
| | Recent Accounting
    Pronouncements

In January 2003, the FASB issued Interpretation
No. 46 (FIN 46), Consolidation of
Variable Interest Entities, which provides new guidance on
the consolidation of certain entities defined as variable
interest entities. FIN 46 specifies that any enterprise
subject to SEC Regulation S-X Rule 6-03(c)(1) shall not
consolidate any entity that is not also subject to the same
rule. The Company is subject to Rule 6-03(c)(1), therefore
FIN 46 does not apply to its portfolio investments. The
Company has adopted FIN 46 and the adoption had no effect
on the Companys financial position or results of
operations.

In December 2004, the FASB issued Statement
No. 123 (Revised 2004), Share-Based Payment,
(the Statement) which requires companies to
recognize the grant-date fair value of stock options and other
equity-based compensation issued to employees in the income
statement. The Statement expresses no preference for a type of
valuation model and is effective for most public companies
interim or annual periods beginning after June 15, 2005.
The scope of the Statement includes a wide range of share-based
compensation arrangements including share options, restricted
share plans, performance-based awards, share appreciation
rights, and employee share purchase plans. The Statement
replaces FASB Statement No. 123, Accounting for
Stock-Based Compensation, and supersedes APB Opinion
No. 25, Accounting for Stock Issued to Employees.
The Company is currently evaluating the effects of the Statement
on its financial position and results of operations with respect
to the selection of a valuation model. See the Companys
current disclosure under APB Opinion No. 25 above.

Note 3. Portfolio



| |                
| | ---------------
| | Private Finance

At December 31, 2004 and 2003, the private
finance portfolio consisted of the following:

|                             |       |      |           |           |  |          |           |           |  |       |      |          |  |   |           |           |  |   |           |           |  |  |      |   | 
|---------------------------- | ----- | ---- | --------- | --------- |  | -------- | --------- | --------- |  | ----- | ---- | -------- |  | - | --------- | --------- |  | - | --------- | --------- |  |  | ---- | - | 
|                             |       |      |           |          
|                             |       | 2004 |           | 2003     
|                             |       |      |           |          
|                             |       | Cost |           | Value     |  | Yield(1) |           | Cost      |  | Value |      | Yield(1)
|($ in thousands)             |       |      |           |           |  |          |           |           |  |       |      |         
|Loans and debt securities(2) |       | $    | 1,679,855 |           |  | $        | 1,602,869 |           |  |       | 13.9 | %        |  | $ | 1,406,052 |           |  | $ | 1,214,886 |           |  |  | 15.0 | %
|Equity interests             |       |      | 705,065   |           |  |          | 699,217   |           |  |       |      |          |  |   | 500,079   |           |  |   | 687,786   |           |  |  |      |  
|                             |       |      |           |           |  |          |           |           |  |       |      |          |  |   |           |           |  |   |           |           |  |  |      |  
|                             | Total |      | $         | 2,384,920 |  |          | $         | 2,302,086 |  |       |      |          |  |   | $         | 1,906,131 |  |   | $         | 1,902,672 |  |  |      |   | 
|                             |       |      |           |           |  |          |           |           |  |       |      |          |  |   |           |           |  |   |           |           |  |  |      |  






|    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     
|--- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(1) | The weighted average yield on loans and debt
    securities is computed as the (a) annual stated interest
    plus the annual amortization of loan origination fees, original
    issue discount, and market discount on accruing loans and debt
    securities less the annual amortization of loan origination
    costs, divided by (b) total loans and debt securities at
    value. At December 31, 2004 and 2003, the cost and value of
    loans and debt securities include the Class A equity
    interests in BLX and the guaranteed dividend yield on these
    equity interests is included in interest income. The weighted
    average yield is computed as of the balance sheet date.
|   
|(2) | The principal balance outstanding on loans and
    debt securities was $1.7 billion and $1.4 billion at
    December 31, 2004 and 2003, respectively. The difference
    between principal and cost is represented by unamortized loan
    origination fees and costs, original issue discounts, and market
    discounts totaling $29.8 million and $40.8 million at
    December 31, 2004 and 2003, respectively.                                                                                                                                                                                                                                                                                 

The Companys private finance investment
activity principally involves providing financing through
privately negotiated long-term debt and equity investments. The
Companys private finance investments are generally issued
by private companies and are



---



##### 



ALLIED CAPITAL CORPORATION AND
SUBSIDIARIES


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)



Note 3. Portfolio, continued


generally illiquid and subject to restrictions on
resale. Private finance investments are generally structured as
loans and debt securities that carry a relatively high fixed
rate of interest, which may be combined with equity features,
such as conversion privileges, or warrants or options to
purchase a portion of the portfolio companys equity at a
pre-determined strike price, which is generally a nominal price
for warrants or options in a private company. The annual stated
interest rate is only one factor in pricing the investment
relative to our rights and priority in the portfolio
companys capital structure, and will vary depending on
many factors, including if the Company has received nominal cost
equity or other components of investment return, such as loan
origination fees or market discount. The stated interest rate
may include some component of contractual payment-in-kind
interest, which represents contractual interest accrued and
added to the loan balance that generally becomes due at
maturity. At December 31, 2004 and 2003, approximately 94%
and 97%, respectively, of the Companys loans and debt
securities had fixed interest rates.

Loans and debt securities generally have a
maturity of five to ten years, with interest-only payments in
the early years and payments of both principal and interest in
the later years, although debt maturities and principal
amortization schedules vary.

Equity interests consist primarily of securities
issued by private companies and may be subject to restrictions
on their resale and are generally illiquid. The Company may
incur closing costs associated with making control investments,
which will be added to the cost basis of the Companys
equity investment. Equity securities generally do not produce a
current return, but are held with the potential for investment
appreciation and ultimate gain on sale.

The Companys largest investments at
December 31, 2004, were in Business Loan Express, LLC and
Advantage Sales & Marketing, Inc. The Companys
largest investments at December 31, 2003, were in Business
Loan Express, LLC and The Hillman Companies, Inc. The
Companys investment in Hillman Companies, Inc. was sold on
March 31, 2004.

At December 31, 2004 and 2003, the Company
had an investment at cost and value totaling $280.4 million
and $335.2 million and $255.1 million and
$342.2 million, respectively, in Business Loan Express, LLC
(BLX), a small business lender that participates in
the U.S. Small Business Administrations 7(a)
Guaranteed Loan Program. At December 31, 2004 and 2003, the
Company owned 94.9% of the voting Class C equity interests.
BLX has an equity appreciation rights plan for management which
will dilute the value available to the Class C equity
interest holders. BLX is headquartered in New York, NY.

During the year ended December 31, 2004, the
Company provided BLX a new $20 million revolving credit facility
for working capital. At December 31, 2004, there were no
amounts outstanding under this facility.

BLX completed its corporate reorganization to a
limited liability company during the first quarter of 2003 by
merging BLX, Inc. into BLX, LLC. Prior to this transaction, BLX
converted $43 million of the Companys subordinated debt to
preferred stock in BLX, Inc., which was exchanged upon the
merger for Class A equity interests of BLX, LLC. In
addition, as part of the merger, the Company exchanged its
existing preferred stock and



---



##### 



ALLIED CAPITAL CORPORATION AND
SUBSIDIARIES


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)



Note 3. Portfolio, continued


common equity investments in BLX, Inc. for
similar classes of members equity in BLX, LLC represented
by Class B and Class C equity interests, respectively.

As a limited liability company, BLXs
taxable income flows through directly to its members. BLXs
annual taxable income generally differs from its book income for
the fiscal year due to temporary and permanent differences in
the recognition of income and expenses. The Company holds all of
BLXs Class A and Class B interests, and 94.9% of
the Class C interests. BLXs taxable income is first
allocated to the Class A interests to the extent that
dividends are paid in cash or in kind on such interests, with
the remainder being allocated to the Class B and
Class C interests. BLX declares dividends on its
Class B interests based on an estimate of its annual
taxable income allocable to such interests.

Total interest and related portfolio income
earned from the Companys investment in BLX for the years
ended December 31, 2004, 2003, and 2002, was
$50.0 million, $46.7 million, and $40.2 million,
respectively, which included interest income on the subordinated
debt and Class A equity interests of $23.2 million,
$21.9 million, and $20.7 million, respectively,
dividend income on Class B interests of $14.8 million,
$7.8 million, and $0, respectively, loan prepayment
premiums of $0, $0.1 million, and $0, respectively, and
fees and other income of $12.0 million, $16.9 million,
and $19.5 million, respectively. Interest and dividend
income from BLX for the years ended December 31, 2004,
2003, and 2002, included interest and dividend income of
$25.4 million, $17.5 million, and $9.5 million,
respectively, which was paid in kind. The interest and dividends
paid in kind were paid to the Company through the issuance of
additional debt or equity interests.

Net change in unrealized appreciation or
depreciation for the year ended December 31, 2004, includes
a net decrease in unrealized appreciation of $32.3 million
on the Companys investment in BLX. Net change in
unrealized appreciation or depreciation for the years ended
December 31, 2003 and 2002, include $51.7 million and
$19.9 million, respectively, of unrealized appreciation
related to BLX.

At the time of the corporate reorganization of
BLX, Inc. from a C corporation to a limited liability
company in 2003, for tax purposes BLX had a built-in
gain representing the aggregate fair market value of its
assets in excess of the tax basis of its assets. As a RIC, the
Company will be subject to special built-in gain rules on the
assets of BLX. Under these rules, taxes will be payable by the
Company at the time and to the extent that the built-in gains on
BLXs assets at the date of reorganization are recognized
in a taxable disposition of such assets in the 10-year period
following the date of the reorganization. At such time, the
built-in gains realized upon the disposition of these assets
will be included in the Companys taxable income, net of
the corporate level taxes paid by the Company on the built-in
gains. However, if these assets are disposed of after the
10-year period, there will be no corporate level taxes on these
built-in gains.

While the Company has no obligation to pay the
built-in gains tax until these assets are disposed of in the
future, it may be necessary to record a liability for these
taxes in the future should the Company intend to sell the assets
of BLX within the 10-year period. The Company estimates that its
future tax liability resulting from the built-in gains at the
date



---



##### 



ALLIED CAPITAL CORPORATION AND
SUBSIDIARIES


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)



Note 3. Portfolio, continued


of BLXs reorganization may total up to
$40 million. At December 31, 2004 and 2003, the
Company considered the increase in fair value of its investment
in BLX due to BLXs tax attributes as an LLC and has also
considered the reduction in fair value of its investment due to
these estimated built-in gain taxes in determining the fair
value of its investment in BLX.

As the controlling equity owner of BLX, the
Company has provided an unconditional guaranty to the BLX credit
facility lenders in an amount equal to 50% of the total
obligations (consisting of principal, letters of credit issued
under the facility, accrued interest, and other fees) on
BLXs three-year $275.0 million revolving credit
facility, which includes a sub-facility for the issuance of
letters of credit for up to a total of $50.0 million. The
facility matures in January 2007. The amount guaranteed by
the Company at December 31, 2004, was $94.6 million.
This guaranty can be called by the lenders only in the event of
a default by BLX. BLX was in compliance with the terms of its
credit facility at December 31, 2004. At December 31,
2004, the Company had also provided four standby letters of
credit totaling $35.6 million in connection with four term
securitization transactions completed by BLX. In consideration
for providing the guaranty and the standby letters of credit,
BLX paid the Company fees of $6.0 million,
$4.1 million, and $3.1 million for the years ended
December 31, 2004, 2003, and 2002, respectively.

In June 2004, the Company completed the
purchase of a majority ownership in Advantage Sales &
Marketing, Inc. (Advantage). At December 31,
2004, the Companys investment totaled $258.7 million
at cost and $283.0 at value. Advantage is a leading sales and
marketing agency providing outsourced sales, merchandising, and
marketing services to the consumer packaged goods industry.
Advantage has offices across the United States and is
headquartered in Irvine, CA.

At the closing of the transaction, the Company
invested $90.2 million in loans and subordinated debt and
$73.5 million in common stock. In addition, prior to
completing the purchase, the Company had invested
$93.7 million in subordinated debt in certain predecessor
companies of Advantage, of which $63.5 million was invested in
the first and second quarters of 2004. This existing debt was
exchanged for new subordinated debt in Advantage as part of the
transaction.

Total interest and related portfolio income
earned from the Companys investment in Advantage for the
year ended December 31, 2004, (since and including
June 30, 2004), was $21.3 million, which includes
interest income of $15.5 million and fees and other income
of $5.8 million. Net change in unrealized appreciation or
depreciation for the year ended December 31, 2004, includes
$24.3 million of unrealized appreciation related to
Advantage.

At December 31, 2003, the Company had an
investment in The Hillman Companies, Inc. (Hillman)
totaling $94.6 million at cost and $234.5 million at
value. On March 31, 2004, the Company sold its control
investment in Hillman for a total transaction value of
$510 million, including the repayment of outstanding debt
and adding the value of Hillmans outstanding trust
preferred shares. The Company was repaid its existing
$44.6 million in outstanding debt. Total consideration to
the Company from the sale at closing, including the repayment of
debt, was $244.3 million, which included net cash proceeds
of $196.8 million and the receipt of a new subordinated
debt instrument of



---



##### 



ALLIED CAPITAL CORPORATION AND
SUBSIDIARIES


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

Note 3. Portfolio, continued

$47.5 million. During the second quarter of
2004, the Company sold a $5.0 million participation in its
subordinated debt in Hillman to a third party, which reduced the
Companys investment, and no gain or loss resulted from the
transaction. For the year ended December 31, 2004, the
Company realized a gain of $150.3 million on the
transaction, including gains of $1.3 million realized after
closing resulting from post-closing adjustments, which provided
additional cash consideration to the Company in the same amount.
The sale of Hillman is subject to certain other post-closing
adjustments.

Total interest and related portfolio income
earned from the Companys control investment in Hillman for
the years ended December 31, 2004, 2003, and 2002, was
$2.5 million, $9.7 million, and $9.3 million,
respectively, which includes interest and dividend income of
$2.1 million, $7.9 million, and $7.5 million,
respectively, and fees and other income of $0.4 million,
$1.8 million, and $1.8 million, respectively.

Other activities in portfolio companies more than
25% owned excluding changes in unrealized appreciation or
depreciation during the year ended December 31, 2004,
included:



| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         
| | - | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | a $155.3 million debt and equity investment
    to purchase a majority ownership in Insight Pharmaceuticals
    Corporation;                                                                                                                                                                                                                                                                                                                                                                                                                            
|
| |  | a $93.1 million debt and equity investment
    to purchase a majority ownership in Financial Pacific Company;                                                                                                                                                                                                                                                                                                                                                                                                                                           
|
| |  | an $83.0 million debt and equity investment
    to purchase a majority ownership in Mercury Air Centers, Inc.
    and additional common stock and debt investments of
    $1.6 million and $0.8 million, respectively;                                                                                                                                                                                                                                                                                                                                  
|
| |  | an additional $42.2 million debt investment
    in Callidus Capital Corporation related to its middle market
    underwriting and syndication facility;                                                                                                                                                                                                                                                                                                                                                                                                 
|
| |  | a $7.0 million debt and equity investment to
    purchase Legacy Partners Group, LLC and an additional debt
    investment of $5.0 million for working capital;                                                                                                                                                                                                                                                                                                                                                                                         
|
| |  | an equity investment of $7.5 million and an
    exchange of existing subordinated debt with a cost basis of
    $7.3 million for equity interests in an affiliate of Impact
    Innovations Group, LLC (this investment was repaid during the
    third quarter of 2004);                                                                                                                                                                                                                                                                               
|
| |  | GAC Investments, Inc.s (GACI)
    acquisition of certain of the assets of Galaxy American
    Communications, LLC (Galaxy) out of bankruptcy
    during the third quarter of 2004. The Company exchanged its
    outstanding debt in Galaxy for debt and equity in GACI to
    facilitate the asset acquisition. The company is doing business
    as Longview Cable & Data. The Companys investment in
    GACI was $54.4 million at cost at December 31, 2004,
    which included additional equity investments of
    $3.7 million during 2004;
|
| |  | an exchange of existing debt securities, along
    with accrued and unpaid interest thereon, with a total cost
    basis of $49.8 million for $12.5 million of new debt and a
    68.5% common stock interest in Startec Global Communications
    Corporation (Startec) upon its emergence from
    bankruptcy in May 2004. The Company also                                                                                                                                                                                                         



---



##### 



ALLIED CAPITAL CORPORATION AND
SUBSIDIARIES


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)



Note 3. Portfolio, continued




| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                
| | - | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |   | provided a $4.0 million term loan to Startec
    to make an acquisition and for working capital;                                                                                                                                                                                                                                                                                                                                                               
|
| |  | an exchange of existing loans in Gordian Group,
    Inc., along with accrued and unpaid interest thereon, with a
    total cost basis of $11.1 million for new debt with a cost
    basis of $9.4 million and a contribution to capital of the
    remaining $1.7 million;                                                                                                                                                                                     
|
| |  | a new equity investment of $0.8 million and
    an exchange of existing debt securities, along with accrued and
    unpaid interest thereon, with a total cost basis of
    $13.4 million for new debt of $11.3 million with the
    remaining cost basis attributed to equity, in Fairchild
    Industrial Products Company (Fairchild) upon its
    emergence from bankruptcy in July 2004. The Company now owns
    100% of the common stock of Fairchild;
|
| |  | the repayment in kind of $10.0 million of
    debt in American Healthcare Services, Inc. and its affiliates
    (AHS) with debt in MedBridge Healthcare, LLC; the
    repayment in kind of $2.7 million of AHS debt with
    $2.5 million of equity in Maui Body Works, Inc. and
    $0.2 million of debt from other companies;                                                                                                                              
|
| |  | the sale of The Color Factory, Inc. during the
    third quarter of 2004; and                                                                                                                                                                                                                                                                                                                                                                                  
|
| |  | the exit of our investment in Ace Products, Inc.
    during the fourth quarter of 2004.                                                                                                                                                                                                                                                                                                                                                                        

At December 31, 2004 and 2003, loans and
debt securities at value not accruing interest were as follows:

|                                                                             |                               |       |   |        |        |  |   |        |         | 
|---------------------------------------------------------------------------- | ----------------------------- | ----- | - | ------ | ------ |  | - | ------ | ------- | 
|                                                                             |                               | 2004  |   | 2003  
|($ in thousands)                                                             |                               |       |   |       
|Loans and debt securities in workout status
    (classified as Grade 4 or 5) |                               |       |   |        |        |  |   |       
|                                                                             | Companies more than 25% owned |       | $ | 34,374 |        |  | $ | 31,873 |        
|                                                                             | Companies 5% to 25% owned     |       |   |       |        |  |   | 2,777  |        
|                                                                             | Companies less than 5% owned  |       |   | 16,550 |        |  |   | 28,027 |        
|Loans and debt securities not in workout status                              |                               |       |   |        |        |  |   |       
|                                                                             | Companies more than 25% owned |       |   | 29,368 |        |  |   | 31,897 |        
|                                                                             | Companies 5% to 25% owned     |       |   | 678    |        |  |   |       |        
|                                                                             | Companies less than 5% owned  |       |   | 15,864 |        |  |   | 16,532 |        
|                                                                             |                               |       |   |        |        |  |   |       
|                                                                             |                               | Total |   | $      | 96,834 |  |   | $      | 111,106 | 
|                                                                             |                               |       |   |        |        |  |   |       



---



##### 



ALLIED CAPITAL CORPORATION AND
SUBSIDIARIES


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)



Note 3. Portfolio, continued


The industry and geographic compositions of the
private finance portfolio at value at December 31, 2004 and
2003, were as follows:

|                                                                                                                                                                                                                         |       |      |    |      |   |  |    |     |  
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------ | ----- | ---- | -- | ---- | - |  | -- | --- | -
|                                                                                                                                                                                                                         |       | 2004 |    | 2003
|                                                                                                                                                                                                                         |       |      |    |     
|Industry                                                                                                                                                                                                                 |       |      |    |      |   |  |    |    
|Business services                                                                                                                                                                                                        |       |      | 32 | %    |   |  | 22 | %  
|Financial services                                                                                                                                                                                                       |       |      | 21 |      |   |  | 19 |    
|Consumer products                                                                                                                                                                                                        |       |      | 20 |      |   |  | 30 |    
|Healthcare services                                                                                                                                                                                                      |       |      | 8  |      |   |  | 8  |    
|Industrial products                                                                                                                                                                                                      |       |      | 8  |      |   |  | 6  |    
|Energy services                                                                                                                                                                                                          |       |      | 2  |      |   |  | 4  |    
|Retail                                                                                                                                                                                                                   |       |      | 2  |      |   |  | 4  |    
|Broadcasting and cable                                                                                                                                                                                                   |       |      | 2  |      |   |  | 2  |    
|Other                                                                                                                                                                                                                    |       |      | 5  |      |   |  | 5  |    
|                                                                                                                                                                                                                         |       |      |    |      |   |  |    |    
|                                                                                                                                                                                                                         | Total |      |    | 100  | % |  |    | 100 | %
|                                                                                                                                                                                                                         |       |      |    |      |   |  |    |    
|Geographic Region(1)                                                                                                                                                                                                     |       |      |    |      |   |  |    |    
|Mid-Atlantic                                                                                                                                                                                                             |       |      | 40 | %    |   |  | 40 | %  
|West                                                                                                                                                                                                                     |       |      | 30 |      |   |  | 16 |    
|Midwest                                                                                                                                                                                                                  |       |      | 16 |      |   |  | 26 |    
|Southeast                                                                                                                                                                                                                |       |      | 10 |      |   |  | 13 |    
|Northeast                                                                                                                                                                                                                |       |      | 4  |      |   |  | 4  |    
|International                                                                                                                                                                                                            |       |      |   |      |   |  | 1  |    
|                                                                                                                                                                                                                         |       |      |    |      |   |  |    |    
|                                                                                                                                                                                                                         | Total |      |    | 100  | % |  |    | 100 | %
|                                                                                                                                                                                                                         |       |      |    |      |   |  |    |    
|                                                                                                                                                                                                                         |       |      |    |      |   |  |    |    
|(1)The
    geographic region for the private finance portfolio depicts the
    location of the headquarters for the Companys portfolio
    companies. The portfolio companies may have a number of other
    locations.



| |                                   
| | ----------------------------------
| | Commercial Real Estate
    Finance

At December 31, 2004 and 2003, the
commercial real estate finance portfolio consisted of the
following:

|                               |       |      |         |         |  |          |         |         |  |       |      |          |  |   |         |         |  |   |         |         |  |  |      |   | 
|------------------------------ | ----- | ---- | ------- | ------- |  | -------- | ------- | ------- |  | ----- | ---- | -------- |  | - | ------- | ------- |  | - | ------- | ------- |  |  | ---- | - | 
|                               |       |      |         |        
|                               |       | 2004 |         | 2003   
|                               |       |      |         |        
|                               |       | Cost |         | Value   |  | Yield(1) |         | Cost    |  | Value |      | Yield(1)
|($ in thousands)               |       |      |         |         |  |          |         |         |  |       |      |         
|CMBS bonds                     |       | $    | 383,310 |         |  | $        | 373,805 |         |  |       | 14.6 | %        |  | $ | 399,106 |         |  | $ | 393,979 |         |  |  | 14.1 | %
|CDO bonds and preferred shares |       |      | 212,590 |         |  |          | 212,573 |         |  |       | 16.8 | %        |  |   | 186,824 |         |  |   | 186,557 |         |  |  | 16.7 | %
|Commercial mortgage loans      |       |      | 99,373  |         |  |          | 95,056  |         |  |       | 6.8  | %        |  |   | 87,427  |         |  |   | 83,639  |         |  |  | 8.6  | %
|Real estate owned              |       |      | 16,170  |         |  |          | 16,871  |         |  |       |      |          |  |   | 15,931  |         |  |   | 12,856  |         |  |  |      |  
|Equity interests               |       |      | 11,169  |         |  |          | 13,020  |         |  |       |      |          |  |   | 5,641   |         |  |   | 4,896   |         |  |  |      |  
|                               |       |      |         |         |  |          |         |         |  |       |      |          |  |   |         |         |  |   |         |         |  |  |      |  
|                               | Total |      | $       | 722,612 |  |          | $       | 711,325 |  |       |      |          |  |   | $       | 694,929 |  |   | $       | 681,927 |  |  |      |   | 
|                               |       |      |         |         |  |          |         |         |  |       |      |          |  |   |         |         |  |   |         |         |  |  |      |  




|    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
|--- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(1) | The weighted average yield on the
    interest-bearing investments is computed as the (a) annual
    stated interest plus the annual amortization of loan origination
    fees, original issue discount, and market discount on accruing
    interest-bearing investments less the annual amortization of
    origination costs, divided by (b) total interest-bearing
    investments at value. The weighted average yield is computed as
    of the balance sheet date.



---



##### 



ALLIED CAPITAL CORPORATION AND
SUBSIDIARIES


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)



Note 3. Portfolio, continued




| |                                                                                                                                                                 
| | ----------------------------------------------------------------------------------------------------------------------------------------------------------------
| | Interest-bearing investments for the commercial
    real estate finance portfolio include all investments except for
    real estate owned and equity interests.

CMBS Bonds.At December 31, 2004 and 2003, CMBS bonds consisted of the
following:

|                        |  |      |           |      |  |   |           |  
|----------------------- |  | ---- | --------- | ---- |  | - | --------- | -
|                        |  | 2004 |           | 2003
|($ in thousands)        |  |      |           |     
|Face                    |  | $    | 1,043,688 |      |  | $ | 1,016,533 |  
|Original issue discount |  |      | (660,378  | )    |  |   | (617,427  | )
|                        |  |      |           |      |  |   |           |  
|Cost                    |  | $    | 383,310   |      |  | $ | 399,106   |  
|                        |  |      |           |      |  |   |           |  
|Value                   |  | $    | 373,805   |      |  | $ | 393,979   |  
|                        |  |      |           |      |  |   |           |  

The underlying rating classes of the CMBS bonds
at cost and value at December 31, 2004 and 2003, were as
follows:

|                 |       |      |         |            |  |       |         |            |  |       |      |       |   |   |         |         |  |   |        |         |  |  |      |       |  
|---------------- | ----- | ---- | ------- | ---------- |  | ----- | ------- | ---------- |  | ----- | ---- | ----- | - | - | ------- | ------- |  | - | ------ | ------- |  |  | ---- | ----- | -
|                 |       |      |         |           
|                 |       | 2004 |         | 2003      
|                 |       |      |         |           
|                 |       |      |         | Percentage |  |       |         | Percentage
|                 |       |      |         | of Total   |  |       |         | of Total  
|                 |       | Cost |         | Value      |  | Value |         | Cost       |  | Value |      | Value
|($ in thousands) |       |      |         |            |  |       |         |            |  |       |      |      
|AA               |       | $    | 4,669   |            |  | $     | 4,658   |            |  |       | 1.2  | %     |   | $ |        |         |  | $ |       |         |  |  |     | %    
|A                |       |      | 4,549   |            |  |       | 4,539   |            |  |       | 1.2  |       |   |   |        |         |  |   |       |         |  |  |     |      
|BBB-             |       |      | 9,029   |            |  |       | 9,016   |            |  |       | 2.4  |       |   |   |        |         |  |   |       |         |  |  |     |      
|BB+              |       |      | 7,195   |            |  |       | 7,695   |            |  |       | 2.1  |       |   |   | 49,477  |         |  |   | 51,157 |         |  |  | 13.0 |      
|BB               |       |      | 5,940   |            |  |       | 5,952   |            |  |       | 1.6  |       |   |   | 22,031  |         |  |   | 23,008 |         |  |  | 5.9  |      
|BB-              |       |      | 7,490   |            |  |       | 7,676   |            |  |       | 2.1  |       |   |   | 13,538  |         |  |   | 14,266 |         |  |  | 3.6  |      
|B+               |       |      | 13,123  |            |  |       | 15,318  |            |  |       | 4.1  |       |   |   | 54,464  |         |  |   | 54,246 |         |  |  | 13.8 |      
|B                |       |      | 61,767  |            |  |       | 62,582  |            |  |       | 16.7 |       |   |   | 38,416  |         |  |   | 38,362 |         |  |  | 9.7  |      
|B-               |       |      | 89,341  |            |  |       | 88,099  |            |  |       | 23.6 |       |   |   | 84,986  |         |  |   | 83,859 |         |  |  | 21.3 |      
|CCC+             |       |      | 22,506  |            |  |       | 18,585  |            |  |       | 5.0  |       |   |   | 15,935  |         |  |   | 15,494 |         |  |  | 3.9  |      
|CCC              |       |      | 24,078  |            |  |       | 20,306  |            |  |       | 5.4  |       |   |   | 13,323  |         |  |   | 11,413 |         |  |  | 2.9  |      
|CCC-             |       |      |        |            |  |       |        |            |  |       |     |       |   |   | 3,133   |         |  |   | 2,410  |         |  |  | 0.6  |      
|CC               |       |      | 998     |            |  |       | 610     |            |  |       | 0.2  |       |   |   |        |         |  |   |       |         |  |  |     |      
|Unrated          |       |      | 132,625 |            |  |       | 128,769 |            |  |       | 34.4 |       |   |   | 103,803 |         |  |   | 99,764 |         |  |  | 25.3 |      
|                 |       |      |         |            |  |       |         |            |  |       |      |       |   |   |         |         |  |   |        |         |  |  |      |      
|                 | Total |      | $       | 383,310    |  |       | $       | 373,805    |  |       |      | 100.0 | % |   | $       | 399,106 |  |   | $      | 393,979 |  |  |      | 100.0 | %
|                 |       |      |         |            |  |       |         |            |  |       |      |       |   |   |         |         |  |   |        |         |  |  |      |      

The CMBS bonds in which the Company invests are
junior in priority for payment of interest and principal to the
more senior tranches of the related CMBS bond issuance. Cash
flow from the underlying mortgages is generally allocated first
to the senior tranches in order of priority, with the most
senior tranches having a priority right to the cash flow. Then,
any remaining cash flow is allocated, generally, among the other
tranches in order of their relative seniority. To the extent
there are defaults and unrecoverable losses on the underlying
mortgages or the properties securing those mortgages resulting
in reduced cash flows, the most subordinate tranche will bear
this loss first. At December 31, 2004, the face value of
the CMBS bonds rated BBB- and below held by the Company were
subordinate to 84% to 99% of the face value of the bonds issued
in these various CMBS transactions. At December 31, 2003,
the face value of the CMBS bonds held by the Company were
subordinate to 87% to 99% of the face value of the bonds issued
in these



---



##### 



ALLIED CAPITAL CORPORATION AND
SUBSIDIARIES


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)



Note 3. Portfolio, continued


various CMBS transactions. Given that the
non-investment grade CMBS bonds in which the Company invests are
junior in priority for payment of interest and principal, the
Company invests in these CMBS bonds at a discount from the face
amount of the bonds.

At December 31, 2004 and 2003, the Company held
CMBS bonds in 45 and 38 separate CMBS issuances,
respectively. The underlying collateral pool, consisting of
commercial mortgage loans and real estate owned
(REO) properties, for these CMBS issuances consisted
of the following at December 31, 2004 and 2003:

|                                                                     |  |      |         |      |  |          |        | 
|-------------------------------------------------------------------- |  | ---- | ------- | ---- |  | -------- | ------ | 
|                                                                     |  | 2004 |         | 2003
|($ in millions)                                                      |  |      |         |     
|Approximate number of loans and REO
    properties(1)                |  |      | 6,200   |      |  |          | 5,600  | 
|Total outstanding principal balance                                  |  |      | $42,759 |      |  | $        | 38,437 | 
|Loans over 30 days delinquent or classified as
    REO properties(2) |  |      | 1.6%(3) |      |  | 1.5% (3)



---

|    |                                                                                                                                                                                                                                                                                                                                                                      
|--- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(1) | Includes approximately 39 and 22 REO properties
    obtained through the foreclosure of commercial mortgage loans at
    December 31, 2004 and 2003, respectively.                                                                                                                                                                                                   
|   
|(2) | As a percentage of total outstanding principal
    balance.                                                                                                                                                                                                                                                                                                          
|   
|(3) | At December 31, 2004 and 2003, the
    Companys investments included bonds in the first loss,
    unrated bond class in 43 and 34 separate CMBS issuances,
    respectively. For these issuances, loans over 30 days
    delinquent or classified as REO properties were 1.7% of the
    total outstanding principal balance at both December 31,
    2004 and 2003.

The property types and the geographic composition
of the underlying mortgage loans and REO properties in the
underlying collateral pools for all CMBS issuances calculated
using the outstanding principal balance at December 31,
2004 and 2003, were as follows:

|                  |       |      |    |      |   |  |    |     |  
|----------------- | ----- | ---- | -- | ---- | - |  | -- | --- | -
|                  |       | 2004 |    | 2003
|                  |       |      |    |     
|Property Type     |       |      |    |      |   |  |    |    
|Retail            |       |      | 34 | %    |   |  | 35 | %  
|Office            |       |      | 26 |      |   |  | 24 |    
|Housing           |       |      | 24 |      |   |  | 25 |    
|Industrial        |       |      | 6  |      |   |  | 5  |    
|Hospitality       |       |      | 4  |      |   |  | 5  |    
|Other             |       |      | 6  |      |   |  | 6  |    
|                  |       |      |    |      |   |  |    |    
|                  | Total |      |    | 100  | % |  |    | 100 | %
|                  |       |      |    |      |   |  |    |    
|Geographic Region |       |      |    |      |   |  |    |    
|West              |       |      | 29 | %    |   |  | 31 | %  
|Mid-Atlantic      |       |      | 27 |      |   |  | 27 |    
|Midwest           |       |      | 22 |      |   |  | 21 |    
|Southeast         |       |      | 17 |      |   |  | 17 |    
|Northeast         |       |      | 5  |      |   |  | 4  |    
|                  |       |      |    |      |   |  |    |    
|                  | Total |      |    | 100  | % |  |    | 100 | %
|                  |       |      |    |      |   |  |    |    

The Companys yield on its CMBS bonds is
based upon a number of assumptions that are subject to certain
business and economic uncertainties and contingencies. Examples



---



##### 



ALLIED CAPITAL CORPORATION AND
SUBSIDIARIES


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)



Note 3. Portfolio, continued


include the timing and magnitude of credit losses
on the mortgage loans underlying the CMBS bonds that are a
result of the general condition of the real estate market,
including vacancies, changes in market rental rates and tenant
credit quality. The initial yield on each CMBS bond has
generally been computed assuming an approximate 1% loss rate on
its underlying collateral mortgage pool, with the estimated
losses being assumed to occur in three equal installments in
years three, six, and nine. As each CMBS bond ages, the expected
amount of losses and the expected timing of recognition of such
losses in the underlying collateral pool is updated, and the
respective yield will be adjusted as appropriate. Changes in
estimated yield are recognized as an adjustment to the estimated
yield over the remaining life of the CMBS bonds from the date
the estimated yield is changed. As these uncertainties and
contingencies are difficult to predict and are subject to future
events which may alter these assumptions, no assurance can be
given that the anticipated yields to maturity will be achieved.

At December 31, 2004 and 2003, the unamortized
discount related to the CMBS bond portfolio was
$660.4 million and $617.4 million, respectively, and
the Company had set aside $346.5 million and
$295.8 million, respectively, of this unamortized discount
to absorb potential future losses. The yields on the CMBS bonds
of 14.6% and 14.1%, respectively, assume that this amount that
has been set aside will not be amortized.

At December 31, 2004 and 2003, the Company had
reduced the face amount and the original issue discount on the
CMBS bonds for specifically identified losses of
$110.3 million and $52.6 million, respectively, which
had the effect of also reducing the amount of unamortized
discount set aside to absorb potential future losses since those
losses have now been recognized. The reduction of the face
amount and the original issue discount on the CMBS bonds to
reflect specifically identified losses will not result in a
change in the cost basis of the CMBS bonds.

The Company completed a securitization of
$53.7 million of commercial mortgage loans during 2004. In
connection with this securitization, the Company received
proceeds, net of costs, of $54.0 million, which included
cash, A and AA rated bonds, and LLC interests. The bonds and LLC
interests are included in the CMBS portfolio at
December 31, 2004. The realized gain from this
securitization was $0.3 million.

At December 31, 2004 and 2003, CMBS bonds with a
value of $0.1 and $0.2 million, respectively, were not
accruing interest.

Collateralized Debt Obligation Bonds and
Preferred Shares
(CDOs).At
December 31, 2004, the Company owned BB+ rated bonds
in one CDO totaling $5.9 million at value and preferred
shares in nine CDOs totaling $206.7 million at value. At
December 31, 2003, the Company owned BBB rated bonds in one
CDO totaling $16.0 million at value, BB rated bonds in one
CDO totaling $0.9 million at value and preferred shares in
seven CDOs totaling $169.7 million at value.

The bonds and preferred shares of the CDOs in
which the Company has invested are junior in priority for
payment of interest and principal to the more senior tranches of
debt issued by the CDOs. Cash flow from the underlying
collateral generally is allocated first to the senior bond
tranches in order of priority, with the most senior tranches
having a



---



##### 



ALLIED CAPITAL CORPORATION AND
SUBSIDIARIES


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)



Note 3. Portfolio, continued


priority right to the cash flow. Then, any
remaining cash flow is generally distributed to the preferred
shareholders. To the extent there are defaults and unrecoverable
losses on the underlying collateral that result in reduced cash
flows, the preferred shares will bear this loss first and then
the bonds would bear any loss after the preferred shares. At
December 31, 2004, the Companys bonds and preferred
shares in the CDOs were subordinate to 70% to 98% of the more
senior tranches of debt issued in the various CDO transactions.
At December 31, 2003, the Companys bonds in the CDO
were subordinate to 61% to 93% of the more senior tranches of
debt issued in the various CDO transactions and the preferred
shares in the CDOs were subordinate to 84% to 98% of the more
senior tranches of debt issued in the various CDO transactions.
In addition, included in the CMBS collateral for the CDOs at
December 31, 2004 and 2003, were certain CMBS bonds that
are senior in priority of repayment to certain lower rated CMBS
bonds held directly by the Company.

At December 31, 2004 and 2003, the
underlying collateral for the Companys investment in the
outstanding CDO issuances had balances as follows:

|                                   |                  |      |          |          |  |  |          |          | 
|---------------------------------- | ---------------- | ---- | -------- | -------- |  |  | -------- | -------- | 
|($ in millions)                    |                  | 2004 |          | 2003    
|                                   |                  |      |          |         
|Investment grade REIT debt(1)      |                  |      | $1,532.5 |          |  |  | $1,338.0 |         
|Investment grade CMBS bonds(2)     |                  |      | 918.8    |          |  |  | 662.3    |         
|Non-investment grade CMBS bonds(3) |                  |      | 1,636.4  |          |  |  | 1,133.7  |         
|Other collateral                   |                  |      | 355.8    |          |  |  | 32.4     |         
|                                   |                  |      |          |          |  |  |          |         
|                                   | Total collateral |      |          | $4,443.5 |  |  |          | $3,166.4 | 
|                                   |                  |      |          |          |  |  |          |         



---

|    |                                                                                
|--- | -------------------------------------------------------------------------------
|(1) | Issued by 44 REITs for both periods presented.                                 
|(2) | Issued in 121 and 78 transactions, respectively,
    for the periods presented.
|(3) | Issued in 109 and 68 transactions, respectively,
    for the periods presented.

The initial yields on the CDO bonds and preferred
shares are based on the estimated future cash flows from the
assets in the underlying collateral pool to be paid to these CDO
classes. As each CDO bond and preferred share ages, the
estimated future cash flows will be updated based on the
estimated performance of the collateral, and the respective
yield will be adjusted as necessary. As future cash flows are
subject to uncertainties and contingencies that are difficult to
predict and are subject to future events which may alter current
assumptions, no assurance can be given that the anticipated
yields to maturity will be achieved.

As of December 31, 2004, 2003, and 2002, the
Company acted as the disposition consultant with respect to six,
five, and three, respectively, of the CDOs, which allows the
Company to approve disposition plans for individual collateral
securities. For these services, the Company collects annual fees
based on the outstanding collateral pool balance, and for the
years ended December 31, 2004, 2003, and 2002, these fees
totaled $1.7 million, $1.2 million, and
$0.5 million, respectively.

Loans and Equity Interests.The commercial mortgage loan
portfolio contains loans that were originated by the Company or
were purchased from third-party sellers. At December 31,
2004, approximately 94% and 6% of the Companys commercial
mortgage



---



##### 



ALLIED CAPITAL CORPORATION AND
SUBSIDIARIES


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)



Note 3. Portfolio, continued


loan portfolio was composed of fixed and
adjustable interest rate loans, respectively. At
December 31, 2003, approximately 92% and 8% of the
Companys commercial mortgage loan portfolio was composed
of fixed and adjustable interest rate loans, respectively. As of
December 31, 2004 and 2003, loans with a value of
$18.0 million and $6.8 million, respectively, were not
accruing interest. Loans greater than 120 days delinquent
generally do not accrue interest.

Equity interests consist primarily of equity
securities issued by privately owned companies that invest in
single real estate properties. These equity interests may be
subject to restrictions on their resale and are generally
illiquid. Equity interests generally do not produce a current
return, but are generally held in anticipation of investment
appreciation and ultimate realized gain on sale.

The property types and the geographic composition
securing the commercial mortgage loans and equity interests at
value at December 31, 2004 and 2003, were as follows:

|                  |       |      |    |      |   |  |    |     |  
|----------------- | ----- | ---- | -- | ---- | - |  | -- | --- | -
|                  |       | 2004 |    | 2003
|                  |       |      |    |     
|Property Type     |       |      |    |      |   |  |    |    
|Hospitality       |       |      | 49 | %    |   |  | 41 | %  
|Retail            |       |      | 21 |      |   |  | 21 |    
|Office            |       |      | 17 |      |   |  | 22 |    
|Housing           |       |      | 5  |      |   |  | 4  |    
|Healthcare        |       |      |   |      |   |  | 7  |    
|Other             |       |      | 8  |      |   |  | 5  |    
|                  |       |      |    |      |   |  |    |    
|                  | Total |      |    | 100  | % |  |    | 100 | %
|                  |       |      |    |      |   |  |    |    
|                 
|Geographic Region |       |      |    |      |   |  |    |    
|Midwest           |       |      | 30 | %    |   |  | 30 | %  
|Southeast         |       |      | 26 |      |   |  | 34 |    
|Mid-Atlantic      |       |      | 20 |      |   |  | 9  |    
|West              |       |      | 16 |      |   |  | 20 |    
|Northeast         |       |      | 8  |      |   |  | 7  |    
|                  |       |      |    |      |   |  |    |    
|                  | Total |      |    | 100  | % |  |    | 100 | %
|                  |       |      |    |      |   |  |    |    



---



##### 



ALLIED CAPITAL CORPORATION AND
SUBSIDIARIES


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

Note 4. Debt

At December 31, 2004 and 2003, the Company
had the following debt:

|                              |                         |                                    |         |           |           |          |         |           |           |        |      |          |      |  |         |           |         |  |   |         |         |  |   |      |      | 
|----------------------------- | ----------------------- | ---------------------------------- | ------- | --------- | --------- | -------- | ------- | --------- | --------- | ------ | ---- | -------- | ---- |  | ------- | --------- | ------- |  | - | ------- | ------- |  | - | ---- | ---- | 
|                              |                         |                                    |         |          
|                              |                         | 2004                               |         | 2003     
|                              |                         |                                    |         |          
|                              |                         |                                    |         | Annual    |           |          |         | Annual   
|                              |                         | Facility                           |         | Amount    |           | Interest |         | Facility  |           | Amount |      | Interest
|                              |                         | Amount                             |         | Drawn     |           | Cost(1)  |         | Amount    |           | Drawn  |      | Cost(1) 
|($ in thousands)              |                         |                                    |         |           |           |          |         |           |           |        |      |         
|Notes payable and debentures: |                         |                                    |         |           |           |          |         |           |           |        |      |          |      |  |         |           |         |  |   |         |         |  |   |     
|                              | Unsecured notes payable |                                    | $       | 981,368   |           |          | $       | 981,368   |           |        |      | 6.5%     |      |  | $       | 854,000   |         |  | $ | 854,000 |         |  |   | 7.2% |     
|                              | SBA debentures          |                                    |         | 84,800    |           |          |         | 77,500    |           |        |      | 8.2%     |      |  |         | 101,800   |         |  |   | 94,500  |         |  |   | 8.1% |     
|                              | OPIC loan               |                                    |         | 5,700     |           |          |         | 5,700     |           |        |      | 6.6%     |      |  |         | 5,700     |         |  |   | 5,700   |         |  |   | 6.6% |     
|                              |                         |                                    |         |           |           |          |         |           |           |        |      |          |      |  |         |           |         |  |   |         |         |  |   |     
|                              |                         | Total notes payable and debentures |         |           | 1,071,868 |          |         |           | 1,064,568 |        |      |          | 6.6% |  |         |           | 961,500 |  |   |         | 954,200 |  |   |      | 7.3% | 
|Revolving line of credit      |                         |                                    | 552,500 |           |           |          | 112,000 |           |           |        | 6.3% | (2)      |      |  | 532,500 |           |         |  |  |         |         |  |  | (2) 
|                              |                         |                                    |         |           |           |          |         |           |           |        |      |          |      |  |         |           |         |  |   |         |         |  |   |     
|                              | Total debt              |                                    | $       | 1,624,368 |           |          | $       | 1,176,568 |           |        |      | 6.6%     | (2)  |  | $       | 1,494,000 |         |  | $ | 954,200 |         |  |   | 7.5% | (2) 
|                              |                         |                                    |         |           |           |          |         |           |           |        |      |          |      |  |         |           |         |  |   |         |         |  |   |     



---

|    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|--- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(1) | The weighted average annual interest cost is
    computed as the (a) annual stated interest on the debt plus the
    annual amortization of commitment fees and other facility fees
    that are recognized into interest expense over the contractual
    life of the respective borrowings, divided by (b) debt
    outstanding on the balance sheet date.                                                                                                                                                                                                                                                                                   
|   
|(2) | The stated interest rate payable on the revolving
    line of credit was 4.7% at December 31, 2004, which
    excluded the annual cost of commitment fees and other facility
    fees of $1.8 million. There were no amounts drawn on the
    revolving line of credit at December 31, 2003. The annual
    cost of commitment fees and other facility fees was
    $2.7 million at December 31, 2003. The annual interest
    cost for total debt includes the annual cost of commitment fees
    and other facility fees on the revolving line of credit
    regardless of the amount drawn on the facility as of the balance
    sheet date.

Notes Payable and
Debentures

Unsecured Notes
Payable.The Company has issued
unsecured long-term notes to private institutional investors.
The notes require semi-annual interest payments until maturity
and have original terms of five or seven years. At
December 31, 2004, the notes had remaining maturities of
five months to seven years. The notes may be prepaid in whole or
in part, together with an interest premium, as stipulated in the
note agreement.

On November 15, 2004, the Company issued
$252.5 million of five-year and $72.5 million of
seven-year unsecured long-term notes, primarily to insurance
companies. The five- and seven-year notes have fixed interest
rates of 5.53% and 5.99%, respectively, and have substantially
the same terms as the Companys existing unsecured
long-term notes. In addition, on November 15, 2004,
$102.0 million of the Companys existing unsecured
long-term notes matured and the Company used the proceeds from
the new long-term note issuance to repay this debt.

During 2004, the Company also repaid
$112.0 million of the unsecured notes payable that matured
on May 1, 2004.

On March 25, 2004, the Company issued
five-year unsecured long-term notes denominated in Euros and
Sterling for a total U.S. dollar equivalent of
$15.2 million. The notes have fixed interest rates and have
substantially the same terms as the Companys existing
unsecured notes. The Euro notes require annual interest payments
and the Sterling notes require semi-annual interest payments
until maturity. Simultaneous with issuing the



---



##### 



ALLIED CAPITAL CORPORATION AND
SUBSIDIARIES


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)



Note 4. Debt, continued


notes, the Company entered into a cross-currency
swap with a financial institution which fixed the Companys
interest and principal payments in U.S. dollars for the life of
the debt.

SBA
Debentures.At December 31,
2004 and 2003, the Company had debentures payable to the SBA
with original terms of ten years and at fixed interest rates
ranging from 5.9% to 7.6% and 5.9% to 8.2%, respectively. During
the year ended December 31, 2004, the Company repaid
$17.0 million of the SBA debentures. At December 31,
2004, the debentures had remaining maturities of nine months to
seven years. The debentures require semi-annual interest-only
payments with all principal due upon maturity. The SBA
debentures are subject to prepayment penalties if paid prior to
the fifth anniversary date of the notes.

At December 31, 2004, the Company had a
commitment from the SBA to borrow up to an additional
$7.3 million above the current amount outstanding. The
commitment expires on September 30, 2005.

Scheduled
Maturities.Scheduled future
maturities of notes payable and debentures at December 31,
2004, were as follows:

|           |       |                  |         |           | 
|---------- | ----- | ---------------- | ------- | --------- | 
|Year       |       | Amount Maturing 
|           |       |                 
|           |       | ($ in thousands)
|2005       |       | $                | 169,000 |          
|2006       |       |                  | 180,700 |          
|2007       |       |                  |        |          
|2008       |       |                  | 153,000 |          
|2009       |       |                  | 268,868 |          
|Thereafter |       |                  | 293,000 |          
|           |       |                  |         |          
|          
|           | Total |                  | $       | 1,064,568 | 
|           |       |                  |         |          



| |                         
| | ------------------------
| | Revolving Line of Credit

The committed amount under the unsecured
revolving credit facility is $552.5 million and may be
further expanded through new or additional commitments up to
$600 million at the Companys option. The facility
generally bears interest at a rate, at the Companys
option, equal to (i) the one-month LIBOR plus 1.50%,
(ii) the Bank of America, N.A. cost of funds plus 1.50% or
(iii) the higher of the Bank of America, N.A. prime rate or
the Federal Funds rate plus 0.50%. The interest rate adjusts at
the beginning of each new interest period, usually every
30 days. The facility requires an annual commitment fee
equal to 0.25% of the committed amount. The annual cost of
commitment fees and other facility fees was $1.8 million
and $2.7 million at December 31, 2004 and 2003,
respectively. The line of credit generally requires monthly
payments of interest, and all principal is due upon maturity.
The line of credit expires in April 2005 and may be extended
under substantially similar terms for one additional year at the
Companys option. An extension of the facility would
require payment of an extension fee of 0.3% on existing



---



##### 



ALLIED CAPITAL CORPORATION AND
SUBSIDIARIES


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)



Note 4. Debt, continued


commitments and the interest rate on outstanding
borrowings would increase by 0.5% during the extension period.

The average debt outstanding on the revolving
line of credit was $75.2 million and $41.5 million for
the years ended December 31, 2004 and 2003, respectively.
The maximum amount borrowed under this facility and the weighted
average stated interest rate for the years ended
December 31, 2004 and 2003, were $353.0 million and
3.1%, and $208.8 million and 2.0%, respectively. As of
December 31, 2004, the amount available under the revolving
line of credit was $396.4 million, net of amounts committed
for standby letters of credit of $44.1 million issued under
the credit facility. As of December 31, 2003, the amount
available under the revolving line of credit was
$487.0 million, net of amounts committed for standby
letters of credit of $45.5 million issued under the credit
facility.



| |                   
| | ------------------
| | Fair Value of Debt

The Company records debt at cost. The fair value
of the Companys outstanding debt was approximately
$1.2 billion and $1.0 billion at December 31,
2004 and 2003, respectively. The fair value of the
Companys debt was determined using market interest rates
as of the balance sheet date for similar instruments.



| |                    
| | -------------------
| | Covenant Compliance

The Company has various financial and operating
covenants required by the notes payable and debentures and the
revolving line of credit. These covenants require the Company to
maintain certain financial ratios, including debt to equity and
interest coverage, and a minimum net worth. The Companys
credit facilities limit its ability to declare dividends if the
Company defaults under certain provisions. As of
December 31, 2004 and 2003, the Company was in compliance
with these covenants.

Note 5. Guarantees and Other
Commitments

In the ordinary course of business, the Company
has issued guarantees and has extended standby letters of credit
through financial intermediaries on behalf of certain portfolio
companies. All standby letters of credit have been issued
through Bank of America, N.A. As of December 31, 2004 and
2003, the Company had issued guarantees of debt, rental
obligations, lease obligations and severance obligations
aggregating $100.2 million and $83.4 million,
respectively, and had extended standby letters of credit
aggregating $44.1 million and $45.5 million,
respectively. Under these arrangements, the Company would be
required to make payments to third-party beneficiaries if the
portfolio companies were to default on their related payment
obligations. The maximum amount of potential future payments was
$144.3 million and $128.9 million at December 31,
2004 and 2003, respectively. At December 31, 2004,
$0.8 million had been recorded as a liability for the
Companys guarantees and no amounts had been recorded as a
liability for the Companys standby letters of credit. At
December 31, 2003, no amounts had been recorded as a
liability for the Companys guarantees or standby letters
of credit.



---



##### 



ALLIED CAPITAL CORPORATION AND
SUBSIDIARIES


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

Note 5. Guarantees and Other
Commitments, continued

As of December 31, 2004, the guarantees and
standby letters of credit expire as follows:

|                             |       |       |       |       |  |      |     |      |  |      |      |      |  |            |      |      |  |   |     |     |  |   |     |     |  |   |     |     | 
|---------------------------- | ----- | ----- | ----- | ----- |  | ---- | --- | ---- |  | ---- | ---- | ---- |  | ---------- | ---- | ---- |  | - | --- | --- |  | - | --- | --- |  | - | --- | --- | 
|                             |       | Total |       | 2005  |  | 2006 |     | 2007 |  | 2008 |      | 2009 |  | After 2009
|($ in millions)              |       |       |       |       |  |      |     |      |  |      |      |      |  |           
|Guarantees                   |       | $     | 100.2 |       |  | $    | 0.6 |      |  | $    | 1.1  |      |  | $          | 94.8 |      |  | $ | 0.1 |     |  | $ | 2.5 |     |  | $ | 1.1 |    
|Standby letters of credit(1) |       |       | 44.1  |       |  |      |    |      |  |      | 44.1 |      |  |            |     |      |  |   |    |     |  |   |    |     |  |   |    |    
|                             |       |       |       |       |  |      |     |      |  |      |      |      |  |            |      |      |  |   |     |     |  |   |     |     |  |   |     |    
|                             | Total |       | $     | 144.3 |  |      | $   | 0.6  |  |      | $    | 45.2 |  |            | $    | 94.8 |  |   | $   | 0.1 |  |   | $   | 2.5 |  |   | $   | 1.1 | 
|                             |       |       |       |       |  |      |     |      |  |      |      |      |  |            |      |      |  |   |     |     |  |   |     |     |  |   |     |    



---

|    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
|--- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(1) | Standby letters of credit are issued under the
    Companys revolving line of credit that expires in April
    2005 and may be extended under substantially similar terms for
    one additional year at the Companys option, for an assumed
    maturity of April 2006. Therefore, unless a standby letter of
    credit is set to expire at an earlier date, it is assumed that
    the standby letters of credit will expire contemporaneously with
    the expiration of the Companys line of credit in April
    2006.

In the ordinary course of business, the Company
enters into agreements with service providers and other parties
that may contain provisions for the Company to indemnify such
parties under certain circumstances.

At December 31, 2004, the Company had
outstanding commitments to fund investments totaling
$330.2 million. In addition, during the fourth quarter of
2004, the Company sold certain commercial mortgage loans that
the Company may be required to repurchase under certain
circumstances. These recourse provisions expire by January 2006.
The aggregate outstanding principal balance of these sold loans
was $11.7 million at December 31, 2004.

Note 6. Preferred Stock

At December 31, 2003, Allied Investment had
outstanding a total of 60,000 shares of $100 par value, 3%
cumulative preferred stock and 10,000 shares of $100 par value,
4% redeemable cumulative preferred stock issued to the SBA
pursuant to Section 303(c) of the Small Business Investment
Act of 1958, as amended. In April 2004, Allied Investment
redeemed the preferred stock by paying the SBA the par value of
such securities plus any dividends accumulated and unpaid to the
date of redemption. Accordingly, there were no amounts
outstanding at December 31, 2004.

Note 7. Shareholders
Equity

Sales of common stock for the years ended
December 31, 2004, 2003, and 2002, were as follows:

|                                        |              |      |        |        |  |      |         |         |  |   |         |         | 
|--------------------------------------- | ------------ | ---- | ------ | ------ |  | ---- | ------- | ------- |  | - | ------- | ------- | 
|                                        |              | 2004 |        | 2003   |  | 2002
|(in thousands)                          |              |      |        |        |  |     
|Number of common shares                 |              |      | 3,000  |        |  |      | 18,700  |         |  |   | 8,047   |        
|                                        |              |      |        |        |  |      |         |         |  |   |         |        
|Gross proceeds                          |              | $    | 75,000 |        |  | $    | 442,680 |         |  | $ | 177,345 |        
|Less costs, including underwriting fees |              |      | (4,749 | )      |  |      | (20,675 | )       |  |   | (4,498  | )      
|                                        |              |      |        |        |  |      |         |         |  |   |         |        
|                                        | Net proceeds |      | $      | 70,251 |  |      | $       | 422,005 |  |   | $       | 172,847 | 
|                                        |              |      |        |        |  |      |         |         |  |   |         |        



---



##### 



ALLIED CAPITAL CORPORATION AND
SUBSIDIARIES


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)



Note 7. Shareholders Equity,
continued


In addition, the Company issued 123,814 shares of
common stock with a value of $3.2 million to acquire one
portfolio investment during 2004, and 32,266 shares of common
stock with a value of $0.9 million to acquire one portfolio
investment during 2003.

The Company has a dividend reinvestment plan,
whereby the Company may buy shares of its common stock in the
open market or issue new shares in order to satisfy dividend
reinvestment requests. If the Company issues new shares, the
issue price is equal to the average of the closing sale prices
reported for the Companys common stock for the five
consecutive trading days immediately prior to the dividend
payment date. For the years ended December 31, 2004, 2003,
and 2002, the Company issued new shares in order to satisfy
dividend reinvestment requests.

Dividend reinvestment plan activity for the years
ended December 31, 2004, 2003, and 2002, was as follows:

|                                         |  |      |       |      |  |      |       |  |  |   |       | 
|---------------------------------------- |  | ---- | ----- | ---- |  | ---- | ----- |  |  | - | ----- | 
|                                         |  | 2004 |       | 2003 |  | 2002
|(in thousands, except per share amounts) |  |      |       |      |  |     
|Shares issued                            |  |      | 222   |      |  |      | 279   |  |  |   | 275   | 
|Average price per share                  |  | $    | 26.34 |      |  | $    | 23.60 |  |  | $ | 22.78 | 

Note 8. Earnings Per Common
Share

Earnings per common share for the years ended
December 31, 2004, 2003, and 2002, were as follows:

|                                                         |  |      |         |      |  |      |         |   |  |   |         |  
|-------------------------------------------------------- |  | ---- | ------- | ---- |  | ---- | ------- | - |  | - | ------- | -
|                                                         |  | 2004 |         | 2003 |  | 2002
|(in thousands, except per share amounts)                 |  |      |         |      |  |     
|Net increase in net assets resulting from
    operations |  | $    | 249,486 |      |  | $    | 192,011 |   |  | $ | 228,291 |  
|Less preferred stock dividends                           |  |      | (62     | )    |  |      | (210    | ) |  |   | (230    | )
|                                                         |  |      |         |      |  |      |         |   |  |   |         |  
|Income available to common shareholders                  |  | $    | 249,424 |      |  | $    | 191,801 |   |  | $ | 228,061 |  
|                                                         |  |      |         |      |  |      |         |   |  |   |         |  
|Weighted average common shares
    outstanding  basic   |  |      | 129,828 |      |  |      | 116,747 |   |  |   | 102,107 |  
|Dilutive options outstanding to officers                 |  |      | 2,630   |      |  |      | 1,604   |   |  |   | 1,467   |  
|                                                         |  |      |         |      |  |      |         |   |  |   |         |  
|Weighted average common shares
    outstanding  diluted |  |      | 132,458 |      |  |      | 118,351 |   |  |   | 103,574 |  
|                                                         |  |      |         |      |  |      |         |   |  |   |         |  
|Basic earnings per common share                          |  | $    | 1.92    |      |  | $    | 1.64    |   |  | $ | 2.23    |  
|                                                         |  |      |         |      |  |      |         |   |  |   |         |  
|Diluted earnings per common share                        |  | $    | 1.88    |      |  | $    | 1.62    |   |  | $ | 2.20    |  
|                                                         |  |      |         |      |  |      |         |   |  |   |         |  

Note 9. 401(k) Plan and Deferred
Compensation Plans

The Companys 401(k) retirement investment
plan is open to all of its full-time employees who are at least
21 years of age. The employees may elect voluntary pre-tax
wage deferrals ranging from 0% to 100% of eligible compensation
for the year up to $13 thousand annually for the 2004 plan
year. Plan participants who reached the age of 50



---



##### 



ALLIED CAPITAL CORPORATION AND
SUBSIDIARIES


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)



Note 9. 401(k) Plan and Deferred
Compensation Plans, continued


during the 2004 plan year were eligible to defer
an additional $3 thousand during the year. The Company
makes contributions to the 401(k) plan of up to 5% of each
participants eligible compensation for the year up to a
maximum compensation permitted by the IRS, which fully vests at
the time of contribution. For the year ended December 31,
2004, the maximum compensation was $0.2 million. Employer
contributions that exceed the IRS limitation are directed to the
participants deferred compensation plan account. Total
401(k) contribution expense for the years ended
December 31, 2004, 2003, and 2002, was $0.9 million,
$0.7 million, and $0.6 million, respectively.

The Company also has a deferred compensation
plan. Eligible participants in the deferred compensation plan
may elect to defer some of their compensation and have such
compensation credited to a participant account. In addition, the
Company makes contributions to the deferred compensation plan on
compensation deemed ineligible for a 401(k) contribution.
Contribution expense for the deferred compensation plan for the
years ended December 31, 2004, 2003, and 2002, was
$0.7 million, $0.4 million, and $0.3 million,
respectively. All amounts credited to a participants
account are credited solely for purposes of accounting and
computation and remain assets of the Company and subject to the
claims of the Companys general creditors. Amounts credited
to participants under the deferred compensation plan are at all
times 100% vested and non-forfeitable. A participants
account shall become distributable upon his or her separation
from service, retirement, disability, death, or at a future
determined date. All deferred compensation plan accounts will be
distributed in the event of a change of control of the Company
or in the event of the Companys insolvency. Amounts
deferred by participants under the deferred compensation plan
are funded to a trust, which is administered by trustees. The
accounts of the deferred compensation trust are consolidated
with the Companys accounts. The assets of the trust are
classified as other assets and the liability to the plan
participants is included in other liabilities in the
accompanying financial statements. The deferred compensation
plan accounts at December 31, 2004 and 2003, totaled
$16.1 million and $13.0 million, respectively.

In the first quarter of 2004, the Company
established the Individual Performance Award (IPA)
as a long-term incentive compensation program for certain
officers. In conjunction with the program, the Board of
Directors has approved a non-qualified deferred compensation
plan (DCP II), which is administered through a
trust by an independent third-party trustee. The administrator
of the DCP II is the Compensation Committee of the
Companys Board of Directors (DCP II
Administrator).

The IPA, which will generally be determined
annually at the beginning of each year, is deposited in the
trust in four equal installments, generally on a quarterly
basis, in the form of cash. The Compensation Committee of the
Board of Directors designed the DCP II to require the
trustee to use the cash to purchase shares of the Companys
common stock in the open market. During 2004, 0.5 million
shares were purchased in the DCP II.

All amounts deposited and then credited to a
participants account in the trust, based on the amount of
the IPA received by such participant, are credited solely for
purposes of accounting and computation and remain assets of the
Company and subject to the claims



---



##### 



ALLIED CAPITAL CORPORATION AND
SUBSIDIARIES


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)



Note 9. 401(k) Plan and Deferred
Compensation Plans, continued


of the Companys general creditors. Amounts
credited to participants under the DCP II are immediately
vested and non-forfeitable once deposited by the Company into
the trust. A participants account shall generally become
distributable only after his or her termination of employment,
or in the event of a change of control of the Company. Upon the
participants termination of employment, one-third of the
participants account will be immediately distributed,
one-half of the then current remaining balance will be
distributed on the first anniversary of his or her employment
termination date and the remainder of the account balance will
be distributed on the second anniversary of the employment
termination date. Distributions are subject to the
participants adherence to certain non-solicitation
requirements. All DCP II accounts will be distributed in a
single lump sum in the event of a change of control of the
Company. To the extent that a participant has an employment
agreement, such participants DCP II account will be
fully distributed in the event that such participants
employment is terminated for good reason as defined under that
participants employment agreement. The DCP II
Administrator may also determine other distributable events and
the timing of such distributions. Sixty days following a
distributable event, the Company and each participant may, at
the discretion of the Company, and subject to the Companys
trading window during that time, redirect the participants
account to other investment options.

During any period of time in which a participant
has an account in the DCP II, any dividends declared and
paid on shares of the Companys common stock allocated to
the participants account shall be reinvested by the
trustee as soon as practicable in shares of the Companys
common stock purchased in the open market.

For the year ended December 31, 2004, the
Company recorded $13.4 million in IPA expense. These
amounts were contributed into the DCP II trust and invested
in the Companys common stock. The accounts of the
DCP II are consolidated with the Companys accounts.
The common stock is classified as common stock held in deferred
compensation trust in the accompanying financial statements and
the deferred compensation obligation, which represents the
amount owed to the employees, is included in other liabilities.
Changes in the value of the Companys common stock are not
recognized in the common stock held in deferred compensation
trust. However, the obligation is adjusted with a corresponding
charge or credit to compensation expense. The effect of this
adjustment for the year ended December 31, 2004, was to
reduce the individual performance award expense by
$0.4 million. This resulted in a total IPA expense of
$13.0 million for the year ended December 31, 2004.

Note 10. Stock Option Plan



| |                
| | ---------------
| | The Option Plan

The purpose of the stock option plan
(Option Plan) is to provide officers and non-officer
directors of the Company with additional incentives. Options are
exercisable at a price equal to the fair market value of the
shares on the day the option is granted. Each option states the
period or periods of time within which the option may be
exercised by



---



##### 



ALLIED CAPITAL CORPORATION AND
SUBSIDIARIES


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)



Note 10. Stock Option Plan,
continued


the optionee, which may not exceed ten years from
the date the option is granted. The options granted vest ratably
over a three- or five-year period.

All rights to exercise options terminate
60 days after an optionee ceases to be (i) a
non-officer director, (ii) both an officer and a director,
if such optionee serves in both capacities, or (iii) an
officer (if such officer is not also a director) of the Company
for any cause other than death or total and permanent
disability. In the event of a change of control of the Company,
all outstanding options will become fully vested and exercisable
as of the change of control.

At December 31, 2004, there were
32.2 million shares authorized under the Option Plan and
the number of shares available to be granted under the Option
Plan was 7.9 million. At December 31, 2003, there were
26.0 million shares authorized under the Option Plan and
the number of shares available to be granted under the Option
Plan was 8.8 million.

Information with respect to options granted,
exercised and forfeited under the Option Plan for the years
ended December 31, 2004, 2003, and 2002, is as follows:

|                                         |  |        |        |                |  |   |       | 
|---------------------------------------- |  | ------ | ------ | -------------- |  | - | ----- | 
|                                         |  |        |        | Weighted      
|                                         |  |        |        | Average       
|                                         |  |        |        | Exercise Price
|                                         |  | Shares |        | Per Share     
|(in thousands, except per share amounts) |  |        |        |               
|Options outstanding at January 1, 2002   |  |        | 10,480 |                |  | $ | 19.63 | 
|                                         |  |        |        |                |  |   |       | 
|Granted                                  |  |        | 6,162  |                |  | $ | 22.07 | 
|Exercised                                |  |        | (769   | )              |  | $ | 18.85 | 
|Forfeited                                |  |        | (1,184 | )              |  | $ | 21.09 | 
|                                         |  |        |        |                |  |   |       | 
|Options outstanding at December 31, 2002 |  |        | 14,689 |                |  | $ | 20.57 | 
|                                         |  |        |        |                |  |   |       | 
|Granted                                  |  |        | 1,045  |                |  | $ | 22.74 | 
|Exercised                                |  |        | (408   | )              |  | $ | 21.01 | 
|Forfeited                                |  |        | (442   | )              |  | $ | 21.66 | 
|                                         |  |        |        |                |  |   |       | 
|Options outstanding at December 31, 2003 |  |        | 14,884 |                |  | $ | 20.68 | 
|                                         |  |        |        |                |  |   |       | 
|Granted                                  |  |        | 8,170  |                |  | $ | 28.34 | 
|Exercised                                |  |        | (1,635 | )              |  | $ | 19.73 | 
|Forfeited                                |  |        | (1,059 | )              |  | $ | 26.07 | 
|                                         |  |        |        |                |  |   |       | 
|Options outstanding at December 31, 2004 |  |        | 20,360 |                |  | $ | 23.55 | 
|                                         |  |        |        |                |  |   |       | 



---



##### 



ALLIED CAPITAL CORPORATION AND
SUBSIDIARIES


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

Note 10. Stock Option Plan,
continued

The following table summarizes information about
stock options outstanding at December 31, 2004:

|                                                   |  |             |        |                  |  |          |      |             |  |          |       |  |  |  |        |  |  |   |       | 
|-------------------------------------------------- |  | ----------- | ------ | ---------------- |  | -------- | ---- | ----------- |  | -------- | ----- |  |  |  | ------ |  |  | - | ----- | 
|                                                   |  |             |        |                  |  |         
|                                                   |  | Outstanding |        |                 
|                                                   |  |             |        | Exercisable     
|                                                   |  |             |        | Weighted         |  |          |      |            
|                                                   |  |             |        | Average          |  | Weighted |      |             |  | Weighted
|                                                   |  | Total       |        | Remaining        |  | Average  |      | Total       |  | Average 
|Range of                                           |  | Number      |        | Contractual Life |  | Exercise |      | Number      |  | Exercise
|Exercise Prices                                    |  | Outstanding |        | (Years)          |  | Price    |      | Exercisable |  | Price   
|                                                   |  |             |        |                  |  |          |      |             |  |         
|                                                   |  |            
|(in thousands, except per share amounts and years) |  |            
|$16.81$21.38                                      |  |             | 4,978  |                  |  |          | 4.41 |             |  | $        | 18.75 |  |  |  | 4,962  |  |  | $ | 18.74 | 
|$21.52                                             |  |             | 4,488  |                  |  |          | 7.95 |             |  | $        | 21.52 |  |  |  | 2,982  |  |  | $ | 21.52 | 
|$21.59$26.29                                      |  |             | 4,389  |                  |  |          | 7.78 |             |  | $        | 23.18 |  |  |  | 2,818  |  |  | $ | 22.58 | 
|$26.73$27.38                                      |  |             | 315    |                  |  |          | 8.68 |             |  | $        | 27.06 |  |  |  | 104    |  |  | $ | 27.24 | 
|$28.98                                             |  |             | 6,190  |                  |  |          | 9.19 |             |  | $        | 28.98 |  |  |  | 1,547  |  |  | $ | 28.98 | 
|                                                   |  |             |        |                  |  |          |      |             |  |          |       |  |  |  |        |  |  |   |       | 
|$16.81$28.98                                      |  |             | 20,360 |                  |  |          | 7.44 |             |  | $        | 23.55 |  |  |  | 12,413 |  |  | $ | 21.63 | 
|                                                   |  |             |        |                  |  |          |      |             |  |          |       |  |  |  |        |  |  |   |       | 

The Company accounts for its stock options as
required by APB Opinion No. 25, Accounting for Stock
Issued to Employees, and accordingly no compensation cost
has been recognized as the exercise price equals the market
price on the date of grant.

Notes
Receivable from the Sale of Common Stock

As a business development company under the
Investment Company Act of 1940, the Company is entitled to
provide and has provided loans to the Companys officers in
connection with the exercise of options. However, as a result of
provisions of the Sarbanes-Oxley Act of 2002, the Company is
prohibited from making new loans to its executive officers in
the future. The outstanding loans are full recourse, have
varying terms not exceeding ten years, bear interest at the
applicable federal interest rate in effect at the date of issue
and have been recorded as a reduction to shareholders
equity. At December 31, 2004 and 2003, the Company had
outstanding loans to officers of $5.5 million, and
$18.6 million, respectively. Officers with outstanding
loans repaid principal of $13.2 million, $6.1 million,
and $3.7 million, for the years ended December 31,
2004, 2003, and 2002, respectively. The Company recognized
interest income from these loans of $0.5 million,
$1.3 million, and $1.5 million, respectively, during
these same periods. This interest income is included in interest
and dividends for companies less than 5% owned.



---



##### 



ALLIED CAPITAL CORPORATION AND
SUBSIDIARIES


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

Note 11. Dividends and
Distributions

For the years ended December 31, 2004, 2003,
and 2002, the Company declared the following distributions:

|                                               |                                            |        |        |           |  |        |      |           |  |        |        |           |  |   |      |      |  |   |        |         |  |   |      |      | 
|---------------------------------------------- | ------------------------------------------ | ------ | ------ | --------- |  | ------ | ---- | --------- |  | ------ | ------ | --------- |  | - | ---- | ---- |  | - | ------ | ------- |  | - | ---- | ---- | 
|                                               |                                            |        |        |           |  |       
|                                               |                                            | 2004   |        | 2003      |  | 2002  
|                                               |                                            |        |        |           |  |       
|                                               |                                            | Total  |        | Total Per |  | Total  |      | Total Per |  | Total  |        | Total Per
|                                               |                                            | Amount |        | Share     |  | Amount |      | Share     |  | Amount |        | Share    
|                                               |                                            |        |        |           |  |        |      |           |  |        |        |          
|($ in thousands, except per share
    amounts) |                                            |        |        |           |  |        |      |           |  |        |        |           |  |   |      |      |  |   |        |         |  |   |      |     
|First quarter                                  |                                            | $      | 73,357 |           |  | $      | 0.57 |           |  | $      | 62,971 |           |  | $ | 0.57 |      |  | $ | 53,259 |         |  | $ | 0.53 |     
|Second quarter                                 |                                            |        | 73,465 |           |  |        | 0.57 |           |  |        | 64,503 |           |  |   | 0.57 |      |  |   | 56,224 |         |  |   | 0.55 |     
|Third quarter                                  |                                            |        | 74,010 |           |  |        | 0.57 |           |  |        | 68,685 |           |  |   | 0.57 |      |  |   | 57,340 |         |  |   | 0.56 |     
|Fourth quarter                                 |                                            |        | 75,833 |           |  |        | 0.57 |           |  |        | 71,679 |           |  |   | 0.57 |      |  |   | 59,851 |         |  |   | 0.56 |     
|Extra dividend                                 |                                            |        | 2,661  |           |  |        | 0.02 |           |  |        |       |           |  |   |     |      |  |   | 3,261  |         |  |   | 0.03 |     
|                                               |                                            |        |        |           |  |        |      |           |  |        |        |           |  |   |      |      |  |   |        |         |  |   |      |     
|                                               | Total distributions to common shareholders |        | $      | 299,326   |  |        | $    | 2.30      |  |        | $      | 267,838   |  |   | $    | 2.28 |  |   | $      | 229,935 |  |   | $    | 2.23 | 
|                                               |                                            |        |        |           |  |        |      |           |  |        |        |           |  |   |      |      |  |   |        |         |  |   |      |     

For income tax purposes, distributions for 2004,
2003, and 2002, were composed of the following:

|                                               |                                                   |        |         |           |  |        |      |           |  |        |         |           |  |   |      |      |  |   |         |         |  |   |      |      | 
|---------------------------------------------- | ------------------------------------------------- | ------ | ------- | --------- |  | ------ | ---- | --------- |  | ------ | ------- | --------- |  | - | ---- | ---- |  | - | ------- | ------- |  | - | ---- | ---- | 
|                                               |                                                   |        |         |           |  |       
|                                               |                                                   | 2004   |         | 2003      |  | 2002  
|                                               |                                                   |        |         |           |  |       
|                                               |                                                   | Total  |         | Total Per |  | Total  |      | Total Per |  | Total  |         | Total Per
|                                               |                                                   | Amount |         | Share     |  | Amount |      | Share     |  | Amount |         | Share    
|                                               |                                                   |        |         |           |  |        |      |           |  |        |         |          
|($ in thousands, except per share
    amounts) |                                                   |        |         |           |  |        |      |           |  |        |         |           |  |   |      |      |  |   |         |         |  |   |      |     
|Ordinary income(1)                             |                                                   | $      | 145,365 |           |  | $      | 1.12 |           |  | $      | 212,272 |           |  | $ | 1.81 |      |  | $ | 178,246 |         |  | $ | 1.73 |     
|Long-term capital gains                        |                                                   |        | 153,961 |           |  |        | 1.18 |           |  |        | 55,566  |           |  |   | 0.47 |      |  |   | 51,689  |         |  |   | 0.50 |     
|                                               |                                                   |        |         |           |  |        |      |           |  |        |         |           |  |   |      |      |  |   |         |         |  |   |      |     
|                                               | Total distributions
    to common shareholders(2) |        | $       | 299,326   |  |        | $    | 2.30      |  |        | $       | 267,838   |  |   | $    | 2.28 |  |   | $       | 229,935 |  |   | $    | 2.23 | 
|                                               |                                                   |        |         |           |  |        |      |           |  |        |         |           |  |   |      |      |  |   |         |         |  |   |      |     



---

|    |                                                                                                                                                                                                                                           
|--- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(1) | For the years ended December 31, 2004 and
    2003, ordinary income included dividend income of approximately
    $0.04 per share and $0.05 per share, respectively,
    that qualified to be taxed at the 15% maximum capital gains rate.
|   
|(2) | For certain eligible corporate shareholders, the
    dividend received deduction for 2004 and 2003 was
    $0.038 per share and $0.044 per share, respectively.                                                                           



---



##### 



ALLIED CAPITAL CORPORATION AND
SUBSIDIARIES


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

Note 11. Dividends and
Distributions, continued

The following table summarizes the differences
between financial statement net increase in net assets resulting
from operations and taxable income available for distribution to
shareholders for the years ended December 31, 2004, 2003,
and 2002:

|                                                                             |                                                                            |                |         |         |         |      |         |        |         |   |         |         |         | 
|---------------------------------------------------------------------------- | -------------------------------------------------------------------------- | -------------- | ------- | ------- | ------- | ---- | ------- | ------ | ------- | - | ------- | ------- | ------- | 
|                                                                             |                                                                            | 2004           |         | 2003    |         | 2002
|                                                                             |                                                                            |                |         |         |         |     
|($ in thousands)                                                             |                                                                            | (ESTIMATED)    |         |         |         |     
|Financial statement net increase in net assets
    resulting from operations |                                                                            | $              | 249,486 |         |         | $    | 192,011 |        |         | $ | 228,291 |        
|Adjustments:                                                                 |                                                                            |                |         |         |         |      |         |        |         |   |         |        
|                                                                             | Net change in unrealized appreciation or
    depreciation                  |                |         | 68,712  |         |      |         | 78,466 |         |   |         | 571     |        
|                                                                             | Amortization of discounts and fees                                         |                |         | (10,396 | )       |      |         | 948    |         |   |         | (10,097 | )      
|                                                                             | Interest- and dividend-related items                                       |                |         | 3,630   |         |      |         | (2,400 | )       |   |         | 8,787   |        
|                                                                             | Employee compensation-related items                                        |                |         | 6,381   |         |      |         | 2,902  |         |   |         | 867     |        
|                                                                             | Net income (loss) from partnerships and limited
    liability companies(1) |                |         | 5,624   |         |      |         | (1,316 | )       |   |         | (3,822  | )      
|                                                                             | Realized gains deferred through installment
    treatment (2)              |                |         | (29,339 | )       |      |         |       |         |   |         |        |        
|                                                                             | Income (loss) from securitized commercial
    mortgage loans               |                |         |        |         |      |         | (251   | )       |   |         | 1,258   |        
|                                                                             | Net loss from consolidated SBIC
    subsidiary(3)                          |                |         | 15,615  |         |      |         |       |         |   |         |        |        
|                                                                             | Net (income) loss from consolidated taxable
    subsidiary, net of tax     |                |         | (1,008  | )       |      |         | 3,864  |         |   |         | (1,160  | )      
|                                                                             | Other                                                                      |                |         | 15,413  |         |      |         | (7,947 | )       |   |         | 4,740   |        
|                                                                             |                                                                            |                |         |         |         |      |         |        |         |   |         |        
|                                                                             |                                                                            | Taxable income |         | $       | 324,118 |      |         | $      | 266,277 |   |         | $       | 229,435 | 
|                                                                             |                                                                            |                |         |         |         |      |         |        |         |   |         |        




|    |                                                                                                                                                                                                                                                                                                                                                                   
|--- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(1) | Includes taxable income passed through to the
    Company from Business Loan Express, LLC in excess of
    interest and related portfolio income from BLX included in the
    financial statements totaling $10.0 million and
    $3.4 million for the years ended December 31, 2004 and
    2003, respectively. See Note 3 for additional related
    disclosure.
|   
|(2) | Includes the deferral of long-term capital gains
    through installment treatment related to the Companys sale
    of its control equity investment in Hillman.                                                                                                                                                                                                 
|   
|(3) | 2004 includes estimated capital loss
    carryforwards of $8.7 million.                                                                                                                                                                                                                                                                                           

The Company must distribute at least 90% of its
investment company taxable income to qualify for pass-through
tax treatment and maintain its RIC status. The Company has
distributed and currently intends to distribute or retain
through a deemed distribution sufficient dividends to eliminate
taxable income. Dividends declared and paid by the Company in a
year generally differ from taxable income for that year as such
dividends may include the distribution of current year taxable
income, less amounts carried forward into the following year,
and the distribution of prior year taxable income carried
forward into and distributed in the current year. Estimated
taxable income for 2004 includes undistributed income of
$27.5 million that is being carried forward for
distribution in 2005, which includes $7.1 million of
ordinary income and $20.4 million of net long-term capital
gains.

The Companys undistributed book earnings of
$12.1 million as of December 31, 2004, substantially
relate to undistributed long-term capital gains.



---



##### 



ALLIED CAPITAL CORPORATION AND
SUBSIDIARIES


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)



Note 11. Dividends and
Distributions, continued


At December 31, 2004 and 2003, the aggregate
gross unrealized appreciation of the Companys investments
above cost for federal income tax purposes was
$323.3 million (estimated) and $429.8 million,
respectively. At December 31, 2004 and 2003, the aggregate
gross unrealized depreciation of the Companys investments
below cost for federal income tax purposes was
$265.0 million (estimated) and $319.2 million,
respectively. The aggregate net unrealized appreciation of the
Companys investments over cost for federal income tax
purposes was $58.3 million (estimated) and
$110.6 million at December 31, 2004 and 2003,
respectively. At December 31, 2004 and 2003, the aggregate
cost of securities, for federal income tax purposes was
$3.0 billion (estimated) and $2.5 billion,
respectively.

The Companys consolidated subsidiary, AC
Corp, is subject to federal and state income taxes. The Company
recorded tax provisions of $1.1 million and
$0.9 million for the years ended December 31, 2004 and
2002, respectively, and a tax benefit of $2.5 million for
the year ended December 31, 2003. At December 31,
2004, 2003, and 2002, the Company had a net deferred tax asset
of $6.0 million, $3.1 million, and $0.4 million,
respectively, which was composed primarily of net operating loss
carry forwards. Management believes that the realization of the
net deferred tax asset is more likely than not based on
expectations as to future taxable income and scheduled reversals
of temporary differences. Accordingly, the Company did not
record a valuation allowance at December 31, 2004, 2003, or
2002.

Note 12. Cash and Cash
Equivalents

The Company places its cash with financial
institutions and, at times, cash held in checking accounts in
financial institutions may be in excess of the Federal Deposit
Insurance Corporation insured limit.

At December 31, 2004 and 2003, cash and cash
equivalents consisted of the following:

|                          |                                 |      |        |        |  |   |         |         | 
|------------------------- | ------------------------------- | ---- | ------ | ------ |  | - | ------- | ------- | 
|                          |                                 | 2004 |        | 2003  
|($ in thousands)          |                                 |      |        |       
|Cash and cash equivalents |                                 | $    | 57,576 |        |  | $ | 218,160 |        
|Less escrows held         |                                 |      | (416   | )      |  |   | (3,993  | )      
|                          |                                 |      |        |        |  |   |         |        
|                          | Total cash and cash equivalents |      | $      | 57,160 |  |   | $       | 214,167 | 
|                          |                                 |      |        |        |  |   |         |        

Note 13. Supplemental Disclosure of
Cash Flow Information

For the years ended December 31, 2004, 2003,
and 2002, the Company paid interest of $74.6 million,
$73.8 million, and $69.1 million, respectively.

Principal collections related to investment
repayments or sales include the collection of discounts
previously amortized into interest income and added to the cost
basis of a loan or debt security totaling $11.4 million,
$17.6 million, and $6.8 million, for the years ended
December 31, 2004, 2003, and 2002, respectively.



---



##### 



ALLIED CAPITAL CORPORATION AND
SUBSIDIARIES


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)



Note 13. Supplemental Disclosure of
Cash Flow Information, continued


Non-cash operating activities for the year ended
December 31, 2004, included notes or other securities
received as consideration from the sale of investments of
$56.6 million. The notes received for the year ended
December 31, 2004, included a note received for
$47.5 million in conjunction with the sale of the
Companys investment in Hillman. During the second quarter
of 2004, the Company sold a $5.0 million participation in
its subordinated debt in Hillman to a third party, which reduced
its investment, and no gain or loss resulted from the
transaction.

Non-cash operating activities for the year ended
December 31, 2004, also included an exchange of
$93.7 million of subordinated debt in certain predecessor
companies of Advantage Sales & Marketing, Inc. for new
subordinated debt in Advantage; an exchange of existing debt
securities with a cost basis of $46.4 million for new debt
and common stock in Startec Global Communications Corporation;
an exchange of existing debt securities with a cost basis of
$13.1 million for new debt of $11.3 million with the
remaining cost basis attributed to equity in Fairchild
Industrial Products Company; an exchange of existing loans with
a cost basis of $11.1 million for a new loan and equity in
Gordian Group, Inc.; the repayment in kind of $12.7 million
of existing debt in AHS with $10.0 million of debt in
MedBridge Healthcare, LLC and $2.7 million of debt and
equity from other companies; and an exchange of existing
subordinated debt with a cost basis of $7.3 million for
equity interests in an affiliate of Impact Innovations Group,
LLC. In addition, GACI acquired certain assets of Galaxy out of
bankruptcy during the third quarter of 2004. The Company
exchanged its $50.7 million outstanding debt in Galaxy for
debt and equity in GACI to facilitate the asset acquisition. See
Note 3 for related disclosures.

Finally, non-cash operating activities for the
year ended December 31, 2004, included $25.5 million
of CMBS bonds and LLC interests received from the
securitization of commercial mortgage loans.

Non-cash operating activities for the year ended
December 31, 2003, included transfers of commercial
mortgage loans and real estate owned in the repayment of the
Companys residual interest totaling $69.3 million,
real estate owned received in connection with foreclosure on
commercial mortgage loans of $9.1 million, receipt of
commercial mortgage loans in satisfaction of private finance
loans and debt securities of $9.1 million and receipt of a
note as consideration from the sale of real estate owned of $3.0
million. Non-cash operating activities for the year ended
December 31, 2002, included real estate owned received in
connection with foreclosure on commercial mortgage loans of
$2.5 million.

For the years ended December 31, 2004, 2003,
and 2002, the Companys non-cash financing activities
included stock option exercises and dividend reinvestment
totaling $5.8 million, $6.6 million and
$8.6 million, respectively. The non-cash financing
activities for the years ended December 31, 2004 and 2003,
also included the issuance of $3.2 million and
$0.9 million, respectively, of the Companys common
stock as consideration to acquire portfolio investments.



---



##### 



ALLIED CAPITAL CORPORATION AND
SUBSIDIARIES


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

Note 14. Hedging
Activities

The Company invests in CMBS and CDO bonds, which
are purchased at prices that are based in part on comparable
Treasury rates. The Company has entered into transactions with
one or more financial institutions to hedge against movement in
Treasury rates on certain of the higher rated CMBS and CDO
bonds. These transactions, referred to as short sales, involve
the Company receiving the proceeds from the short sales of
borrowed Treasury securities, with the obligation to replenish
the borrowed Treasury securities at a later date based on the
then current market price. Borrowed Treasury securities and the
related obligations to replenish the borrowed Treasury
securities at value, including accrued interest payable on the
obligations, as of December 31, 2004 and 2003, consisted of
the following:

|                                               |       |      |        |        |  |   |        |        | 
|---------------------------------------------- | ----- | ---- | ------ | ------ |  | - | ------ | ------ | 
|($ in thousands)                               |       |      |        |       
|Description of Issue                           |       | 2004 |        | 2003  
|                                               |       |      |        |       
|5-year Treasury securities, due November 2007  |       | $    |       |        |  | $ | 7,185  |       
|5-year Treasury securities, due February 2008  |       |      |       |        |  |   | 5,977  |       
|5-year Treasury securities, due December 2009  |       |      | 533    |        |  |   |       |       
|10-year Treasury securities, due November 2012 |       |      |       |        |  |   | 9,357  |       
|10-year Treasury securities, due February 2013 |       |      | 3,908  |        |  |   | 32,226 |       
|10-year Treasury securities, due May 2013      |       |      |       |        |  |   | 5,281  |       
|10-year Treasury securities, due August 2013   |       |      |       |        |  |   | 23,666 |       
|10-year Treasury securities, due November 2013 |       |      |       |        |  |   | 14,833 |       
|10-year Treasury securities, due February 2014 |       |      | 4,709  |        |  |   |       |       
|10-year Treasury securities, due August 2014   |       |      | 14,743 |        |  |   |       |       
|10-year Treasury securities, due November 2014 |       |      | 14,333 |        |  |   |       |       
|                                               |       |      |        |        |  |   |        |       
|                                               | Total |      | $      | 38,226 |  |   | $      | 98,525 | 
|                                               |       |      |        |        |  |   |        |       

As of December 31, 2004 and 2003, the total
obligations to replenish borrowed Treasury securities had
decreased since the related original sale dates due to changes
in the yield on the borrowed Treasury securities, resulting in
unrealized appreciation on the obligations of $0.3 million
and $0.6 million, respectively.

The net proceeds related to the sales of the
borrowed Treasury securities were $38.5 million and
$98.5 million at December 31, 2004 and 2003,
respectively. Under the terms of the transactions, the Company
had received cash payments of $0.3 million at December 31,
2004, and had provided additional cash collateral of
$18 thousand at December 31, 2003, for the difference
between the net proceeds related to the sales of the borrowed
Treasury securities and the obligations to replenish the
securities.

The Company has deposited the proceeds related to
the sales of the borrowed Treasury securities and the additional
cash collateral with Wachovia Capital Markets, LLC under
repurchase agreements. The repurchase agreements are
collateralized by U.S. Treasury securities and are settled
weekly. As of December 31, 2004, the repurchase agreements were
due on January 5, 2005, and had a weighted average interest
rate of 1.3%. The weighted average interest rate on the
repurchase agreements as of December 31, 2003 was 0.3%.



---



##### 



ALLIED CAPITAL CORPORATION AND
SUBSIDIARIES


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

Note 15. Financial Highlights

|                                                                                      |                       |                                                               |           |      |       |      |           |      |       |   |           |      |       |  
|------------------------------------------------------------------------------------- | --------------------- | ------------------------------------------------------------- | --------- | ---- | ----- | ---- | --------- | ---- | ----- | - | --------- | ---- | ----- | -
|                                                                                      |                       |                                                              
|                                                                                      |                       | At and for the Years                                         
|                                                                                      |                       | Ended December 31,                                           
|                                                                                      |                       |                                                              
|                                                                                      |                       | 2004                                                          |           | 2003 |       | 2002
|                                                                                      |                       |                                                               |           |      |       |     
|Per Common Share
    Data(1)                                                          |                       |                                                               |           |      |       |      |           |      |       |   |           |     
|Net asset value, beginning of year                                                    |                       | $                                                             | 14.94     |      |       | $    | 14.22     |      |       | $ | 13.57     |     
|                                                                                      |                       |                                                               |           |      |       |      |           |      |       |   |           |     
|                                                                                      | Net investment income |                                                               |           | 1.52 |       |      |           | 1.65 |       |   |           | 1.77 |      
|                                                                                      | Net realized gains(2) |                                                               |           | 0.88 |       |      |           | 0.63 |       |   |           | 0.44 |      
|                                                                                      |                       |                                                               |           |      |       |      |           |      |       |   |           |     
|                                                                                      |                       | Net investment income plus net realized gains                 |           |      | 2.40  |      |           |      | 2.28  |   |           |      | 2.21  |  
|                                                                                      |                       | Net change in unrealized appreciation or
    depreciation (2) |           |      | (0.52 | )    |           |      | (0.66 | ) |           |      | (0.01 | )
|                                                                                      |                       |                                                               |           |      |       |      |           |      |       |   |           |     
|Net increase in net assets resulting from
    operations                              |                       |                                                               | 1.88      |      |       |      | 1.62      |      |       |   | 2.20      |     
|                                                                                      |                       |                                                               |           |      |       |      |           |      |       |   |           |     
|Net decrease in net assets from shareholder
    distributions                         |                       |                                                               | (2.30     | )    |       |      | (2.28     | )    |       |   | (2.23     | )   
|Net increase in net assets from capital share
    transactions                        |                       |                                                               | 0.35      |      |       |      | 1.38      |      |       |   | 0.68      |     
|                                                                                      |                       |                                                               |           |      |       |      |           |      |       |   |           |     
|Net asset value, end of year                                                          |                       | $                                                             | 14.87     |      |       | $    | 14.94     |      |       | $ | 14.22     |     
|                                                                                      |                       |                                                               |           |      |       |      |           |      |       |   |           |     
|Market value, end of year                                                             |                       | $                                                             | 25.84     |      |       | $    | 27.88     |      |       | $ | 21.83     |     
|Total return(3)                                                                       |                       |                                                               | 1         | %    |       |      | 41        | %    |       |   | (7        | )%  
|Ratios and Supplemental Data($ and shares in thousands,
    except per share amounts) |                       |                                                               |           |      |       |      |           |      |       |   |           |     
|Ending net assets                                                                     |                       | $                                                             | 1,979,778 |      |       | $    | 1,914,577 |      |       | $ | 1,546,071 |     
|Common shares outstanding at end of year                                              |                       |                                                               | 133,099   |      |       |      | 128,118   |      |       |   | 108,698   |     
|Diluted weighted average common shares outstanding                                    |                       |                                                               | 132,458   |      |       |      | 118,351   |      |       |   | 103,574   |     
|Employee and administrative expenses/average net
    assets (4)                       |                       |                                                               | 4.65      | %    |       |      | 3.50      | %    |       |   | 3.82      | %   
|Total expenses/average net assets                                                     |                       |                                                               | 8.58      | %    |       |      | 8.06      | %    |       |   | 8.75      | %   
|Net investment income/average net assets                                              |                       |                                                               | 10.45     | %    |       |      | 11.51     | %    |       |   | 12.94     | %   
|Net increase in net assets resulting from
    operations/ average net assets          |                       |                                                               | 12.97     | %    |       |      | 11.33     | %    |       |   | 15.98     | %   
|Portfolio turnover rate                                                               |                       |                                                               | 32.97     | %    |       |      | 31.12     | %    |       |   | 15.12     | %   
|Average debt outstanding                                                              |                       | $                                                             | 985,616   |      |       | $    | 943,507   |      |       | $ | 938,148   |     
|Average debt per share(1)                                                             |                       | $                                                             | 7.44      |      |       | $    | 7.97      |      |       | $ | 9.06      |     



---

|    |                                                                                                                                                        
|--- | -------------------------------------------------------------------------------------------------------------------------------------------------------
|(1) | Based on diluted weighted average number of
    common shares outstanding for the year.                                                                
|   
|(2) | Net realized gains and net change in unrealized
    appreciation or depreciation can fluctuate significantly from
    year to year.                    
|   
|(3) | Total return assumes the reinvestment of all
    dividends paid for the periods presented.                                                             
|   
|(4) | Employee expenses for the year ended
    December 31, 2004, include the expense related to the
    individual performance award totaling $13.0 million.



---



##### 



ALLIED CAPITAL CORPORATION AND
SUBSIDIARIES


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

Note 16. Selected Quarterly Data
(Unaudited)

|                                                         |  |        |        |        |  |        |        |        |  |   |        |  |  |   |         | 
|-------------------------------------------------------- |  | ------ | ------ | ------ |  | ------ | ------ | ------ |  | - | ------ |  |  | - | ------- | 
|                                                         |  |       
|                                                         |  | 2004  
|                                                         |  |       
|($ in thousands, except per share amounts)               |  | Qtr. 1 |        | Qtr. 2 |  | Qtr. 3 |        | Qtr. 4
|                                                         |  |        |        |        |  |        |        |       
|Total interest and related portfolio income              |  | $      | 81,765 |        |  | $      | 87,500 |        |  | $ | 96,863 |  |  | $ | 100,962 | 
|Net investment income                                    |  | $      | 44,545 |        |  | $      | 48,990 |        |  | $ | 52,745 |  |  | $ | 54,678  | 
|Net increase in net assets resulting from
    operations |  | $      | 20,308 |        |  | $      | 95,342 |        |  | $ | 85,999 |  |  | $ | 47,837  | 
|Basic earnings per common share                          |  | $      | 0.16   |        |  | $      | 0.74   |        |  | $ | 0.67   |  |  | $ | 0.36    | 
|Diluted earnings per common share                        |  | $      | 0.15   |        |  | $      | 0.73   |        |  | $ | 0.66   |  |  | $ | 0.35    | 

|                                                         |  |        |        |        |  |        |        |        |  |   |        |  |  |   |        | 
|-------------------------------------------------------- |  | ------ | ------ | ------ |  | ------ | ------ | ------ |  | - | ------ |  |  | - | ------ | 
|                                                         |  |       
|                                                         |  | 2003  
|                                                         |  |       
|                                                         |  | Qtr. 1 |        | Qtr. 2 |  | Qtr. 3 |        | Qtr. 4
|                                                         |  |        |        |        |  |        |        |       
|Total interest and related portfolio income              |  | $      | 73,130 |        |  | $      | 77,214 |        |  | $ | 88,870 |  |  | $ | 90,015 | 
|Net investment income                                    |  | $      | 42,670 |        |  | $      | 44,598 |        |  | $ | 53,608 |  |  | $ | 54,254 | 
|Net increase in net assets resulting from
    operations |  | $      | 19,873 |        |  | $      | 59,940 |        |  | $ | 33,744 |  |  | $ | 78,454 | 
|Basic earnings per common share                          |  | $      | 0.18   |        |  | $      | 0.53   |        |  | $ | 0.28   |  |  | $ | 0.63   | 
|Diluted earnings per common share                        |  | $      | 0.18   |        |  | $      | 0.52   |        |  | $ | 0.28   |  |  | $ | 0.62   | 

Note 17. Litigation

The Company is party to certain lawsuits in the
normal course of business. While the outcome of these legal
proceedings cannot at this time be predicted with certainty, the
Company does not expect that these proceedings will have a
material effect upon the Companys financial condition or
results of operations.



---



##### 



ALLIED CAPITAL CORPORATION AND
SUBSIDIARIES

CONSOLIDATING BALANCE SHEET

|                                                                    |                                                             |                                            |        |            |           |        |        |              |         |       |        |        |         |  |         |          |          |   |        |           |           | 
|------------------------------------------------------------------- | ----------------------------------------------------------- | ------------------------------------------ | ------ | ---------- | --------- | ------ | ------ | ------------ | ------- | ----- | ------ | ------ | ------- |  | ------- | -------- | -------- | - | ------ | --------- | --------- | 
|                                                                    |                                                             |                                           
|                                                                    |                                                             | December 31, 2004                         
|                                                                    |                                                             |                                           
|                                                                    |                                                             | Allied                                     |        | Allied     |           |        |        | Consolidated
|                                                                    |                                                             | Capital                                    |        | Investment |           | Others |        | Eliminations |         | Total
|                                                                    |                                                             |                                            |        |            |           |        |        |              |         |      
|(in thousands)                                                      |                                                             |                                            |        |            |           |        |        |              |         |      
|ASSETS                                                             
|Portfolio at value:                                                 |                                                             |                                            |        |            |           |        |        |              |         |       |        |        |         |  |         |          |          |   |        |          
|                                                                    | Private finance                                             |                                            | $      | 2,179,798  |           |        | $      | 100,769      |         |       | $      | 21,519 |         |  | $       |         |          |   | $      | 2,302,086 |          
|                                                                    | Commercial real estate finance                              |                                            |        | 649,587    |           |        |        | 599          |         |       |        | 61,139 |         |  |         |         |          |   |        | 711,325   |          
|                                                                    | Investments in subsidiaries                                 |                                            |        | 136,681    |           |        |        |             |         |       |        | 5,768  |         |  |         | (142,449 | )        |   |        |          |          
|                                                                    |                                                             |                                            |        |            |           |        |        |              |         |       |        |        |         |  |         |          |          |   |        |          
|                                                                    |                                                             | Total portfolio at value                   |        |            | 2,966,066 |        |        |              | 101,368 |       |        |        | 88,426  |  |         |          | (142,449 | ) |        |           | 3,013,411 | 
|                                                                    |                                                             |                                            |        |            |           |        |        |              |         |       |        |        |         |  |         |          |          |   |        |          
|Deposits of proceeds from sales of borrowed
    Treasury securities |                                                             |                                            | 38,226 |            |           |        |       |              |         |       |       |        |         |  |        |          |          |   | 38,226 |          
|Accrued interest and dividends receivable                           |                                                             |                                            | 76,995 |            |           |        | 2,172  |              |         |       | 322    |        |         |  |        |          |          |   | 79,489 |          
|Other assets                                                        |                                                             |                                            | 33,927 |            |           |        | 3,023  |              |         |       | 35,762 |        |         |  |        |          |          |   | 72,712 |          
|Intercompany notes and receivables                                  |                                                             |                                            | 68,444 |            |           |        | 5,727  |              |         |       | 15,338 |        |         |  | (89,509 | )        |          |   |       |          
|Cash and cash equivalents                                           |                                                             |                                            |       |            |           |        | 46,184 |              |         |       | 10,976 |        |         |  |        |          |          |   | 57,160 |          
|                                                                    |                                                             |                                            |        |            |           |        |        |              |         |       |        |        |         |  |         |          |          |   |        |          
|                                                                    |                                                             | Total assets                               |        | $          | 3,183,658 |        |        | $            | 158,474 |       |        | $      | 150,824 |  |         | $        | (231,958 | ) |        | $         | 3,260,998 | 
|                                                                    |                                                             |                                            |        |            |           |        |        |              |         |       |        |        |         |  |         |          |          |   |        |          
|LIABILITIES AND SHAREHOLDERS
    EQUITY                           
|Liabilities:                                                        |                                                             |                                            |        |            |           |        |        |              |         |       |        |        |         |  |         |          |          |   |        |          
|                                                                    | Notes payable and debentures                                |                                            | $      | 987,068    |           |        | $      | 77,500       |         |       | $      |       |         |  | $       |         |          |   | $      | 1,064,568 |          
|                                                                    | Revolving line of credit                                    |                                            |        | 112,000    |           |        |        |             |         |       |        |       |         |  |         |         |          |   |        | 112,000   |          
|                                                                    | Obligations to replenish borrowed Treasury
    securities   |                                            |        | 38,226     |           |        |        |             |         |       |        |       |         |  |         |         |          |   |        | 38,226    |          
|                                                                    | Accounts payable and other liabilities                      |                                            |        | 40,107     |           |        |        | 2,117        |         |       |        | 24,202 |         |  |         |         |          |   |        | 66,426    |          
|                                                                    | Intercompany notes and payables                             |                                            |        | 26,479     |           |        |        | 25,085       |         |       |        | 37,945 |         |  |         | (89,509  | )        |   |        |          |          
|                                                                    |                                                             |                                            |        |            |           |        |        |              |         |       |        |        |         |  |         |          |          |   |        |          
|                                                                    |                                                             | Total liabilities                          |        |            | 1,203,880 |        |        |              | 104,702 |       |        |        | 62,147  |  |         |          | (89,509  | ) |        |           | 1,281,220 | 
|                                                                    |                                                             |                                            |        |            |           |        |        |              |         |       |        |        |         |  |         |          |          |   |        |          
|Commitments and contingencies                                       |                                                             |                                            |        |            |           |        |        |              |         |       |        |        |         |  |         |          |          |   |        |          
|Shareholders equity:                                               |                                                             |                                            |        |            |           |        |        |              |         |       |        |        |         |  |         |          |          |   |        |          
|                                                                    | Common stock                                                |                                            |        | 13         |           |        |        |             |         |       |        | 1      |         |  |         | (1       | )        |   |        | 13        |          
|                                                                    | Additional paid-in capital                                  |                                            |        | 2,094,421  |           |        |        | 36,712       |         |       |        | 93,377 |         |  |         | (130,089 | )        |   |        | 2,094,421 |          
|                                                                    | Common stock held in deferred compensation trust            |                                            |        | (13,503    | )         |        |        |             |         |       |        |       |         |  |         |         |          |   |        | (13,503   | )        
|                                                                    | Notes receivable from sale of common stock                  |                                            |        | (5,470     | )         |        |        |             |         |       |        |       |         |  |         |         |          |   |        | (5,470    | )        
|                                                                    | Net unrealized appreciation (depreciation) on
    portfolio |                                            |        | (107,767   | )         |        |        | (2,775       | )       |       |        | 1,258  |         |  |         | 1,517    |          |   |        | (107,767  | )        
|                                                                    | Undistributed (distributions in excess of)
    earnings     |                                            |        | 12,084     |           |        |        | 19,835       |         |       |        | (5,959 | )       |  |         | (13,876  | )        |   |        | 12,084    |          
|                                                                    |                                                             |                                            |        |            |           |        |        |              |         |       |        |        |         |  |         |          |          |   |        |          
|                                                                    |                                                             | Total shareholders equity                 |        |            | 1,979,778 |        |        |              | 53,772  |       |        |        | 88,677  |  |         |          | (142,449 | ) |        |           | 1,979,778 | 
|                                                                    |                                                             |                                            |        |            |           |        |        |              |         |       |        |        |         |  |         |          |          |   |        |          
|                                                                    |                                                             | Total liabilities and shareholders equity |        | $          | 3,183,658 |        |        | $            | 158,474 |       |        | $      | 150,824 |  |         | $        | (231,958 | ) |        | $         | 3,260,998 | 
|                                                                    |                                                             |                                            |        |            |           |        |        |              |         |       |        |        |         |  |         |          |          |   |        |          



---



##### 



ALLIED CAPITAL CORPORATION AND
SUBSIDIARIES

CONSOLIDATING STATEMENT OF
OPERATIONS

|                                                         |                                                           |                                             |         |            |         |        |        |              |        |       |        |        |        |   |         |         |         |   |         |         |         | 
|-------------------------------------------------------- | --------------------------------------------------------- | ------------------------------------------- | ------- | ---------- | ------- | ------ | ------ | ------------ | ------ | ----- | ------ | ------ | ------ | - | ------- | ------- | ------- | - | ------- | ------- | ------- | 
|                                                         |                                                           |                                            
|                                                         |                                                           | For the Year Ended December 31, 2004       
|                                                         |                                                           |                                            
|                                                         |                                                           | Allied                                      |         | Allied     |         |        |        | Consolidated
|                                                         |                                                           | Capital                                     |         | Investment |         | Others |        | Eliminations |        | Total
|                                                         |                                                           |                                             |         |            |         |        |        |              |        |      
|(in thousands)                                           |                                                           |                                             |         |            |         |        |        |              |        |      
|Interest and Related Portfolio Income                    |                                                           |                                             |         |            |         |        |        |              |        |       |        |        |        |   |         |         |         |   |         |        
|                                                         | Interest and dividends                                    |                                             | $       | 304,395    |         |        | $      | 10,551       |        |       | $      | 4,696  |        |   | $       |        |         |   | $       | 319,642 |        
|                                                         | Intercompany interest                                     |                                             |         | 5,076      |         |        |        |             |        |       |        |       |        |   |         | (5,076  | )       |   |         |        |        
|                                                         | Loan prepayment premiums                                  |                                             |         | 4,834      |         |        |        | 528          |        |       |        | 140    |        |   |         |        |         |   |         | 5,502   |        
|                                                         | Income from investments in wholly owned
    subsidiaries  |                                             |         | (13,185    | )       |        |        |             |        |       |        |       |        |   |         | 13,185  |         |   |         |        |        
|                                                         | Fees and other income                                     |                                             |         | 19,824     |         |        |        | 356          |        |       |        | 50,366 |        |   |         | (28,600 | )       |   |         | 41,946  |        
|                                                         |                                                           |                                             |         |            |         |        |        |              |        |       |        |        |        |   |         |         |         |   |         |        
|                                                         |                                                           | Total interest and related portfolio income |         |            | 320,944 |        |        |              | 11,435 |       |        |        | 55,202 |   |         |         | (20,491 | ) |         |         | 367,090 | 
|                                                         |                                                           |                                             |         |            |         |        |        |              |        |       |        |        |        |   |         |         |         |   |         |        
|Expenses                                                 |                                                           |                                             |         |            |         |        |        |              |        |       |        |        |        |   |         |         |         |   |         |        
|                                                         | Interest                                                  |                                             |         | 68,628     |         |        |        | 7,015        |        |       |        | 7      |        |   |         |        |         |   |         | 75,650  |        
|                                                         | Intercompany interest                                     |                                             |         |           |         |        |        | 190          |        |       |        | 4,886  |        |   |         | (5,076  | )       |   |         |        |        
|                                                         | Employee                                                  |                                             |         | 17,293     |         |        |        |             |        |       |        | 23,435 |        |   |         |        |         |   |         | 40,728  |        
|                                                         | Individual performance award                              |                                             |         | 7,417      |         |        |        |             |        |       |        | 5,594  |        |   |         |        |         |   |         | 13,011  |        
|                                                         | Administrative                                            |                                             |         | 47,129     |         |        |        | 112          |        |       |        | 17,045 |        |   |         | (28,600 | )       |   |         | 35,686  |        
|                                                         |                                                           |                                             |         |            |         |        |        |              |        |       |        |        |        |   |         |         |         |   |         |        
|                                                         |                                                           | Total operating expenses                    |         |            | 140,467 |        |        |              | 7,317  |       |        |        | 50,967 |   |         |         | (33,676 | ) |         |         | 165,075 | 
|                                                         |                                                           |                                             |         |            |         |        |        |              |        |       |        |        |        |   |         |         |         |   |         |        
|Net investment income before income taxes                |                                                           |                                             | 180,477 |            |         |        | 4,118  |              |        |       | 4,235  |        |        |   | 13,185  |         |         |   | 202,015 |        
|Income tax expense                                       |                                                           |                                             | 72      |            |         |        | 1      |              |        |       | 984    |        |        |   |        |         |         |   | 1,057   |        
|                                                         |                                                           |                                             |         |            |         |        |        |              |        |       |        |        |        |   |         |         |         |   |         |        
|Net investment income                                    |                                                           |                                             | 180,405 |            |         |        | 4,117  |              |        |       | 3,251  |        |        |   | 13,185  |         |         |   | 200,958 |        
|                                                         |                                                           |                                             |         |            |         |        |        |              |        |       |        |        |        |   |         |         |         |   |         |        
|Net Realized and Unrealized Gains (Losses)               |                                                           |                                             |         |            |         |        |        |              |        |       |        |        |        |   |         |         |         |   |         |        
|                                                         | Net realized gains (losses)                               |                                             |         | 137,793    |         |        |        | (20,990      | )      |       |        | 437    |        |   |         |        |         |   |         | 117,240 |        
|                                                         | Net change in unrealized appreciation or
    depreciation |                                             |         | (68,712    | )       |        |        | 33,749       |        |       |        | 8,030  |        |   |         | (41,779 | )       |   |         | (68,712 | )      
|                                                         |                                                           |                                             |         |            |         |        |        |              |        |       |        |        |        |   |         |         |         |   |         |        
|                                                         |                                                           | Total net gains (losses)                    |         |            | 69,081  |        |        |              | 12,759 |       |        |        | 8,467  |   |         |         | (41,779 | ) |         |         | 48,528  | 
|                                                         |                                                           |                                             |         |            |         |        |        |              |        |       |        |        |        |   |         |         |         |   |         |        
|Net increase in net assets resulting from
    operations |                                                           | $                                           | 249,486 |            |         | $      | 16,876 |              |        | $     | 11,718 |        |        | $ | (28,594 | )       |         | $ | 249,486 |        
|                                                         |                                                           |                                             |         |            |         |        |        |              |        |       |        |        |        |   |         |         |         |   |         |        



---



##### 



ALLIED CAPITAL CORPORATION AND
SUBSIDIARIES

CONSOLIDATING STATEMENT OF CASH
FLOWS

|                                                         |                                                                   |                                                                                  |                                                         |            |            |          |        |              |         |         |        |        |         |        |   |         |         |   |          |          |            |          |  
|-------------------------------------------------------- | ----------------------------------------------------------------- | -------------------------------------------------------------------------------- | ------------------------------------------------------- | ---------- | ---------- | -------- | ------ | ------------ | ------- | ------- | ------ | ------ | ------- | ------ | - | ------- | ------- | - | -------- | -------- | ---------- | -------- | -
|                                                         |                                                                   |                                                                                 
|                                                         |                                                                   | For the Year Ended December 31, 2004                                            
|                                                         |                                                                   |                                                                                 
|                                                         |                                                                   | Allied                                                                           |                                                         | Allied     |            |          |        | Consolidated
|                                                         |                                                                   | Capital                                                                          |                                                         | Investment |            | Others   |        | Eliminations |         | Total  
|                                                         |                                                                   |                                                                                  |                                                         |            |            |          |        |              |         |        
|(in thousands)                                           |                                                                   |                                                                                  |                                                         |            |            |          |        |              |         |        
|Cash flows from operating activities                     |                                                                   |                                                                                  |                                                         |            |            |          |        |              |         |         |        |        |         |        |   |         |         |   |          |         
|                                                         | Net increase in net assets resulting from
    operations          |                                                                                  | $                                                       | 249,486    |            |          | $      | 16,876       |         |         | $      | 11,718 |         |        | $ | (28,594 | )       |   | $        | 249,486  |           
|                                                         | Adjustments                                                       |                                                                                  |                                                         |            |            |          |        |              |         |         |        |        |         |        |   |         |         |   |          |          |           
|                                                         |                                                                   | Portfolio investments                                                            |                                                         |            | (1,438,867 | )        |        |              | (19,978 | )       |        |        | (13,551 | )      |   |         |        |   |          |          | (1,472,396 | )       
|                                                         |                                                                   | Principal collections related to investment
    repayments or sales              |                                                         |            | 868,496    |          |        |              | 33,816  |         |        |        | 6,877   |        |   |         |        |   |          |          | 909,189    |         
|                                                         |                                                                   | Change in accrued or reinvested interest and
    dividends                       |                                                         |            | (54,289    | )        |        |              | 2,095   |         |        |        | 1       |        |   |         |        |   |          |          | (52,193    | )       
|                                                         |                                                                   | Net change in intercompany investments                                           |                                                         |            | (7,891     | )        |        |              | 20,415  |         |        |        | 661     |        |   |         | (13,185 | ) |          |          |           |         
|                                                         |                                                                   | Amortization of discounts and fees                                               |                                                         |            | (4,651     | )        |        |              | (523    | )       |        |        | (61     | )      |   |         |        |   |          |          | (5,235     | )       
|                                                         |                                                                   | Changes in other assets and liabilities                                          |                                                         |            | 22,904     |          |        |              | 375     |         |        |        | (4,563  | )      |   |         |        |   |          |          | 18,716     |         
|                                                         |                                                                   | Depreciation and amortization                                                    |                                                         |            |           |          |        |              |        |         |        |        | 1,433   |        |   |         |        |   |          |          | 1,433      |         
|                                                         |                                                                   | Notes or other securities received as
    consideration from sale of investments |                                                         |            | (45,460    | )        |        |              | (2,037  | )       |        |        |        |        |   |         |        |   |          |          | (47,497    | )       
|                                                         |                                                                   | Realized losses                                                                  |                                                         |            | 123,818    |          |        |              | 26,631  |         |        |        | 13      |        |   |         |        |   |          |          | 150,462    |         
|                                                         |                                                                   | Net change in unrealized appreciation or
    depreciation                        |                                                         |            | 68,712     |          |        |              | (33,749 | )       |        |        | (8,030  | )      |   |         | 41,779  |   |          |          | 68,712     |         
|                                                         |                                                                   |                                                                                  |                                                         |            |            |          |        |              |         |         |        |        |         |        |   |         |         |   |          |         
|                                                         |                                                                   |                                                                                  | Net cash provided by (used in) operating
    activities |            |            | (217,742 | )      |              |         | 43,921  |        |        |         | (5,502 | ) |         |         |  |          |          |            | (179,323 | )
|                                                         |                                                                   |                                                                                  |                                                         |            |            |          |        |              |         |         |        |        |         |        |   |         |         |   |          |         
|Cash flows from financing activities                     |                                                                   |                                                                                  |                                                         |            |            |          |        |              |         |         |        |        |         |        |   |         |         |   |          |         
|                                                         | Sale of common stock                                              |                                                                                  |                                                         | 70,251     |            |          |        |             |         |         |        |       |         |        |   |        |         |   |          | 70,251   |           
|                                                         | Sale of common stock upon the exercise of stock
    options       |                                                                                  |                                                         | 32,274     |            |          |        |             |         |         |        |       |         |        |   |        |         |   |          | 32,274   |           
|                                                         | Collections of notes receivable from sale of
    common stock     |                                                                                  |                                                         | 13,162     |            |          |        |             |         |         |        |       |         |        |   |        |         |   |          | 13,162   |           
|                                                         | Borrowings under notes payable and debentures                     |                                                                                  |                                                         | 340,212    |            |          |        |             |         |         |        |       |         |        |   |        |         |   |          | 340,212  |           
|                                                         | Repayments on notes payable and debentures                        |                                                                                  |                                                         | (214,000   | )          |          |        | (17,000      | )       |         |        |       |         |        |   |        |         |   |          | (231,000 | )         
|                                                         | Net borrowings under (repayments on) revolving
    line of credit |                                                                                  |                                                         | 112,000    |            |          |        |             |         |         |        |       |         |        |   |        |         |   |          | 112,000  |           
|                                                         | Redemption of preferred stock                                     |                                                                                  |                                                         |           |            |          |        | (7,000       | )       |         |        |       |         |        |   |        |         |   |          | (7,000   | )         
|                                                         | Purchase of common stock held in deferred
    compensation trust  |                                                                                  |                                                         | (13,687    | )          |          |        |             |         |         |        |       |         |        |   |        |         |   |          | (13,687  | )         
|                                                         | Other financing activities                                        |                                                                                  |                                                         | (3,004     | )          |          |        |             |         |         |        |       |         |        |   |        |         |   |          | (3,004   | )         
|                                                         | Common stock dividends and distributions paid                     |                                                                                  |                                                         | (290,830   | )          |          |        |             |         |         |        |       |         |        |   |        |         |   |          | (290,830 | )         
|                                                         | Preferred stock dividends paid                                    |                                                                                  |                                                         |           |            |          |        | (52          | )       |         |        | (10    | )       |        |   |        |         |   |          | (62      | )         
|                                                         |                                                                   |                                                                                  |                                                         |            |            |          |        |              |         |         |        |        |         |        |   |         |         |   |          |         
|                                                         |                                                                   |                                                                                  | Net cash provided by (used in) financing
    activities |            |            | 46,378   |        |              |         | (24,052 | )      |        |         | (10    | ) |         |         |  |          |          |            | 22,316   |  
|                                                         |                                                                   |                                                                                  |                                                         |            |            |          |        |              |         |         |        |        |         |        |   |         |         |   |          |         
|Net increase (decrease) in cash and cash
    equivalents |                                                                   |                                                                                  | (171,364                                                | )          |            |          | 19,869 |              |         |         | (5,512 | )      |         |        |  |         |         |   | (157,007 | )       
|Cash and cash equivalents at beginning of year           |                                                                   |                                                                                  | 171,364                                                 |            |            |          | 26,315 |              |         |         | 16,488 |        |         |        |  |         |         |   | 214,167  |         
|                                                         |                                                                   |                                                                                  |                                                         |            |            |          |        |              |         |         |        |        |         |        |   |         |         |   |          |         
|Cash and cash equivalents at end of year                 |                                                                   | $                                                                                |                                                        |            |            | $        | 46,184 |              |         | $       | 10,976 |        |         | $      |  |         |         | $ | 57,160   |         
|                                                         |                                                                   |                                                                                  |                                                         |            |            |          |        |              |         |         |        |        |         |        |   |         |         |   |          |         



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ALLIED CAPITAL CORPORATION AND SUBSIDIARIES Stockholder
Information Corporate Headquarters
    
    Market Listings
    
    Information Requests1919 Pennsylvania Avenue, NW
Washington, DC 20006
Toll Free: 888.818.5298
Telephone: 202.331.1112
Fax: 202.659.2053
www.alliedcapital.com Regional Offices 
401 North Michigan Avenue
Suite 2050
Chicago, IL 60611
Telephone: 312.828.0330
Fax: 312.828.0909 
520 Madison Avenue
27th Floor
New York, NY 10022
Telephone: 212.246.0616
Fax: 212.246.0618 
11111 Santa Monica Boulevard
Suite 2100
Los Angeles, CA 90025
Telephone: 310.231.7410
Fax: 310.231.7411
    
    Allied Capital Corporations common
stock trades on the New York Stock
Exchange under the trading symbol
ALD. There are approximately
4,700 shareholders of record and
approximately 165,000 beneficial
shareholders of the Company. Stock Transfer Agent & Registrar 
Investors with questions concerning
account information, new certificate
issuances, lost or stolen certificate
replacement, securities transfers,
participation in the dividend
reinvestment plan, dividend payments,
direct deposit information, or the
processing of a change of address
should contact: 
American Stock Transfer
& Trust Company
59 Maiden Lane, 1st Floor
New York, NY 10038
Telephone: 800.937.5449 or 212.936.5100
www.amstock.com
    
    Allied Capital Corporations annual report on Form
10-K, all quarterly reports on Form 10-Q, and all other
filings made with the Securities and Exchange
Commission are available on the Companys web site.
Hard copies will be provided without charge to
shareholders upon written request to the Investor
Relations Department at the Companys corporate
headquarters, or may be requested online in the
Investors Resources section of www.alliedcapital.com. Investor Relations 
IR Hotline: 888.253.0512
ir@alliedcapital.com Independent Public Accountants 
KPMG LLP
Washington, DC Corporate Counsel 
Sutherland Asbill & Brennan LLP
Washington, DC Annual Meeting of Stockholders 
The Companys Annual Meeting of Stockholders will
be held at 10:00 a.m. on Tuesday, May 17, 2005, at
the Four Seasons Hotel, 2800 Pennsylvania Avenue,
NW, Washington, DC. All stockholders are welcome to attend.
 Quarterly Stock Prices for 2004 and 2003 2004
    
    
    2003Q1
    
    
    Q2
    
    
    Q3
    
    
    Q4
    
    
    Q1
    
    
    Q2
    
    
    Q3
    
    
    Q4High
    
    $
    30.85
    
    
    $
    30.25
    
    
    $
    25.80
    
    
    $
    28.47
    
    
    $
    23.85
    
    
    $
    25.16
    
    
    $
    26.60
    
    
    $
    28.16Low
    
    $
    27.15
    
    
    $
    23.06
    
    
    $
    22.22
    
    
    $
    24.46
    
    
    $
    19.82
    
    
    $
    19.85
    
    
    $
    22.97
    
    
    $
    24.63Close
    
    $
    30.29
    
    
    $
    24.42
    
    
    $
    24.39
    
    
    $
    25.84
    
    
    $
    19.98
    
    
    $
    23.10
    
    
    $
    24.59
    
    
    $
    27.88